Valufocus investing: a cash-loving contrarian way to invest in stocks A Cash-Loving Contrarian Way to Invest in Stocks Wiley Finance Series, Vol. 779

How to Pick a Stock is written for the contrarian investor who wants an investing method that is based on cash flow facts, not on media hype and speculative impulse. This book combines an accessible presentation of a contrarian investment model and the ValuFocus tool that offers a highly studious, detailed explanation of understanding a company's true intrinsic value.

If you can calculate a company's intrinsic value on the basis of knowing if the market is currently under, fairly, or over pricing its stock, then it is possible to invest wisely in the stock market. Investors who want to buy undervalued stocks, or sell (short) overvalued ones will find this book immensely useful. The ValuFocus investing tool calculates the intrinsic value of every company in their database automatically. Thus, an individual investor can become an "A" student of a modeling process, or can go right ahead in using this tool to pick stocks and manage their own portfolio. Additionally, this book helps to develop an enhanced framework to fundamental equity valuation.

• Contains the ValuFocus tool for calculating the intrinsic value of every company in the LCRT Nucleus database
• Offers specific and innovative valuation techniques of practicing professionals for individuals to use in picking stocks long-term
• Highlights the most state-of-the-art approaches to unconventional stock-picking for investors and corporate finance professionals

Offering encouragement to individual investors by outlining a model that delivers satisfying returns, How to Pick a Stock is especially useful for those who are patient and believe in longer-term investing horizons.

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.® Why Not. 77

Why Use Cash Flow ROI, CFROI,® 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® or Residual Income Models 83

CFROI® 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

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.