Active Value Investing

VITALIY N. KATSENELSON, CFA, has been involved with the investment industry since 1994. He is a portfolio manager with Investment Management Associates, where he comanages institutional and personal assets utilizing fundamental analysis. He is also an adjunct faculty member at the University of Colorado at Denver, Graduate School of Business. Katsenelson is a regular contributor to the Financial Times, MarketWatch from Dow Jones, and Minyanville.com. He is a CFA charter holder, member of CFA Institute, has served on the boards of the CFA Society of Colorado, and is currently on the board of the Retirement Investment Institute. Katsenelson received both his bachelor of science and his master of science in finance from the University of Colorado at Denver, where he graduated cum laude. To read articles Katsenelson has written over the years, please visit: ContrarianEdge.com or ActiveValueInvesting.com

• Preface xiiiPart One What the Future HoldsChapter 1 Introduction: Range-Bound Markets Happen 3Fasten Your Seat Belts and Lower Your Expectations 3Let’s Identify the Animal 4Secular versus Cyclical 4Distinction between Secular Bull, Bear, and Range-Bound Markets 6Is 100 Years Long Enough? 7Stocks Carried the Torch in the Long-Run Marathon 8International Stocks Were Bright Lights, Too 10Will Gold Shine Again? 11Gold’s Recently Emerged Competition 13The Deception of the Long Run (Marathon) 14Range-Bound Markets Erode Bull Market Returns 15The Long Run for Us May Be Shorter Than We Think 17Chapter 2 Emotions of Secular Bull, Bear, and Range-Bound Markets 23Bull Market Euphoria 23Bear Market Doldrums 25What Does a Secular Range-Bound Market Feel Like? 29Volatility of Bull and Range-Bound Markets 31Chapter 3 Stock Market Math 37Sources of Capital Appreciation: Earnings Growth 38Sources of Capital Appreciation: Price to Earnings 48Sources of Dividend Yield 57Why Range-Bound Markets Follow Bull Markets 61It Is Not Over Until It Is Over 62Chapter 4 Bonds: A Viable Alternative? 67Why Not Bonds? 67Asset Allocation Role Is Diminished in Range-Bound Markets 69Part Two Active Value Investing AnalyticsIntroduction to Analytics: The Quality, Valuation, and Growth Framework 77Chapter 5 The ‘‘Q’’—Quality 79Competitive Advantage 79Management 82Predictable Earnings 89Strong Balance Sheet 91Significance of Free Cash Flows 95High Return on Capital 102Conclusion 102Chapter 6 The ‘‘G’’—Growth 103Sources of Growth: Earnings Growth and Dividends 103Past Has Passed 111Future Engines of Growth 112Dividends 114Growth Matters—A Lot! 117Chapter 7 The ‘‘V’’—Valuation 119Tevye the Milkman’s Approach to Valuation 119Review of Relative Valuation Tools 128Absolute Valuation Tools—Discounted Cash Flow Analysis 132Relative versus Absolute Tools 134Absolute Models Overview 136The False Precision of Math 137Absolute P/E Model 139Discount Rate Model 148Margin of Safety Model 151The Marriage of Absolute P/E and Margin of Safety 155Bring Out the Toolbox 155The P/E Compression and How to Deal with It 157Chapter 8 Let’s Put It All Together 165The Added Clarity 165One Out of Three Is Not Enough 165Two Out of Three Is Better, But Is It Enough? 167Conclusion 174StrategyIntroduction to Strategy: The Value of Process and Discipline 177Chapter 9 Buy Process—Fine-Tuning 179The Value of the Process and Discipline 179Think Long-Term, Act Short-Term 181Meet Your New Best Friend—Volatility 182Time Stocks, Not the Market 183Cash Is King 185Be Ready to Strike When the Time Comes 186Chapter 10 Buy Process—Contrarian Investing 187Contrarian Is the Name of the Game 187You Don’t Have to Own It 189Be a Myth Buster 190Quantify Everything and Be a Contrarian Headline Investor 191Time Arbitrage 192Finding New Ideas 193Do In-Depth Primary (Your Own) Research and Document It 200Chapter 11 Buy Process—International Investing 201The World Has Flattened: Hola, Bonjour, Guten Tag, Buon Giorno to the Rest of the World 201Same Difference 202Location of Corporate Headquarters Abroad May Not Constitute a Foreign Company 203You Are Exposed to More Foreign Political Risk Than You Realize 204What About the United States? 205Pick Your Comfort Zone and Go from There 206Don’t Confuse a Fast-Growing Economy and a Good Investment 207Currency Risk 207How Much Is Too Much? 208Conclusion 209Chapter 12 Sell Process—Make Darwin Proud 211Selling When Stock Price Has Gone Up 212Selling When Fundamentals Have Deteriorated 215Conclusion 221Risk and DiversificationIntroduction to Risk and Diversification 225Chapter 13 A Different View of Risk 227What Is Risk? 227Properties of Randomness 228The Crocodile Hunter, Randomness, and Investing 229Understand the Linkage Between and Inside QVG Dimensions 234Identify Impact of Randomness on Value Creators 235The Cost of Being Wrong 238Conclusion 239Chapter 14 A Different View of Diversification 241Don’t Bet the Farm! 242Too Many Eggs or Too Many Baskets 243Mental Accounting and Diversification 244Mental Accounting and Randomness in a Stock Portfolio 246Randomness Could Be Your Friend 248Chapter 15 Conclusion and Implication 251I Could Be Wrong, But I Doubt It 251Bull Markets 252Bear and Range-Bound Markets 253Bonds? 255No, I Am Not Wrong 256Appendix—Years to Bull Market 257Acknowledgments 267Notes 273Index 275

Katsenelson's is straightforward enough to keep a rookie investor engaged, and in-depth enough to retain the interest of old pros, which makes this a great book for those of all skill levels. He does a comprehensive job of reviewing the market's past, projecting its potential future, and developing a case for why value investing will shine as the market stagnates. He combines historical and financial analysis, along with engaging stories from his experience as a professional investment manager.--Chuck Saletta, Motley Fool This book should be considered a practical compendium of modern finance, leaving no stones unturned on your way to better investments. Katsenelson’s passionate, witty and accessible writing expertly takes the reader through his original framework for valuing stocks in range-bound markets. A student of history and an overzealous stock picker, the author entertainingly illustrates every concept with a collection of real-world examples, demonstrating an impressive breadth and depth of understanding of what makes stocks move!--J.P. Tremblay, CFA"How to adapt value investing for "range-bound" markets." (Financial Times, Tues 26th February 2008)"The new Benjamin Graham is Vitaliy N. Katsenelson. I highly recommend Katsenelson's book, Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007). I like to think the old Ben Graham would have recommended it, too."--Forbes