Beating Range-Bound Markets With Quality Stocks

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History shows that long bull markets are typically followed by range-bound markets where stocks move sideways for years.

This happens because bull markets push valuations too high, creating a situation where earnings growth and price-to-earnings (P/E) compression counteract each other, resulting in flat overall returns.

Vitaliy Katsenelson's 2007 "Active Value Investing: Making Money in Range-Bound Markets" explains that during these challenging periods, earning superior returns means focusing on quality companies that can withstand the P/E compression that typically eats away at returns.

But what exactly makes a "quality" company? Katsenelson provides a framework built around six main factors:

This post explains why these quality factors matter so much and how to evaluate them as an investor. By focusing on them, we can identify companies capable of delivering superior returns even when indexes move sideways for years.

The most important quality characteristic is a sustainable competitive advantage—what Warren Buffett calls a "defensive moat" around the business. This protection allows investors to look further into the future with confidence about a company's cash flows.

Without a strong moat, competitors will quickly move in whenever they see above-average returns, forcing the company to lower prices, give up market share, invest heavily in differentiation, or some combination of all three.

These protective moats come in different forms:

Michael Porter’s Five Forces

In his 1998 book "Competitive Strategy: Techniques for Analyzing Industries and Competitors," Michael Porter described five forces that shape industry structure:

Together, these forces determine a company’s long-term profitability potential.

Understanding these competitive forces helps explain why Katsenelson emphasizes competitive advantages for survival:

Not All Brands Are Equal

When examining competitive advantages, it's important to understand that certain company strengths, such as having a well-known brand, doesn't automatically give companies the ability to charge higher prices:

In today's digitally connected market, brand value has evolved. With consumers exposed to countless options, innovations are quickly copied by competitors. A strong brand might get you in the game, but it doesn't guarantee you can charge higher prices—the real test of market power.

Management quality can make or break even the strongest business model.

Katsenelson stresses that investors should scrutinize management as carefully as they analyze financial statements. Since executive compensation often ties to stock performance, their comments should always be filtered through common sense.

While management executes strategy, their primary goal should be building long-term competitive advantages—shareholder value naturally follows.

Beware of Management Bias

Investors should evaluate management's comments with healthy skepticism.

Katsenelson quotes Toll Brothers’ chairman Robert Toll, who repeatedly denied the housing bubble before 2006 while simultaneously selling hundreds of millions of dollars’ worth of his company’s stock.

Dell vs. Gateway

The Dell ($DELL ( ▼ 0.11% )) vs. Gateway story illustrates how management decisions matter. In 1992, Gateway’s return on assets (ROA) was 3.5x higher than Dell’s. Dell had 2x the sales, but both companies had similar profitability.

Over time, Dell succeeded by fully committing to direct sales, while Gateway gave up this advantage by opening retail stores. When computers became commodities and price a pivotal factor, Dell's cost advantage proved decisive.

Two Management Qualities

The two qualities Katsenelson emphasizes as most important are:

To judge management teams, Katsenelson recommends several approaches:

Long-Term Value Creation

Lastly, Katsenelson discusses how short-term Wall Street thinking/pressure forces even great managers into poor decisions.

He notes that even Costco's ($COST ( ▲ 0.75% )) CEO—from one of the best management teams—admitted losing sleep over short-term stock price movements.

Katsenelson summarizes his management philosophy with this advice:

The early 2000s brought painful lessons about "consistent" earnings growth. Enron, Bristol-Myers Squibb ($BMY ( ▼ 0.52% )), MCI WorldCom, and even General Electric ($GE ( ▲ 0.22% )) were caught manipulating numbers to deliver smooth results Wall Street expected.

Reflecting on these cases, Katsenelson warns:

Recurring Revenue

Companies with predictable earnings face less operational risk, making them better suited for range-bound markets. The primary source of this predictability is recurring revenue.

Recurring revenue creates a foundation that reduces volatility and lessens growth pressure. Companies with high recurring revenue need to generate far less new business to show growth.

Katsenelson provides this comparison to highlight the contrast:

Product Disposability

Katsenelson also explains how product disposability affects earnings predictability:

Companies producing durable goods with long useful lives (houses, cars, equipment) can still be good investments, but require careful timing—typically avoiding periods after supply has flooded the market.

Moreover, their higher earnings volatility should be balanced by stronger balance sheets (discussed below) or a greater margin of safety in valuation.

A strong balance sheet gives companies flexibility to weather mistakes and market downturns. Companies with little debt have more room to maneuver when business conditions change.

Katsenelson observes that businesses that could afford debt often avoid it, while those that would benefit from conservative financing often take on too much.

The reason? Companies with high return on capital and significant free cash flows typically don't need to rely heavily on debt.

When Debt Becomes Dangerous

Certain industries tend to use excessive debt even though their business characteristics make this approach risky. Katsenelson points to auto manufacturing and airlines as examples. These industries share three dangerous characteristics:

Together, these create "total leverage" - a mixture of operational leverage (high fixed costs) and financial leverage (high debt). During downturns, revenues drop while costs stay high, quickly leading to losses.

Balance Sheet Distortions

Stock buybacks can make traditional leverage ratios misleading, such as debt-to-assets (D/A) or debt-to-equity (D/E) ratios.

Katsenelson demonstrates this with Colgate-Palmolive ($CL ( ▼ 0.95% )) from 1999-2002:

Looking at these ratios alone would suggest financial deterioration. However, cash flow based metrics told a completely different story:

Therefore, to avoid being misled, Katsenelson recommends ratios that compare debt levels to earnings and cash flows, as well as those that measure interest coverage:

Hidden Liabilities

Beyond visible debt on the balance sheet, investors should also look for hidden liabilities:

Strong Balance Sheets as Acquisition Targets

There's also a hidden benefit to strong balance sheets - they make companies attractive acquisition targets.

When acquired, shareholders may receive more than the current market price (a "takeover premium"), providing an immediate gain above what they'd get by selling shares on the open market.

Free cash flow (FCF) represents money remaining after a company pays all expenses, including investments for future growth.

Katsenelson defines FCF as "operating cash flows less capital expenditures" - what’s left after paying salaries, taxes, inventory, interest, and investments in physical assets:

Companies with significant FCF gain valuable flexibility during range-bound markets, allowing them to:

Nokia ($NOK ( ▲ 1.19% )) demonstrated this in 2004-2005. When its stock hit multi-year lows (trading at just 12x FCF), Nokia was generating over $5B in free cash flow annually with $15B in cash and virtually no debt. Management repurchased approximately 11% of outstanding shares, creating substantial shareholder value.

Maintenance vs. Growth CapEx

One of Katsenelson's key insights involves distinguishing between two types of CapEx:

When growth slows, which inevitably happens even for successful companies as they reach a size where supernormal growth becomes impossible, the type of CapEx matters:

Walmart ($WMT ( ▲ 0.7% )) exemplifies this. In 2005, it spent $14.5B on CapEx (over 80% of operating cash flow), mostly for new stores and distribution centers.

If Walmart halted expansion, CapEx would drop dramatically, significantly boosting FCF and enabling share buybacks and dividend increases that could partially offset some of the P/E contraction that accompanies slower growth.

Managing FCF Volatility

Katsenelson warns that FCF is typically more volatile than net income because:

To handle this volatility, he recommends averaging free cash flows over several years rather than focusing on any single year's results.

Another approach is using depreciation as a general indicator of CapEx patterns:

Depreciation reflects past investments while CapEx shows current spending. This relationship changes predictably through a company's lifecycle, offering a simple growth stage indicator.

Using FCF Wisely

Finally, Katsenelson emphasizes watching how companies use their FCF, as poor decisions can destroy value. For instance, while some acquisitions create shareholder value, many serve to build “bigger (not better) corporate empires.”

He cites AT&T's ($T ( ▲ 0.17% )) purchase of NCR Corporation in 1992, later sold at a fraction of its cost, and its acquisition of TCI Inc. in the late 1990s, sold to Comcast in 2002 at a loss.

As Hewlett-Packard ($HPQ ( ▲ 0.34% )) founder David Packard observed, "More companies die of indigestion than starvation," suggesting investors should view significant acquisitions skeptically unless the company has a proven track record of successful integration.

Return on capital measures how efficiently a company uses money invested in the business:

This ratio shows how many dollars of profit a company generates for each dollar invested. When a company's return significantly exceeds its cost of capital, it signals the ability to create substantial shareholder value.

Katsenelson identifies return on capital as one of two essential ingredients in the earnings growth formula, alongside growth opportunities.

Companies with high returns can expand using internally generated funds rather than outside financing. This creates significant advantages:

For example, a company generating 20% return on capital can grow twice as fast as a competitor earning 10%, while reinvesting the same amount of profits. Alternatively, it could match the competitor's growth while paying half its earnings as dividends.

Consistently high returns typically signal the presence of a sustainable competitive advantage. Without such protection, high returns would attract competitors who would drive down prices and profit margins (as discussed previously).

Companies maintaining high returns over time usually have established moats protecting them from competitive forces, creating a virtuous cycle of internal financing and sustained profitability.