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The Five Key Sources of Stock Returns

The Five Key Sources of Stock Returns Bob Duwa DeMarche Associates, Inc. CFA Nebraska February 18, 2009. The Five Key Sources of Stock Returns. Key Factor Groups DeMarche Phase Analysis Market Outlook. Key Factor Groups. Forces Affecting Stock Return. The Economy. Market Behavior.

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The Five Key Sources of Stock Returns

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  1. The Five Key Sourcesof Stock ReturnsBob DuwaDeMarche Associates, Inc.CFA NebraskaFebruary 18, 2009

  2. The Five Key Sourcesof Stock Returns • Key Factor Groups • DeMarche Phase Analysis • Market Outlook

  3. Key Factor Groups

  4. Forces Affecting Stock Return The Economy Market Behavior Industry Outlook Stock Price Company Characteristics and Issues

  5. Five Factor Groups Investment Style Factors Dividend yield, book to price, earning yield Firm Factors EPS growth, ROE, asset turnover, profit margin, debt level Industry Factors Competition, regulation Liquidity Factors Trading volume and change in volume, share price, cap size Momentum Factors Short, intermediate and long-term price history

  6. Key Factor GroupsProviding Highest Sources of Alpha Valuation Risk Liquidity “Style” Growth Momentum Industry

  7. DeMarche Style Factors – Growth/Value

  8. Style Leadership – Growth/Value

  9. FAMA Style Indexes1928-2007 Annualized Returns

  10. DeMarche Style Factors - Quality

  11. Style Leadership - Quality

  12. Firm Factors Profitability (ROE) EPS Growth Dividend Growth Asset Turnover Profit Margin Debt Level

  13. G 9 D 8 9 7 8 7 6 6 5 5 4 4 3 3 2 2 A V Topography of the Market Topography of the Market Company Count vs. Growth / Value and Aggressive / Defensive Company Count vs. Growth / Value and Aggressive / Defensive 70 70 60 60 50 50 40 40 Total Company Count Total Company Count 30 30 20 20 10 10 0 0 G G 9 9 D D 8 8 9 9 7 7 8 8 7 7 6 6 6 6 5 5 5 5 4 4 4 4 3 3 3 3 2 2 2 2 Defensive Defensive - - Aggressive Aggressive Value Value - - Growth Growth A A V V

  14. Topography of the Market Topography of the Market Market Cap vs. Growth / Value and Aggressive / Defensive Market Cap vs. Growth / Value and Aggressive / Defensive 12% 12% 10% 10% 8% 8% Percent of Total Market Cap Percent of Total Market Cap 6% 6% 4% 4% 2% 2% 0% 0% G G 9 9 D D 8 8 9 9 7 7 8 8 7 7 6 6 6 6 5 5 5 5 4 4 4 4 3 3 3 3 2 2 2 2 Defensive Defensive - - Aggressive Aggressive Value Value - - Growth Growth V V A A

  15. One-Year Return Predictability of Various Valuation Formulas Valuation Basis Points Formulas R-squaredper Ventile Price to Book 80% 34 Price to Cash Flow 73% 35 Earnings to Price 33% 23 Earnings Surprise & Revisions 3% 4 CAPM 5% -5 Source: DeMarche Associates, 1978 - 2001

  16. One-Year Return Predictability of Various Metrics Basis Points MetricsR-squaredper Ventile Asset Utilization (Turns) 48% 27 Free Cash Flow Return on Investment 41% 21 ROE 40% 11 EVA 32% 13 Cash Flow Return on Investment 12% 7 ROA 0% 2 Source: DeMarche Associates, 1978 - 2001

  17. Predictability? Companies Change! Lakonishok Study (1951 - 1998) Percentage of Firms with ABOVE-MEDIAN Growth in Operating Income for Number of Years 60 50.0 50 40 30 25.6 20 13.0 10 6.8 3.6 2.0 1.2 0.7 0.5 0.3 0 1 2 3 4 5 6 7 8 9 10 Years

  18. Predictability? Companies Change! DeMarche Study (1972-2001) (Lakonishok Method) Percentage of Firms with ABOVE - MEDIAN Growth in Stock Returns for Number of Years 60 60 50.0 50.0 50 50 40 40 27.8 27.8 30 30 20 20 15.0 15.0 8.7 8.7 10 10 4.9 4.9 2.8 2.8 1.6 1.6 0.9 0.9 0.5 0.5 0.3 0.3 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 10 10 Years Years

  19. Benefits for Portfolio Managers • 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

  20. Benefits for Clients & Consultants • Better understanding of investment process • Improve communication between client, manager, and consultant

  21. DeMarche Phase Analysis

  22. Probability Distribution ofThree-Year S&P 500 Returns1929 – December 31, 2008

  23. Market Phase Analysis 1/1/63 to 12/31/08 54.8% 19.2% -15.4% 9.4%

  24. Drivers of Stock Price – Bull Market One-Year Return Predictability of Various Metrics   Basis Points Metrics R-Squared per Ventile ROE 31% 13 Asset Utilization 27% 17 Free Cash Flow Return on Investment 20% 12 EVASM 9% 8 ROA 0% - 1 Source: DeMarche Associates, 1978-2001

  25. Drivers of Stock Price – Bear Market One-Year Return Predictability of Various Metrics   Basis Points Metrics R-Squared per Ventile Asset Utilization 41% 73 Free Cash Flow Return on Investment 32% 65 EVASM 27% 39 ROA 4% 13 ROE 0% 0 Source: DeMarche Associates, 1978-2001

  26. 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. Benefits for Clients & Consultants • Better understanding of manager returns and periods of expected bad performance • Tactical Restructuring

  28. DeMarche Market Outlook

  29. Discretionary Management Services, LLCForecast 2009 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter By Labor Day - Dow tries to break 10,000 Dec 31 - ??? Jan 1 - Dow 8776 Back to 8776 ? --- --- 1st Quarter - Test 7450 low If broken, seeks support below 7000

  30. 3-Yr. Equity Returns? 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. 3-Yr. Fixed Income Returns? Projected bond returns shown above make no assumption about potential default or recovery rates.

  32. Man is not a rational being, man is an animal that rationalizes! Source Unknown

  33. DeMarche Associates913-384-4994www.demarche.comwww.dms-demarche.com

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