The Little Book Of Sideways Markets by Vitaliy Katsenelson

Summary

Bull markets are often followed not by bear markets, but by sideways markets in which P/E ratios revert to the mean and most stock returns come from dividends. Buy-and-hold works well in bull markets; an active buy-and-sell approach works better in sideways markets. Focus on companies with the right Quality, Growth and Value characteristics.

Key Takeaways

• Stock prices in the long run (not minutes or days, but years) are driven by two factors: earnings growth and changes in valuation (P/E ratio). Add a return from dividends, and you’ve captured all the variables responsible for the total return from stocks.
• Mean reversion is as important to investing as the law of gravity is to physics.
• Interest rates/inflation play a secondary role in stock market cycles, while human psychology dominates that game.
• What value investing is all about: analyzing an asset be it a cow, a stock, or a bond by assessing its risk; valuing it or figuring out what it is worth; and calculating a suitable purchase price. If an asset trades at the desired price or below it, you buy it; if not, you wait patiently until it gets to your target price. That’s it!
• The more durable a company’s competitive advantage, the further and the more confidence you’ll have in projecting its cash flows forward, and the further ahead you can forecast its cash flows, the more valuable is the company.
• Just because one fool found a bigger fool to buy a cow for a ridiculous price doesn’t mean that’s what the cow is worth.
• Sustainable competitive advantage, high-quality management, predictable earnings, significant free cash flows, strong balance sheet, and high return on capital are the wish list of a quality company.
• Time is your best friend when a company’s earnings are rising and dividends are constantly deposited in a brokerage account, but it turns into an enemy when that is not the case.
• Perform a relative valuation analysis first. Then do a DCF analysis.
• Stocks should be purchased when the risk/reward equation is tilted in your favour and sold when that stops being the case.

What I got out of it

Before reading The Little Book Of Sideways Markets, I only thought of bull and bear markets. After reading it, I realized how prevalent sideways markets are: markets in which stock prices go up and down in the short term, but effectively don’t move over a longer term (usually a few years). 

The notion that P/E compression during this period effectively wipes out most of the gains in earnings companies experience was also interesting. 

A point to keep in mind: because of this reversion to the mean, 90% of the return in a sideways market comes from dividends. But instead of focusing on dividend stocks during this period, I think pairing Katsenelson’s active buy-and-sell strategy with Carlisle’s undervalued (in Acquirer’s Multiple terms) stocks approach will produce a greater return. Carlisle talks at length about his approach and reversion to the mean in Deep Value and The Acquirer’s Multiple.

Summary Notes

Sideways Markets Are Here To Stay

All long-term markets of the last century, with one exception, were either bull or sideways.

Stock prices in the long run (not minutes or days, but years) are driven by two factors: earnings growth and changes in valuation (P/E ratio). Add a return from dividends, and you’ve captured all the variables responsible for the total return from stocks.

What Happens In A Sideways Market

A secular sideways market is full of little (cyclical) bull and bear markets.

This is what happens in sideways markets: Two forces work against each other. The benefits of earnings growth are wiped out by P/E compression (the staple of sideways markets); stocks don’t go anywhere for a long time, with plenty of (cyclical) volatility, while you patiently collect your dividends, which are meagre in today’s environment.

In bear markets both P/Es and earnings decline.

It is rarely different, and never different when P/E increase is the single source of the supersized returns.

Among the most important concepts in investing is mean reversion, and unfortunately, it is often misunderstood. The mean is the average of a series of low and high numbers – fairly simple stuff. The confusion arises in the application of reversion to the mean concept. Investors often assume that when mean reversion takes place the figures in question settle at the mean, but it just ain’t so.
Although P/Es may settle at the mean, that is not what the concept of mean reversion implies; rather, it suggests tendency (direction) of a movement towards the mean. Add human emotion into the mix and P/Es turn into a pendulum – swinging from one extreme to the other (just as investors’ emotions do) while spending very little time in the center. Thus, it is rational to expect that a period of above-average P/Es should be followed by a period of below-average P/Es and vice-versa.

Mean reversion is as important to investing as the law of gravity is to physics. As long as humans come equipped with the standard emotional equipment package, market cycles will persist and the pendulum will continue to swing from one extreme to the other.

How The Story Ends

The higher the valuation of stocks at the beginning of a sideways market, the longer that market is likely to last. It takes more time, and plenty of volatility, to deflate a higher starting P/E to a below-average one.

The growth rate and final P/E are the wild cards that will decide how long the sideways market will last. Nominal growth has two components that we would have to estimate to come up with the number: real earnings growth and inflation or deflation.

Interest rates/inflation play a secondary role in stock market cycles, while human psychology dominates that game. Interest rates and inflation are ultimately responsible for where a market cycle will settle in its end game.

Over the past hundred-plus years, dividends delivered close to half of all stock market returns.

During the last three sideways markets, dividends were responsible for over 90 percent of stock market returns.

In bull markets, all stocks dominate bonds. Owning a broad market index – a passive buy-and-hold strategy – does wonders. During sideways markets, all stocks don’t dominate fixed income instruments; only the right stocks do.

Rigorous stock selection and a disciplined buy-and-sell strategy must be used to make money in this low-return environment.

The Quintessential Value Investor

What value investing is all about: analyzing an asset be it a cow, a stock, or a bond by assessing its risk; valuing it or figuring out what it is worth; and calculating a suitable purchase price. If an asset trades at the desired price or below it, you buy it; if not, you wait patiently until it gets to your target price. That’s it!

He needed a margin of safety to protect him for two reasons:

1. If things turned out as expected or better, then he would have made an extra return from buying Golde below estimated fair value.
2. More important, if Tevye made a mistake in forecasting future cash flows, or some of the risks surfaced and impacted cash flows, he’d have a margin of safety to fall back on.

The more durable a company’s competitive advantage, the further and the more confidence you’ll have in projecting its cash flows forward, and the further ahead you can forecast its cash flows, the more valuable is the company.

If Tevye had a feeling that the current government was making promises it could not keep, he would start raising his required rate of return or margin of safety, proactively.

Just because one fool found a bigger fool to buy a cow for a ridiculous price doesn’t mean that’s what the cow is worth. Knowing what happened in the past doesn’t tell us what will happen tomorrow. After the dust settles and everybody comes down from all the excitement, prices will swing back to their true level. How long will that take? Well, it may or may not take a while; the answer will be obvious to us only after the fact. That’s why I stop bidding on sunny days when everybody’s got a smile on their face. True value gets real hard to peg on days like that. And of this I’m certain: The cash flows that this cow will bring for its owner in the future don’t support the 7 times cash-flow multiple that she’s trading for at the moment.

Investment Success Comes From Process

Spend more time focusing on the process than on the end results. If it were not for randomness, every decision we make would be right or wrong based solely on the outcome. If that were the case, the process could be judged solely on the end result. But randomness is as constantly present in investing as it is in gambling. Although we are drawn to judge our decisions and those of others on their outcomes, it is dangerous to do so. Randomness may teach us the wrong lesson.

The less ambiguous your investment process, the more likely you’ll have the discipline to stick to it.

Brought To You By The Letter Q (For Quality)

QVG:

• Quality
• Value
• Growth

“Quality is remembered long after the price is forgotten.” – Gucci family slogan

Competitive advantage is the one criterion on which you should not be willing to compromise.

Return on capital is one of two main ingredients in the earnings growth formula. The higher the return on invested capital, the less equity or debt a company must issue to grow. Assuming a company has growth opportunities – the second main ingredient in the growth formula – a company with high return on capital is able to grow based on internally generated funds. This means higher earnings growth with less risk.

Though cash flows are more volatile than earnings in the short run, they tell a truer story of a company’s profitability.

Free cash flows – the cash left after a company pays its expenses, such as salaries, taxes, inventory, interest, management’s country club memberships, various other yearly expenses, and all other expenses required for future growth, such as investment in fixed assets (building new factories and so on).

Capital expenditure levels may understate or overstate company free cash flows, as not all capital expenditures are created equal. An important distinction between investment in future growth and maintenance-capital expenditures often goes unnoticed.

Maintenance-capital expenditures are investments required for a company to maintain its current sales level.
To identify maintenance-capital expenditures, ask yourself: What would happen to a company’s sales if it stopped investing in fixed assets?

Future-growth capital expenditures are investments necessary for a company to grow its sales, such as a retailer building new stores or a shipbuilder expanding its shipyard.

A company that has a high level of maintenance-capital expenditures is unlikely to generate higher free cash flows – even after it stops growing sales – since it will keep pouring money (albeit lower amounts) into fixed assets to keep existing sales from declining.

There is a way to capitalize on companies that have high maintenance-capital expenditures: Buy companies that sell capital equipment to them.

Free cash flow volatility is usually higher than volatility of net income.
The best way to deal with free cash flow volatility is to either average or compute cumulative operating cash flows over a several-year span and then correspondingly either reduce them by average or cumulative capital expenditures over that time period.

Management is responsible for creating and executing a company’s strategy. However, above all its primary goal should be to enhance the company’s long-term sustainable competitive advantage.

Ask: How good is management at spending your money?

The costs of opening a salon are minimal (a payback in two years at most), little inventory is required, technological changes take place only every hundred years or so, and patrons are conditioned to expect annual price increases.

The value of any asset is the present value of its cash flows, but there is an implicit assumption that those cash flows are either returned to shareholders in the form of dividends or stock buybacks, or reinvested when return on capital exceeds its costs.

Ask yourself: What will management do with its cash flows?

Recurrence of revenues beats consistency of earnings.

To find truly predictable earnings, you will need to dig deeper, below the surface of the reported numbers, and look at the actual business to identify the qualities that make companies’ earnings predictable.

A high level of recurring revenues creates higher predictability and sustainability, and this reduces risk for investors.

Timing is extremely important when buying companies that produce highly durable products such as houses, capital equipment, and the like that have a very long useful life. These companies compete against external competitive threats and their own past sales.

Two industries that should not use debt but use it excessively are the U.S. auto manufacturers and airlines.
The combination of high operational and high financial leverages mixed with volatile sales is a recipe for disaster. Costs do not decline with sales, leading to significant losses.

A company that has volatile cash flows and a high degree of operational leverage should use debt with great caution.

Underfunded defined-benefit plans and operational leases are neatly tucked away off the balance sheet. But they should be carefully analyzed and put back on the balance sheet.

Sustainable competitive advantage, high-quality management, predictable earnings, significant free cash flows, strong balance sheet, and high return on capital are the wish list of a quality company.

Brought To You By The Letter G (For Growth)

A company that is growing earnings and paying a dividend is compensating for the wait, substantially reducing the dead-money risk.

When a company pays a high dividend, you are getting paid to wait for the stock to come back to appropriate valuation. Growing earnings are compressing the valuation spring (the P/E) under the stock.

Time is your best friend when a company’s earnings are rising and dividends are constantly deposited in a brokerage account, but it turns into an enemy when that is not the case.

It is important to know the source of a company’s profitability growth. The per-share profitability growth could be illustrated as a pyramid flipped upside down:

• Revenues
• Net Income
• Free Cash Flow
• Free Cash Flow per Share

Each level of the growth pyramid needs to be examined to see if it will be creating or destroying value.

Stock buybacks can create shareholder value if the stock is purchased cheaply, but they often destroy value when management overpays for the stock. Stock buybacks raise two questions:

1. Is management a good investor?
2. Is the stock purchased in order to make the numbers (to meet or beat Wall Street’s expectations of earnings per share)?

Ask: If I don’t want the company to buy its stock at this price, is there a reason why I should continue to own it?

You should analyze stock buybacks on a case-by-case basis, asking these four questions:

1. Is the stock being purchased when it is undervalued?
2. What is management’s motivation for the stock buyback?
3. Is the company leveraging its balance sheet to buy back stock?
4. Is there a better use for this cash?

You should forecast the rate of growth for each engine separately at first, and only after that put them together. Being able to quantify the impact of each growth engine on the company’s valuation will help you maintain a rational mind when things don’t go as expected.

Finding companies that have several growth engines at the core of their growth reduces investment risk; if one growth engine fails or temporarily stalls, the other engines may still be driving the company’s growth forward.

If you know the range of possible growth scenarios, you will be able to use the discounted cash flow model.

Share buybacks are, in theory, as value-creative as dividends, but the absence of strict management accountability makes them unpredictable and thus less value-creative than dividends.

Brought To You By The Letter V (For Value)

The P/E ratio is an important tool, if for only one reason – almost everybody uses it.

There is another hidden benefit of the DCF model – building the DCF model for a company should help you better understand its value creators and destroyers. This, in turn, will help focus your energy on those inputs that have a larger impact on value creation: profit margins, sales growth, capital expenditures, accounts receivable, inventories, forecasted time period, and so on.

Margin of safety is a function of the following variables:

• Company’s quality – its business and financial risks
• Investors’ required rate of return for the stock
• Company’s expected earnings growth rate
• Company’s expected dividend yield

Perform a relative valuation analysis first. Relative valuation tools are important hints that are unlikely to bring you complete answers, at least not at first, but they will put you on the path to asking the right questions: why? Why does a company (or industry) trade at a premium or a discount to its peers (or market)?
Then do a DCF analysis, playing with different good, bad, and ugly scenarios.

If you own some of those high P/E stocks, you want to be absolutely sure that their growth will sufficiently compensate for the P/E contraction that they are facing.

Q + V + G

A basic property of religion is that the believer takes a leap of faith – believing without expecting proof.

You find a great company that has a great brand, strong competitive advantages, a solid balance sheet, nice return on capital, and more. It has an attractive valuation, at least on the surface. It dominates the market where it competes, but its market is not growing fast and it has taken the entire market share that was there for the taking – it is a slow-growth company.

1. Require an increased margin of safety.
2. Look for a catalyst – an event that would close the margin of safety gap within a specific time frame. Two questions to ask:
   1. How certain are you that the catalyst will occur?
   2. Will the catalyst attract enough investor interest to drive the price of the stock to fair value?

Little can help a company that has no competitive advantage.

Valuation and Growth, as Warren Buffet put it, “are joined at the hip,” being the source of returns, while Quality makes sure that the company will still be around to collect the fruits from its labour.

Think Long-Term, Act Short-Term In A Sideways Market

In the sideways market, you should employ an active buy-and-sell strategy: buying stocks when they are undervalued and selling them when they are about to be fully valued, as opposed to waiting until they become overvalued.

Ask:

1. Is XYZ a good company? – Quality and Growth
2. Is XYZ a good stock (investment)? – Value

For the companies that pass the good-company test but fail the good-stock test, create a wish list or “Companies I Would Love To Own At The Right Price” list.

1. Determine the fair value using a combination of relative and absolute (intrinsic) valuation tools. 
2. Settle on the required margin of safety (the discount to the fair value) that will lead to the buy P/E. 
3. Finally (the hardest part), sit and patiently wait for the stock to come down to the predetermined target valuation level and/or price.

“All man’s miseries derive from not being able to sit quietly in a room alone.” – Blaise Pascal

The Importance Of Going Against The Grain In A Sideways Market

Own Your Work and Create a Paper Trail. To keep a sane head, independent of the direction in which the crowd is marching, write down your basis for every investment, identifying value creators and destroyers and your expectations for them.

The larger the pool of stocks you can choose from, the higher the bar – the opportunity cost – that a new stock has to overcome to make it into the portfolio.

Buy And Sell Is The Name Of The Game

Our purchase price and our sell decision should not be related.

We should sell a stock when it reaches our price or valuation target, determined at the time of purchase.

Stock selection, valuation, and diversification are the building blocks of risk management in the long-only portfolio, but a sell process is the glue that holds them all together.

Stocks should be purchased when the risk/reward equation is tilted in your favour and sold when that stops being the case. Stocks that become fairly valued, the ones that exhausted their margins of safety and in which expected total rate of return (earnings growth, plus dividends) now falls below your expectations should be sold – period!

For every company in my portfolio and on my watch list, I determine and write down buy, fair value, and sell P/Es.

Keep fundamental underperformers on a shorter leash, sell sooner, and give them less time for the company to fix things. In a sideways market, a short leash is doubly important.

As an outsider, ask: If we got kicked out and the board brought in a new CEO, what do you think he would do?

Emotions are our worst investing enemy after all since they lead us to do the opposite of what we should be doing. One of the behavioural traps we fall into is anchoring our current views to our past decisions.

Ask periodically: If a new person were to manage my portfolio, the one who did not buy this stock, what would he do?

Once You’ve Sold, What Should You Buy?

An easy way to identify an entire group of stocks the market has dumped in favour of a new fling is by looking at exchange-traded funds (ETFs).

The Little Book That Beat The Market screen: Companies are ranked by P/E (lower P/E gets a lower score) and by return on equity (ROE, higher ROE gets a lower score), and then scores are added together. The top candidates on the list – the ones that have the lowest score – are your latest and greatest ideas.

Hitting the bottom screen: This screens for stocks that are hitting multiweek, -month, or -year lows.

Net-net stocks screen: This is a classic Benjamin Graham screen where you try to buy stocks as close to, or preferably below, their net current assets (current assets less all liabilities including debt and preferred stock).

Looking at the holdings of other value managers is really just another screen for attractive opportunities that are not caught by traditional screens.

Follow the holdings of investors “whose investment approach we admire and can relate to.”

Why You Can’t Stick Your Head In The Sand When It Comes To Global Issues

In our stock valuations, our required margin of safety needs to be increased to compensate for P/E compression that is brought to us by sideways markets and for the uncertainty in “E” that is caused by all the giant grey swans splashing around in the global economy.

High-quality companies outperform lower-quality ones during times of weak or negative economic growth and uncertainty by a significant margin.

A Different Approach To Risk And Diversification

What risk means to us is shaped by our time horizon. If you are investing for the long run – at least five years – a permanent loss of capital is the risk that you should be concerned with the most. The distinction here is that if you are armed with a long-term horizon, volatility is a mere inconvenience (and often an opportunity, especially in a sideways market).
If you have a short-term horizon, to you volatility is not temporary. Even a temporary stock decline results in a permanent loss of capital since you don’t have the time to wait it out.

There is another important, less tangible, issue with volatility: It impacts our emotions and makes us do the wrong things – buy high and sell low.

You shouldn’t ignore the emotional element of volatility. Make reasonable attempts to minimize its impact on the portfolio through diversification, and/or own stocks whose businesses you understand, so that you can be comfortable with their price fluctuations.

Next time you hear a mutual fund or hedge fund manager bragging about the outsized returns of his fund with very little (observed) risk, remember our discussion about randomness and question alternative historical paths.