Question: are we in a bull market or bear market? What if there was a third option? In Active Value Investing: Making Money in Range-bound Markets, Vitaliy Katsenelson makes a case that the current market is actually a "range-bound market" and then gives you the tools to take full advantage of the fact.
What is a Range Bound Market?
Range-bound markets are characterized by their roller-coaster-like volatility and the fact that despite this volatility, money invested in the beginning of the cycle will have close to 0% gains by the end of the cycle. In fact, range-bound markets are more common than bear markets. Katsenelson says:
"…if you look at the U.S. stock market during the entire twentieth century, most of the prolonged (greater than five years) markets were actually bull or range-bound markets. Prolonged bear (declining) markets happened in the past only when high market valuation was coupled with significant economic deterioration, similar to what was going on in Japan from the late 1980s through 2003 or so."
This chart from the book shows the past 107 years bull, bear, and range-bound markets as labeled by Kevin A. Turtle.
Chart by Kevin A. Turtle
You’ll notice that each of the big bull markets was followed by a dip into a prolonged range-bound market. Our current market looks like it is trading in a range (with us on the upswing right now). And though we’re at an all-time high, the market-wide average P/E is still way below it’s pre-2001 levels.
The past shows us that we are due for a range-bound market. I’m not a huge fan of the "since this is how it worked in the past century, this is how things will work now" argument. Many authors stop at just that. Luckily for Katsenelson, he kept my interest by going deeper into things and explaining WHY he thinks the cycle will continue.
This was huge for me. Instead of using faith in history to predict the market, VK discusses human psychology and how the act of going through a long-term bull market (where you never lose going long and your biggest weakness is taking things too slow) affects your investment decisions going forward. What follows is a market of investors who are just more conservative than they were in the bull run, and the end result is a long period of "PE contraction". VK explains this in easy-to-read, convincing language.
Another great summary of why range-bound markets exists comes on page 168:
"If we can agree that the difference between low- and high-P/E stocks is the expectation of growth, this means that in the beginning of a range-bound market investors are willing to pay 200 percent premium for growth, whereas at the end of a range-bound market investors are willing to pay only a 40 percent premium."
Why do I care? What should I do?
Learning about range-bound markets will give you several "aha" moments that will help you think of the current market environment in new ways. But, understanding range-bound markets is just the first part of the book. The more applicable lessons come in the later sections.
The "analytics" section introduces the QVG framework (for quality, valuation, and growth). The basic gist is that because market-wide P/E depreciation is going to eat into profits, you need to be more diligent across these three "vectors" to choose outstanding stocks that will provide greater returns.
Some of the material in the QVG section may be familiar to those of you have read a few investment books. But I think it is still valuable to read these sections closely as there are a lot of good gems in the details. I found VK’s treatment of stock buy backs especially pertinent to some of the tech stocks I trade.
I also appreciated the discussion on sources of growth. We all know to look for Google-like stocks with high earnings and return on investment capital (ROIC) growth rates, but it is also important to know where a company’s growth is coming from so we know how long the growth will last or if something material might happen to affect that growth.
These are the types of details you’ll get out of the book. And even if you’ve been exposed to this stuff before, it is always great to be reminded of it. Additionally, thinking of things from the range-bound angle will bring new meaning to old concepts.
Putting the Value in Active Value Investing
The chapter on value has a cute story about "Tevye the Milkman" and his cow "Golde", which does a great job of explaining how stock evaluation work. It’s a bit elementary, but a fun read anyway. Later in the chapter VK gets into a discussion of "Relative" vs. "Absolute" valuation tools. An example of a relative valuation tool would be the P/E, which is a measure of price relative to earnings. Absolute valuation models are great because they ground your observation in the real world. This is similar to Peter’s Main Street vs. Wall Street analysis or my balking on my GOOG analysis (though I still went long GOOG then and am long now).
If you are a numbers geek (like me), you’ll really like Katsenelson’s treatment of "Absolute P/E". We always say stuff like "I am willing to pay more for the quality of stock x". VK puts specific values on statements like these. What is quality management worth? What is best of breed worth? All of these impact V’s "absolute P/E" calculation, which is very much like calculating the base P/E that we are used to and then adding or docking points based on how the company stands up across a number of factors.
I also like some of the additions VK makes to the typical margin of safety (MOS) discussion. In general stocks with higher growth and dividends can be invested in with lower MOS because less of the gain in stock price will be due to MOS. whereas a stock with 0 growth will gain ALL of its price from MOS.
The typical Graham/Buffet/Town rule-of-thumb is to shoot for a 50% MOS. Katsenelson gives a method for adjusting the required MOS (based on a number of risk factors) before jumping into a stock. This is great because in bull runs, it can be very hard to find solid companies with 50% MOS. Phil Town will tell you that "if you are more familiar with a company, you can lower your required MOS". Vitaliy Katsenelson gives you mathematical way to figure out the exact MOS you can buy at.
Again, the math in the book isn’t too complicated, but it’s there. It shouldn’t scare anyone away from reading the book, but it may get those of you who thrive on quantitative frameworks excited. One of the reasons folks like me like bringing math into investing and other activities like playing poker, is that it allows us to remove our emotions from the game. The goal is to find a formula that makes money that you can replicate over and over. If your formula loses money on a trade (because we’ll all lose money on trades some of the time) it’s easier to handle than if you make the decision based on "feeling" or other less concrete methods.
The Formula. The Strategy.
The strategy section of the book puts forth a pretty simple three-part strategy and then dives further into each part.
- Assemble a portfolio of the right companies.
- Buy them at the right prices.
- Sell them at the right prices.
By the time you get to this section, you’ll have all of the tools (based on the QVG framework) to achieve each of these objectives. The remaining pages include a number of anecdotes and examples that will help you execute the strategy. You’ll see headings like "Think Long Term, Act Short Term", "Decide How the Game Will End Before It Starts", and "Location of Corporate Headquarters Abroad May Not Constitute a Foreign Company". Again, these are anecdotes you may be familiar with. Chances are there are a few in there, you’re not. I enjoyed VK’s fresh view on these concepts and came away with a greater understanding than I had before.
Overall, Active Value Investing is a good read. The concept of a range-bound market is one that you may not have been exposed to yet. Understanding how the range-bound market comes to be and the properties it has will help you understand the current market.
Additionally, while the active value investing model is presented as the best strategy to use in a range-bound market, it’s also not too shabby in a bull (or even bear) market. You’ll have to dig into the book to learn why, but the system VK describes will earn you the most money in a highly volatile market like we are in and save you the most money in a full on bear market. In bull markets, you might be giving up a few % points of return, but this may be worth it for the extra sleep you’ll be getting. And it will defiantly benefit you when the market eventually falls.
This book was a risky one for Katsenelson to write. As he admits in the introduction, books about bull markets sure do sell better… they’re just more exciting. Also, if the market continue to shoot up, VK runs the risk of having a book on the market with a failed prediction at the core. I admire and appreciate VK for writing this book. I think it’s an especially good read in today’s market environment but also a book that you could learn from no matter what.
At $50 for the hard cover, you might want to go-in on this with a buddy or spend a couple days at your local bookstore. If you’re rich, you can buy it now from Amazon and support our site a bit. Link below.
Update: Amazon has been selling the book in the low $30s, which is a good deal. Follow the link below to get the latest price.
Rating: 4 out of 5 stars
Best Suited For: Value-minded folks managing their own portfolios.
Buy the Book: Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance)