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ValuFocus Investing


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Table of Contents

Preface xvii Acknowledgments xxi SECTION ONE The LCRT Investment Process 1 CHAPTER 1 Introducing Our Investment Process 5 Key Takeaways 8 CHAPTER 2 A Better Way to Invest in Stocks 9 Put the Focus in the Right Place: On a Company?s Fundamental Value 9 We Bring You an Improved Methodology 10 Basing Decisions on Under- and Overvaluation by the Market 12 The Key: Recognizing the Inflection Points 13 Looking at Our Model 14 Key Takeaways 16 CHAPTER 3 Advantages of Economic, Cash-Based Modeling 17 Key Takeaway 21 CHAPTER 4 Analyzing Mental Models 23 Key Takeaways 26 CHAPTER 5 The Value Creation Process 27 Cost of Capital and Company Return on Capital 27 The Importance of Adjusting for Inflation 28 Where We Are Going 29 Key Takeaways 31 CHAPTER 6 The Corporate Perspective 33 The Focus for Both Constituencies: Value Creation 33 Earnings Are the Wrong Measure 36 Executive Compensation 38 Creating an Information Advantage 41 Key Takeaways 44 SECTION TWO A Brief History of Investing and Modeling 45 CHAPTER 7 Relevant Market History of Investing 47 Start with Concepts of Risk and Uncertainty 48 Migrate toward Value and Market Inefficiency 49 Enter Modern Portfolio Theory 50 An Emphasis on Earnings, Plus 51 Leading to Multifactor Modeling 51 Finding the Right Factors 52 Dissecting a Multifactor Model 53 Key Takeaways 54 CHAPTER 8 Interpreting Market History 55 Market Is Dealing with Price Change, Not Price Level 56 Bringing History Up to Now 59 Back to Earnings: Why They Still Prevail 60 Key Takeaways 62 SECTION THREE Brief Discussions of Various Investing Methods 63 How Best to Combine Investing Methods with LCRT?s Models 63 CHAPTER 9 Do Stocks Have Intrinsic Value? 65 Basing Investment Decision on Intrinsic Value 66 Value Assets on Economic Basis 68 Estimating Intrinsic Value through a DCF Model 69 Key Takeaways 70 CHAPTER 10 The Pros and Cons of Various Methods and Models 71 Why Price Level Matters 71 Why Use Analysts? Traditional Cash Flow Forecasts. Why Not. 72 Why Use Dividends to Value Stocks. Why Not. 72 Why Use the Simplest Model, EBITDA. Why Not. 73 Why Use Earnings. Why Not. 74 Why Use Price Level from Regression Analysis. Why Not. 75 Why Use Net Free Cash Flow. Why Not. 76 Why Use Residual Income or EVA. (R) Why Not. 77 Why Use Cash Flow ROI, CFROI, (R) Economic Cash Margin, or Cash Economic Return. Why Not. 78 CHAPTER 11 Suppose You Love Your Current DCF Model 81 Dividend Discount Models 82 EVA (R) or Residual Income Models 83 CFROI (R) or Cash Economic Return Models 84 Regression Models of Price Level 84 Multifactor Models 85 SECTION FOUR Explaining LCRT?s Conceptual Framework in Detail 87 CHAPTER 12 Our Approach 91 Differences between Intrinsic Value and Market Value Approaches 93 Explaining Value 94 Attacking the Old Ways 97 Modeling on Economic Fundamentals, Not Accounting Mumbo-Jumbo 98 The Intricacies of the Price Formation Process 100 The Foundation Is Intrinsic Value 101 We?re Fighting Standard Practices, but We Can Win 102 Key Takeaways 103 CHAPTER 13 Focusing on Price Formation 105 Be Proactive, Not Reactive 106 Building a Price Formation Process 107 Oh-Oh: We?re Preaching Again 109 Key Takeaways 110 CHAPTER 14 Our Automated DCF Model?The Better Model 111 Four Primary Measurement Principles to Evaluate a Model 113 Key Takeaways 114 CHAPTER 15 Getting to Know Our LCRT Model 115 Adjustments to Improve DCF Modeling 116 Economic Output and Life of Each Asset 116 Capitalize Cash Flows 117 Understanding Abnormal Accruals 118 Cash Flows Fade: Down and Up 119 Looking at the Discount Rate 120 Summarizing the Model of Choice 121 The Next Generation Will Be Even Better 122 Key Takeaways 123 CHAPTER 16 Digging Deeper into the LCRT Model 125 Exponential Fading of both Cash Economic Return and Growth Rate 125 Certainty-Equivalent Value and the Use of the Area under a Curve 129 Dealing with Debt Leverage 130 Looking at the Discount Rate Again 132 Inflation Adjustments Revisited 134 Importance of Accuracy 135 Calculating Bounded Rationality (Rawley Ranges) 136 Three Fundamental Economic Drivers of Dispersion Affecting Stock Price 138 Buy and Hold Strategies 139 Short-Term Trading Strategies 139 Trading Strategies Shorting the Market 140 Market Sentiment and Micro and Macro Economic Drivers 140 Market Sentiment 140 Macro and Micro Economic Drivers 140 Improving the Model with Your Insights and Analyst Forecasting 142 Key Takeaways 143 CHAPTER 17 Putting Our Valuation Proposition into Perspective 145 SECTION FIVE How to Make Investment Decisions with ValuFocus 147 CHAPTER 18 ValuFocus?The Key Tool for Investing in Stocks 151 The Components of ValuFocus 153 The Relative Wealth Chart: Cash Economic Return, Growth, and Stock Performance 156 Rawley Ranges of Bounded Rationality 158 EPS and Sales Overrides 159 Analyzing Hewlett-Packard 162 Determining the Accuracy of the Value Calculations 164 Using the Value Chart 166 Earnings Results Can Be Misleading 167 The Market Often Is Slow to React to Value Improvements by Management 168 Picking the Right Model Version 169 Contrasting Hewlett-Packard with Coca-Cola 172 Neither Coke nor Pepsi 175 Incorporating Revenue and EPS Forecasts 179 Basic Purpose: Predict Future Stock Price 180 Taking Advantage of the Flexibility of ValuFocus 182 The Importance of Fade Rates to Intrinsic Valuation 184 Continuing Debate: Determining the Right Discount Rate Created from Long-Term Growth Rates 187 Key Takeaways 188 CHAPTER 19 Managing Your Stock Portfolio 191 Ways to Weight Stocks in Your Portfolio 194 Risk and Concentration 195 Rebalancing Your Portfolio 195 Key Takeaways 197 CHAPTER 20 Advanced Portfolio Concepts 199 Selecting Stocks 200 Value and Tracking Error 200 Diversification 200 Inflection Points 201 Buy and Hold Strategies versus SelectiveMarket Timing 202 Portfolio Weighting 206 Achieving Low Risk?High Return Trading around a Core Portfolio 207 Shorting Stocks Based on Value 209 Cash Generator 213 Key Takeaways 218 CHAPTER 21 What If You Don?t Want to Employ ValuFocus 221 CHAPTER 22 Always Going Forward 223 Key Takeaways 229 CHAPTER 23 It Is Time to Get Started 231 SECTION SIX Advanced Topics for Practicing Professionals 233 CHAPTER 24 Security Analysis and Modeling 235 Empirically Test Terminal Valuation Model against History 235 Benefits and Rewards 237 Analyst Dashboard 237 Financial Modelers and Ideas for Future Practitioner Research 240 Key Takeaways 242 CHAPTER 25 Wealth Management 243 Key Takeaway 246 CHAPTER 26 Portfolio Construction 247 New Theory 248 Begin with Under- and Overvaluation, Then Diversify 248 Weighting Schemes 249 Rebalancing Your Portfolio 249 Benefits of Concentration 250 Key Takeaway 251 SECTION SEVEN Advanced Topics for Academics 253 Inefficient Markets 253 Chapters in This Section for the Academic 253 CHAPTER 27 Another Tour through Our LCRT Model 257 Description of the LCRT Model 258 Constructing the Model 258 Basic Components of the Model 260 Dealing with the Many Assumptions 262 The Best of Both: Explaining Our Fade Process in a Single-Period Method 264 Fade and Model Accuracy 267 Starting with a Baseline Model 268 Importance of Understanding Economic Comparables 271 The Difference between Net Free Cash Flow versus Cash Economic Return 272 Comparing Conventional and LCRT Models 273 Validating the Model: The Proof Is in the Comparison 275 Calculation of Tracking Errors 275 Focusing on Cash Economic Return 280 Calculating and Delving into Cash Economic Return 284 Understanding the Growth Rate 290 Arriving at the Discount Rate for a Third Time 292 Summing Up 293 Key Takeaways 295 CHAPTER 28 Incorporating Risk into Our Model 297 Incorporating Risk and Fade into Our LCRT Model 298 How Risk Modeling for Stock Selection Has Evolved 300 Managing Risk in Our LCRT Modeling 304 Looking at Technical Analysis and Ranges of Bounded Rationality Again 305 Measuring the Extent of Over- and Undervaluation 306 Modeling the Dispersion of Stock Price 307 Applying Risk in Our Model 308 Key Takeaways 310 CHAPTER 29 Producing Lower Fat-Tailed Risk with Higher Returns 311 Alternatives to Stable Paretian Distributions 312 Comparison of Traditional Gaussian Measures with Stable Paretian 314 Key Takeaways 318 CHAPTER 30 Comparing Our Model against Three Popular DDMs 319 Evaluating the Three DDMs 322 Testing the Models for Robustness and Accuracy 324 Robustness, Accuracy, Nonbias Enhance Predictability 327 Removing Bias Caused by a Certain Parameter 328 Portfolio Results for Three ROPE Model Specifications 333 Using Our Sophisticated Free Cash Flow Process 335 Key Takeaways 337 CHAPTER 31 Suggestions for Additional Academic Research 339 Epilogue?Key Takeaways 341 About the Authors 343 Index 345

About the Author

Rawley Thomas is President of LifeCycle Returns, Inc. (LCRT). He served as assistant treasurer of SuperValu Stores, joined Callard, Madden in 1981, cofounded Holt Planning in 1985, and directed Value Management research for The Boston Consulting Group for eleven years. Thomas is past Vice President of Practitioner Services for the Financial Management Association International (FMA) and is Chairman of the FMA Practitioner Research Committee. Currently, he serves on the Northern Illinois Accountancy Board and chairs the Financial Management Association Practitioner Demand Driven Academic Research Initiative (FMA PDDARI) supported by the CFA Society of Chicago. WILLIAM MAHONEY is a veteran investor relations practitioner, journalist, and author. He spent twenty years as a communications and investor relations professional with companies such as Motorola, Scott Paper, and Esmark, and twenty-five years as an editor of investor relations and corporate governance publications, including Update , which is the official publication of the National Investor Relations Institute; Shareholder Value magazine; and the newsletter Valuation Issues. He has written a half-dozen books on investor relations and corporate governance. Mahoney began his career as a reporter for the Ft. Wayne News-Sentinel after graduating from Marquette University.

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