AFG’s Investment Grade™ model is designed to provide professional money managers a consistent and proven process for identifying undervalued securities and avoiding potential torpedo stocks while helping them navigate through constantly changing market environments. Simplified letter grades are attached to each company in our database based on rankings within a set of proven proprietary variables including Valuation, Momentum and Quality characteristics all of which are centered on AFG’s Economic Margin Framework.
The Economic Margin Framework is a performance metric that measures the amount a company earns above or below its true economic cost of capital. By correcting many of the distortions inherent in traditional accounting based valuation metrics and DCF models, our valuation process has an advantageous starting point when beginning to understand the value of the firm.
The Investment Grade model seeks to identify companies with the following characteristics;
Positive Economic Margin: Companies that earn above their economic cost of capital are profitable. Profitable firms that grow assets in order to maximize this profitability are more likely to create value for shareholders.
Trading at a discount: Our valuation metric, which is grounded in the Economic Margin framework has proven to correct many of the distortions inherent in traditional accounting approaches. This process has proven to attach meaningful and accurate valuations to companies and help investors outperform.
Positive Economic Margin & Price Momentum: Studies have shown that companies with positive price and earnings momentum tend to outperform. Our momentum variable that focuses on improving Economic Margins rather than EPS is a more dynamic approach to incorporating momentum into a valuation model and our backtests prove that it outperforms traditional EPS momentum.
Strong Earnings Quality: Companies that have a high level of accruals on their books (poor earnings quality) are more likely to encounter negative earnings surprises and underperform. By eliminating companies that have high levels of accruals investors can avoid companies that may not be able to sustain their current level of earnings and focus their attention on companies that provide more realistic projections of future earnings.
Sound Management Strategy: Companies that do not earn back their cost of capital should not be growing. Our Management Quality variable eliminates companies that follow a wealth destroying strategy of growing a business even when not earning a profit rather than first focusing on improving operations.
Why AFG Investment Grade?
All of the factors in this model have proven to add value as standalone screening variables, but are even more successful when used in concert. This dynamic multi-factor model makes slight adjustments to the weightings of each factor on a monthly basis to take full advantage of the variables adding the most alpha in the current market environment. This provides our clients a consistent approach to picking stocks that works well in any market environment. Below is a chart that illustrates the performance of Investment Grade A through F stocks within the Russell 1000 from 1998 to 2015. Our “A” Grade stocks have outperformed the “F” Grade stocks by over 10% over this time span and there is a monotonic relationship from A to F.
We believe that we have developed a more refined approach to picking stocks than traditional DCF approaches and Earnings based metrics. Investors who implement a long term investment strategy of buying “A” & “B” grade stocks and avoiding “D” & “F” grade stocks using AFG’s Investment Grade model are able to pick stocks in any market environment with a consistent approach that has proven to outperform. The stocks listed below all rate well within the model in Valuation, Quality and Momentum factors to be graded as “A” Investment Grade. This list can serve as a solid starting point when looking for new investment ideas in the Large-Cap space.
10 Attractive Russell 1000 Companies