The Five Key Sources of Stock Returns

DeMarche

The Five Key Sourcesof Stock Returns

Bob DuwaDeMarche Associates, Inc.

CFA NebraskaFebruary 18, 2009

2 DeMarche

The Five Key Sourcesof Stock Returns

• Key Factor Groups

• DeMarche Phase Analysis

• Market Outlook

3 DeMarche

Key Factor Groups

4 DeMarche

Forces Affecting Stock Return

The Economy

MarketBehavior

IndustryOutlook

StockPrice

Company Characteristics and Issues

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Five Factor Groups

Investment Style FactorsDividend yield, book to price, earning yield

Firm FactorsEPS growth, ROE, asset turnover, profit margin, debt level

Industry FactorsCompetition, regulation

Liquidity FactorsTrading volume and change in volume, share price, cap size

Momentum FactorsShort, intermediate and long-term price history

6 DeMarche

Key Factor GroupsProviding Highest Sources of Alpha

Valuation

Risk

Growth

Industry

Momentum

Liquidity

“Style”

7 DeMarche

DeMarche Style Factors – Growth/Value

HighDeMarche Growth RatingLow

HighRelative Price StrengthLow

HighEarnings GrowthLow

HighAsset GrowthLow

HighDividend GrowthLow

LowCash Flow YieldHigh

LowDividend YieldHigh

LowSales-to-PriceHigh

LowBook-to-PriceHigh

Growth StocksFactorValue Stocks

HighDeMarche Growth RatingLow

HighRelative Price StrengthLow

HighEarnings GrowthLow

HighAsset GrowthLow

HighDividend GrowthLow

LowCash Flow YieldHigh

LowDividend YieldHigh

LowSales-to-PriceHigh

LowBook-to-PriceHigh

Growth StocksFactorValue Stocks

VALUE TO GROWTH SPECTRUM

8 DeMarche

DeMarche Growth vs. DeMarche Value

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

Dec

-84

Dec

-85

Dec

-86

Dec

-87

Dec

-88

Dec

-89

Dec

-90

Dec

-91

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Moving One-Year Returns

Percent Spread

Value Outperforms

Growth Outperforms

Style Leadership – Growth/Value

9 DeMarche

11.03

15.8613.9

19.68

11.95

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00Large CapGrowth

Large CapValue

Small CapGrowth

Small CapValue

S&P 500

Large Cap Gr Large Cap Val Small Cap Gr Small Cap Val S&P 500

FAMA Style Indexes1928-2007 Annualized Returns

10 DeMarche

DeMarche Style Factors - Quality

AGGRESSIVE TO DEFENSIVE SPECTRUM

HighProfit MarginLow

HighDividend YieldLow

HighCash Flow YieldLow

HighEconomic ReturnLow

HighPayout RatioLow

HighMarket Cap SizeLow

LowNon-Market RiskHigh

LowEarnings VariabilityHigh

LowMarket RiskHigh

LowShare TurnoverHigh

LowTrading RangeHigh

Defensive StocksFactorAggressive Stocks

HighProfit MarginLow

HighDividend YieldLow

HighCash Flow YieldLow

HighEconomic ReturnLow

HighPayout RatioLow

HighMarket Cap SizeLow

LowNon-Market RiskHigh

LowEarnings VariabilityHigh

LowMarket RiskHigh

LowShare TurnoverHigh

LowTrading RangeHigh

Defensive StocksFactorAggressive Stocks

11 DeMarche

Style Leadership - QualityDeMarche Aggressive vs. DeMarche Defensive

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

Dec

-84

Dec

-85

Dec

-86

Dec

-87

Dec

-88

Dec

-89

Dec

-90

Dec

-91

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

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Dec

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Dec

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Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Percent Spread

Moving One-Year Returns

Aggressive Outperforms

Defensive Outperforms

12 DeMarche

Firm Factors

Profitability (ROE)

EPS Growth

Dividend Growth

Asset Turnover

Profit Margin

Debt Level

13 DeMarche

D9

87

65

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87

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10

20

30

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60

70T

ota

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Defensive - Aggressive Value - Growth

Topography of the MarketCompany Count vs. Growth / Value and Aggressive / Defensive

D9

87

65

43

2A

G9

87

65

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2V

D9

87

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Defensive - Aggressive Value - Growth

Topography of the MarketCompany Count vs. Growth / Value and Aggressive / Defensive

14 DeMarche

D9

87

65

43

2A

G9

87

65

43

2V

0%

2%

4%

6%

8%

10%

12%

Pe

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To

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Ma

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ap

Defensive - Aggressive Value - Growth

Topography of the MarketMarket Cap vs. Growth / Value and Aggressive / Defensive

D9

87

65

43

2A

G9

87

65

43

2V

0%

2%

4%

6%

8%

10%

12%

Pe

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Defensive - Aggressive Value - Growth

Topography of the MarketMarket Cap vs. Growth / Value and Aggressive / Defensive

15 DeMarche

Valuation Basis PointsFormulas R-squared per Ventile

Price to Book 80% 34Price to Cash Flow 73% 35Earnings to Price 33% 23Earnings Surprise & Revisions 3% 4CAPM 5% -5

Source: DeMarche Associates, 1978 - 2001

One-Year Return Predictability of Various Valuation Formulas

16 DeMarche

Basis PointsMetrics R-squared per Ventile

Asset Utilization (Turns) 48% 27Free Cash Flow Return on Investment 41% 21ROE 40% 11EVA 32% 13Cash Flow Return on Investment 12% 7ROA 0% 2

Source: DeMarche Associates, 1978 - 2001

One-Year Return Predictability of Various Metrics

17 DeMarche

Lakonishok Study (1951 - 1998)

Percentage of Firms with ABOVE-MEDIANGrowth in Operating Income for Number of Years

50.0

25.6

13.0

6.83.6

2.0 1.2 0.7 0.5 0.30

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

Years

Predictability? Companies Change!

18 DeMarche

DeMarche Study (1972-2001) (Lakonishok Method)

Percentage of Firms with ABOVE-MEDIANGrowth in Stock Returns for Number of Years

50.0

27.8

15.0

8.74.9

2.8 1.6 0.9 0.5 0.30

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

Years

50.0

27.8

15.0

8.74.9

2.8 1.6 0.9 0.5 0.30

10

20

30

40

50

60

1 2 3 4 5 6 7 8 9 10

Years

Predictability? Companies Change!

19 DeMarche

• Focus time on holdings with worst expected return potential to avoid “bombs”

• Identify sell signals

• Quantify basis for shifts in industry bets

• Add value in tilt decisions on growth/value or aggressive/defensive spectrum

Benefits for Portfolio Managers

20 DeMarche

Benefits for Clients & Consultants

• Better understanding of investment process

• Improve communication between client, manager, and consultant

21 DeMarche

DeMarche Phase Analysis

22 DeMarche

Probability Distribution ofThree-Year S&P 500 Returns

1929 – December 31, 2008

Return

Pro

babi

lity

-1 Std. Dev. +2 Std. Dev.+1 Std. Dev.-2 Std. Dev.

10.83%

35.10%

22.96%

-13.45%

-1.31%

S&P 6/30/03-11.21%

S&P 6/30/99 29.10%

S&P 6/30/05 8.37%

S&P 6/30/00 19.67%

S&P 12/31/08-8.36%

23 DeMarche

Phase I 55.5% Early Bull Phase II 19.0% Bull Phase III 3.5% Late Bull/Early Bear Phase IV -19.6% Bear Total Period …………………………………………………… 10.8%

Market Phase Stock Prices Corporate Earnings

S&P 500 Annualized

Return

Market Phase Analysis (01/01/63 to 06/30/05)

Market Phase Analysis1/1/63 to 12/31/08

54.8%

19.2%

-15.4%

9.4%

24 DeMarche

Drivers of Stock Price – Bull MarketOne-Year Return Predictability of Various Metrics

  Basis PointsMetrics R-Squared per VentileROE 31% 13Asset Utilization 27% 17Free Cash Flow Return on Investment 20% 12

EVASM 9% 8ROA 0% - 1

Source: DeMarche Associates, 1978-2001

25 DeMarche

Drivers of Stock Price – Bear Market

One-Year Return Predictability of Various Metrics

  Basis PointsMetrics R-Squared per VentileAsset Utilization 41% 73Free Cash Flow Return on Investment 32% 65

EVASM 27% 39ROA 4% 13ROE 0% 0

Source: DeMarche Associates, 1978-2001

26 DeMarche

Style Leadership by DeMarche Market Phase

Style Leadership

Phase I Small Cap Growth

Phase II Large Cap Growth

Phase III Small Cap Value

Phase IV Large Cap Value

27 DeMarche

Benefits for Clients & Consultants

• Better understanding of manager returns and periods of expected bad performance

• Tactical Restructuring

28 DeMarche

DeMarche Market Outlook

29 DeMarche

Discretionary Management Services, LLCForecast 2009

Jan 1 - Dow 8776 Dec 31 - ???

--- --- Back to 8776 ?

1st Quarter - Test 7450 low

If broken, seeks support below 7000

By Labor Day - Dow tries to break 10,000

1st Quarter 2nd Quarter 3rd Quarter 4th Quarter

30 DeMarche

3-Yr. Equity Returns?Projected 3-Year Stock Returns Using Bogle Model (Values in Table)

Based on Various Earnings Growth Rates and Ending P/Es(Annualized Values in Table)

As of 12/31/2008

Model Inputs: S&P 500Beginning Yield 3.0%Beginning P/E 19.6

Ending P/EScenarios: 12.0 14.0 16.0 18.0 20.0 22.0

6.0% -6.1 -1.6 2.5 6.2 9.7 13.0Earnings 3.0% -9.1 -4.6 -0.5 3.2 6.7 10.0Growth 0.0% -12.1 -7.6 -3.5 0.2 3.7 7.0Rate -3.0% -15.1 -10.6 -6.5 -2.8 0.7 4.0

-6.0% -18.1 -13.6 -9.5 -5.8 -2.3 1.0

Price/Earnings ratio represents the month-end index closing price divided by 12-months quarterly as reported diluted earnings per share (GAAP EPS). As of 12/31/08, nine months of actual reported earnings and three months of estimated earnings were used.Averages Since 1936: P/E 15.8 12 Mo. Earnings Growth Rate 7.3%

31 DeMarche

3-Yr. Fixed Income Returns?Projected 3-Year Bond Returns (Values in Table)

Based on Various Changes in Yields(Annualized Values in Table)

As of 12/31/2008

Barclay's Sector IndexesModel Inputs: Interm. Gov't US Credit High Yield

Beginning Yield 1.5 6.8 19.5

Beginning Duration 3.6 6.0 4.1

Scenarios: Interm. Gov't US Credit High Yield+200 -1.0 2.6 16.7

Net Basis Point +100 0.3 4.7 18.1Change in +0 1.5 6.8 19.5

Yield -100 2.6 8.8 20.9-200 N/A 10.7 22.2

Projected bond returns shown above make no assumption about potential default or recovery rates.

32 DeMarche

Man is not a rational being, man is an animal

that rationalizes!

Source Unknown

33 DeMarche

DeMarche Associates913-384-4994

www.demarche.com

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