Have a safe and happy holiday weekend!!

On Monday we highlighted several companies from our buy/sell list that represented investment ideas for all types of investors, which included Small and Large Cap stocks as well as Growth and Value stocks. Since Value Expectations tends to provide Large Cap Value Stocks for potential Buy ideas, earlier this week we decided it would be helpful to also highlight some small cap stocks we like from the Russell 2000. Now, moving on to the Growth investor, we will focus on companies we classify as growth stocks and find attractive within the S&P 500 (excluding Financials). By definition, AFG classifies growth stocks as companies with a Market Value/Invested Capital (MV/IC) in the top half of their sector.

In the table below are 10 growth stocks that we find attractive based on AFG’s valuation model, and are ranked neutral or higher based on AFG’s default recommendation.

Attractive Growth Companies - S&P 500 (excluding Financials)

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

AFG's Growth Universe - Companies in the AFG universe, which have MV/IC in the top 50% of the universe and have EPS estimates.

Market Value/Invested Capital (MV/IC) - The firm's average total equity, debt and other obligations divided by net invested capital.
 

Many of the institutional clients of The Applied Finance Group, Ltd. (AFG) tend to focus on large cap stocks and benchmark themselves against the S&P 500 Index, which is why many of the buy ideas from ValueExpectations.com usually come from the large cap index. Earlier in the week we highlighted companies from our buy/sell list both from large and small cap, as well as from growth and value style universes. We thought it would be a good follow up for some of the investors we work with who focus on small and mid cap stocks, to provide a more thorough list of companies from the Russell 2000 Index.

Below is a summary of 20 companies to watch from the Russell 2000 Index. The table highlights the 2 companies from each sector (ex. Financials) that have the most attractive Value Score (above 80) and are currently rated Neutral or higher by AFG’s buy/sell criteria. Factors used to derive an AFG recommendation include: Expected change in Economic Margins, Intrinsic Value, and Management Quality. Many classify stocks with market capitalization under $250 million as micro caps, therefore only those companies within the index that met that market cap minimum were considered for the list.

Russell 2000 - Stocks to Watch (above $250 million, ex financials)

What do we use to measure corporate performance and calculate an intrinsic value:
AFG’s Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below its cost of capital. Our Economic Margin Framework encompasses a valuation system that explicitly addresses the four main value drivers of enterprise value: profitability, competition, growth, and cost of capital.
AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).
Management Quality – Assesses management’s ability to make wealth creating decisions.
AFG's Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

Since 1996, The Applied Finance Group has excelled at identifying mispriced securities and helping our clients take advantage of such mispricings within the US markets.  Over the last few years, AFG has been working on expanding our framework internationally to help our clients identify solid long-term equity investment opportunities on a global scale.  Our global research site, AFGViewGlobal.com has coverage on over 30,000 companies with back-test results proving that the same group of variables that have proven successful on a domestic level are quite successful at identifying winners and losers all over the world.

Below is a look at the 10 most undervalued stocks in the Nikkei 225, the most widely quoted average of Japanese equities within the Tokyo Stock Exchange (TSE). According to AFG’s valuation model these companies look to be attractively priced and have considerable long-term upside. We will monitor these 10 stocks through time and compare them against the overall index and provide our performance relative to the overall index just as we have done over the last 7 months with our US Buy recommendations (see ValueExpectations.com buy/sell spread results here).

10 Most Undervalued Stocks - Nikkei 225

AFG's default valuation is a great place to start when looking for potential equity investments as our valuation techniques have proven successful through time at identifying mispriced securities and helping our clients identify investment opportunities resulting in outperforming their chosen benchmark.

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

The table below shows the returns of each country broken down by AFG valuation Top/Bottom Half companies vs. the entire universe. AFG's default valuation works well across sectors, styles, industries and even different countries. Check out the spraeds between Top and Bottom Half companies based on AFG valuation.

Annualized Returns - Valuation Rank

Source: AFGView Databases:

World Return is the weighted US$ return for the 17 countries shown.  It is calculated by converting each country's return into US$ returns and weighting them at its beginning period country market caps.

*Canada data begins 6/30/2004, Taiwan data begins 2/28/1995

Equal Weighted, Monthly Re-balanced Total Returns.

As some investors may believe the market is starting to show "signs of recovery", many of the over 200 institutional firms The Applied Finance Group (AFG) works with can always take advantage of identifying mispriced securities. While some of AFG’s clients might have a specific focus on growth or value, most subscribe to the practice of buying growth at a discount (growth at a reasonable price GARP) and avoiding  “value traps.”

In October 2008 AFG released the study, Then and Now, discussing the low expectations priced into the market "Today many world-class franchises are available at expectations reflecting a very bearish future. Over 150 companies in the S&P 500 (industrials) have negative sales growth expectations embedded into their current market valuations". Following that study AFG issued another study, Analyzing Market Troughs and Rebounds, which pointed out that historical market recoveries have been typically dominated by value stocks.

Whether you are looking for value or more growth oriented securities, we have provided a list of  companies in various asset classes, Large Cap Growth, Large Cap Value, Small Cap Growth, Small Cap Value that are currently on AFG’s Buy and Sell list. If you are a professional investor and would like to view a complete buy and sell list or take a trial of AFG's valuation tools CLICK HERE.

Monthly Buy/Sell list Across the Market
The Applied Finance Group has a disciplined approach for identifying companies that are expected to outperform and underperform the market by using proprietary metrics and measurements that have been tested and proven through time. Because AFG’s research is fundamentally derived, AFG’s quantitative analysis spans across growth and value stocks, all sectors, industries, and market caps with over 4,500 covered securities. By using AFG’s proprietary criteria, AFG publishes a monthly buy/sell list to provide clients with a refined focused list as a starting point for all investments. This focus List of stocks has outperformed the market on an annual basis by greater than 10% with our buy portfolio and underperformed the market by 10% with our sell portfolio. AFG clients then use Value Expectations to further analyze the expectations embedded in a security’s price (example of expectations embedded in the entire S&P500 over the next 5 years below) and to build out their own model to refine an intrinsic value of a company based on their own expectations.

Select Companies From AFG's Current Monthly Buy-Sell List

(Source: The Applied Finance Group)

Again, If you are a professional investor and would like to view a complete buy and sell list or take a trial of AFG's valuation tools CLICK HERE.

Model Portfolio Buy/Sell Results

To view how AFG defines the Large/Small and Growth/Value universe Click Here.

A brief description of some other of AFG's insights:

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.
AFG's Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

The Applied Finance Group’s (AFG’s) Earnings Quality variable is an important indicator of companies that may be more likely to have negative earnings surprises and underperform due to high amounts of accruals. With many firms under pressure to meet sales expectations in the current environment, it is important to watch out for those firms that may be trying to pad their sales numbers, ie. Channel stuffing (sending excess inventory to stores that cannot sell their products).

The EQ score ranges from 1 to 100, 1 being the best EQ score resulting from the lowest accruals, and 100 being the worst EQ score indicating the highest accruals. Because high EQ score companies (bad Earnings Quality) are more likely to have negative earnings surprises, you may want to avoid these firms. Our back-test indicates that the EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

We screened the S&P500 to identify those firms with the worst Earnings Quality (EQ), which may be possible torpedoes. The Chart Below displays the 14 firms along with their EQ scores and our valuation analysis.

Earnings Quality: Accruals

•An accrual is the difference between Cash Flow and Net Income.

•Net Income = Cash Flow + Accruals

•Low Accrual companies outperform high accrual companies

Two ways to approach accruals:

1. Cash Flow Statement
•Difference between Net Income and Cash Flow

2. Balance Sheet
•Change in Net Operating Assets from Period t-1 to t
•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

 14 Worst Earnings Quality Firms

Here is a look at how well the Earnings Quality variable works when you split top half vs. bottom half in each sector/style.

Source: AFGView client databases from 9/1998 - 5/2009   Universe size: 4,000 to 5,500 firms

Here is a look at an example of a poor Earnings Quality company that has a negative earning surprise and thus underperforms.

Eastman Kodak

If you like this article, you might be interested in stocks that fit our Buy Reccomendations: Click here to read

A brief description of some other AFG's insights:

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.
AFG's Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

Paychex is set to report tomorrow with many investors wondering if they will beat estimates. When taking a closer look at Paychex, it is quite impressive how they have continued to improve their Economic Margin (EM). EM’s for Paychex went from 10 in 1994 to roughly 30 in 2007.

*AFG’s Value Expectations allows us to understand the Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. In theory, and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future Sales Growth of Apple assuming its EBITDA Margins and Asset Turnover stays at the 3 year median levels.

However, good companies don’t always make good investments.  By using their 5yr median EBITDA Margins (40.81% ) and asset turns (.31) then solving for the sales growth that is priced in, at $26.16  investors are paying Paychex to grow their sales by 15.58% over the next five years.  Considering sell side estimates for 2009 are expected to be .05%, they have a huge hill to climb.

Source (Applied Finance Group)

What do we use to measure corporate performance and calculate an intrinsic value:
AFG’s Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital. Our Economic Margin Framework encompasses a valuation system that explicitly addresses the four main value drivers of enterprise value: profitability, competition, growth, and cost of capital.

For investor’s concerned with the potential for inflation here at home, companies that derive a significant portion of revenues from outside the U.S. may be of interest. Based on The Applied Finance Group’s valuation model, we found 10 attractive ADRs, as well as 10 unnatractive ADRs, with a market cap greater than $1 billion that derived more than 50% of sales from outside the U.S. in the most recent fiscal year. An ADR (American Depositary Receipt) is a stock that trades in the U.S. but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on American markets just like regular stocks, and are issued/sponsored in the U.S. by a bank or brokerage, making it easier for Americans to invest in foreign companies.

 10 Attractive and 10 Unattractive ADR's

A brief description of some of AFG's insights:

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality– Assesses management’s ability to make wealth creating decisions.
AFG's Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

The AFG 50 is an actively managed model portfolio of 50 stocks, designed to outperform its benchmark (S&P 500) while remaining sector-neutral. The AFG 50 Portfolio serves as an outsourced research team, as our analysts monitor each major economic sector to provide our clients with actionable buy ideas backed by detailed models, reports, updates and a backup list for possible replacements within each sector. Anytime there is a change made to the portfolio, i.e., new stock, reiterated/change of add/drop recommendation or adjustments made to models, our clients are immediately notified via e-mail.

The AFG 50 was launched on June 10, 2004 at AFG’s inaugural client conference. Through June 1st, 2009, our clients have enjoyed the following performance:

Outperforming the Benchmark 4 of 5 years with Cumulative Performance of over 1,100 bps.

• AFG50 and AFG100 are model portfolios and results do not include management fees or transaction costs
• AFG50 and AFG100 are re-balanced at end of each quarter to remain sector neutral vs. their respected benchmark, S&P500 and Russell 2000
• Average Annual Turnover: AFG50 less than 20%, AFG100 less than 40%

AFG 50:
• An actively managed portfolio of 50 stocks, remaining sector-neutral.
• Long-only and targeting turnover of less than 40% annually.

Our Goals:
• To consistently beat the index our clients are most often measured against, the S&P 500.
• To serve as an outsourced research team, distributing relevant content to our clients on a timely basis.
• To provide consistent, actionable buy ideas in each major economic sector.

Here is a sample report from our AFG 50 model portfolio.  The AFG 50 model portfolio provides institutional investment firms access to a devoted research team and investment process with the specific goal of consistently beating the S&P 500.   The AFG 50 leverages our client’s investment process and enables them to focus on their core strengths.  Below is a sample equity research report updating our thoughts on CTSH:

Professional Money Managers, click here to register for a free trial of our AFG 50 Model Portfolio.

Every year Fortune releases a list of the 40 best companies to invest in now to retire on. This long-term portfolio is designed to protect your hard-earned nest-egg as you approach retirement.

Last year Fortune’s portfolio of 40 best stocks to retire on returned -23.07% from 6-20-08 to 6-16-09, relative to the -30.8% returned by the S&P500 during the same time period. This year they are replacing 23 stocks to form the new portfolio.

Provided below are the 40 stocks recommended by Fortune as the best stocks to retire on in 2009 and our outlook of these companies from a valuation perspective based on The Applied Finance Group’s valuation model.

 Fortune's 40 Best Stocks to Retire On - 2009

Related Stock Article:
Is Apple a Buy Hold or Sell?, Click Here to View

Today, Apple will be releasing it's newest iPhone, the 3G S, which offers improvements in speed, memory, and battery life over the previous model, and comes equipped with a new video recording feature. The 3G S also has the latest version of the iPhone’s operating system, OS 3.0, which also seems to have made some improvements over the previous version. Furthermore, Apple just recently announced it is cutting the price of the iPhone 3G by 50% to $99, as it ushers in the newer model. As investors ponder the impact of the release of the iPhone 3G S, as well as the price reduction of the iPhone 3G (we won’t even mention the questions regarding Steve Jobs’ health), we thought it would be timely to show the Value Expectations embedded into Apple’s stock price necessary to justify it's recent peak, trough, and yesterday’s closing trade. These expectations assume that Apple will maintain 3 year median levels for both EBITDA margins and Asset Turnover.

AAPL Trading Price

Chart A

Source(The Applied Finance Group)

In December 2007, Apple's stock price hit a high of $199.82 and along with that came some pretty big expectations to support that price. To justify that trading price now, Apple would have to grow sales by approximately 22.7% over the next five years. This translates to about $90 billion in annual sales by 2013.

Chart B

Source(The Applied Finance Group)

On January 20th 2009, Apple's stock price hit a low of $78.2 and along with that came some very low expectations to support that price. To justify that trading price now, Apple would only have to grow sales by about 1.6% over the next five years. This translates to about $35 billion in annual sales by 2013.

Chart C

Source(The Applied Finance Group)

Yesterday, Thursday, June 18, Apple closed at $135.88. To justify this price, Apple must generate annual sales growth of approximately 13.9% over the next five years. This translates to about $62 billion in annual sales by 2013.

AFG's Value Expectations interface provides you the flexiblity of building your own set of expectations for a company, and will translate those expectations into an intrinsic value for its stock price. In regards to Apple, the answer to whether you should BUY, SELL, or Hold heavily depends on your confidence in the company’s ability to generate annual sales growth of 13.9% over the next five years (as well as the EBITDA Margin and Asset Turnover expectations). If you expect the company to deliver results in line with these expectations, the company would appear to be fairly valued. In the next couple of weeks we will be issuing some new buy ideas. If you would like to be the first to recieve them via emal, click here to register with Value Expectations.

*AFG’s Value Expectations allows us to understand the Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. In theory, and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future Sales Growth of Apple assuming its EBITDA Margins and Asset Turnover stays at the 3 year median levels.

The Applied Finance Group's Valuation, Corporate Performance, Management Quality and Earnings Quality variables work by making several adjustments to as-reported information from financial statements to see through the gaps in GAAP accounting principles. For example, AFG views R&D as an investment instead of as an expenditure, thus rewarding companies for investing in R&D instead of punishing them. Everyone agrees that accounting based information provides an incomplete view of a firm's true economics. AFG's Economic Margin provides a systematic approach to converting as-reported accounting data into a performance measure that captures a firm's true economics, and is comparable across time, peers, and even industries. Below is a graphic example of how AFG's variables correct for some of the distortions caused by GAAP accounting.

One of the key variables AFG uses when identifying potential investment opportunities is the Management Quality Score, which provides insight into management’s ability to create or destroy shareholders wealth. Below is a brief description of the Management Quality Score, followed by a graphical representation that describes each of the four quadrants.

Management Quality Score Insights:

•Measures a company’s Economic Margin (EM+1) and LFY Asset Growth.

•Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.

•Un-biased quantitative way to analyze a company

•Holds management teams accountable for unprofitable growth

Management Quality - Evaluating Management:

• Assess companies’ Economic Margins.

• Evaluate the ability of companies to sustain Economic Margins based on historical performance.

• Build out companies’ future cash flows to better evaluate expected future performance relative to their peer group.

• Look at companies’ investment prospects, and review how they are growing or shrinking their business.
A company with a wealth creating strategy has a positive EM + 1 and is growing its asset base, or Management Quality Score = 1. A wealth destroying company has a negative EM + 1 and is continuing to grow its assets, or Management Quality Score = -1.

AFG recommends avoiding companies with management teams that implement a wealth destroying strategy, as these companies have proven to be more likely to underperform their chosen benchmarks than those companies following a wealth creating strategy.

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.
 

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

Join Value Expectations... it's FAST and FREE!