Vitaliy Katsenelson's 'Active Value Investing' helps make sense of it all

There's one book out there that helps to define what is taking place in this 'flip-flop' market.  I had the pleasure of reading a copy of Vitaliy Katsenelson's 'Active Value Investing' and I highly recommend it to any investor that is looking for a decent guide to today's market.

Click here to shop for his book on Amazon.com.  Vitaliy recently wrote the following article in Financial Planning Magazine:

I believe over the next dozen or so years, the U.S. stockmarket will experience plenty of volatility but will ultimately go nowhere, with the average U.S. stock ending roughly at the same level as it is today. The market will be what I call range-bound, where buy-and-hold and passive index investors can expect close to 0% stock returns and meager dividends.

I know this prediction has a science fiction feel to it, but consider that over the past 200 years, every full-blown, long-lasting bull market-we just had a supersize one from 1982 to 2000-was followed by a range-bound market that lasted roughly 15 years. (The current range-bound market may last longer because it started at very high valuations.) This happened every time over the last two centuries, with the exception of the Great Depression.

Why? Contrary to common perception, inflation, gross domestic product or earnings growth-although responsible for short-term market volatility-have not driven long-term stock market cycles. The long-term driver has, in fact, been the compression of high market valuations. Dividends aside, returns from stocks can be mathematically explained by two variables: earnings growth and price-to-earnings expansion. During bull markets, a vibrant combination of P/E expansion and earnings growth brings outsize returns to jubilant investors. Prolonged bull markets end with P/Es much above average-the year 2000 market ended with the highest valuations we had observed in the 20th century. P/Es, however, are mean-reverting creatures, and after a bull market, high P/Es will head down toward and below the average. This P/E compression wipes out most, if not all, earnings growth, resulting in meager returns.

Today's corporate profit margins are at a 25-year high. Similar to P/Es, profit margins are extremely mean- reverting: As companies start to earn above-average economic profits, new competition waltzes in and draws these excess profits away. If these corporate profit margins revert to their 25-year average, or a decrease of 3%, earnings would drop 25%. As a result, the P/E would jump to 23 times earnings, making stocks less than a bargain. So where can an investor look for returns?

Investment Framework

I propose active value investing using a quality, valuation and growth framework. I see quality as a sustainable competitive advantage, a strong balance sheet, great management, a high return on capital and so forth. Growth comprises earnings growth and dividends. I've found that 90% of the return in previous range-bound markets came from dividends, versus less than 20% in previous bull markets. And, instead of focusing on relative valuation, buy based on what a company's future cash flows will bring. To combat P/E compression in the range-bound market look for a higher discount to intrinsic value (what a company is worth) when you buy a stock.

In the 1966 to 1982 range-bound market, value stocks killed growth. They had a lower P/E compression and bull-market-like returns; plus, the lower P/E led to a higher dividend yield.

In a range-bound market, you'll often be selling when others are buying and vice versa. While maintaining your long-term investment mind-set, your objective will be to time individual stocks (but not to time the market!) by buying when they are undervalued and selling when they are fairly valued.

And what if a range-bound market isn't in the cards? If a bull market develops, active value investing should do at least as well as buy-and-hold investing or passive indexing. In the case of a bear market, your portfolio should decline a lot less. After all, you'll own high-quality companies that grow earnings and pay above-average dividends.

Vitaliy N. Katsenelson is the portfolio manager of Investment Management Associates and author of Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007). Visit www.activevalueinvesting.com.