With the S&P 500 at all-time highs and growing concerns of a possible market correction/recession, it is important to identify companies that may have become overvalued in the recent bull market. Today we will provide a list of stocks that are among the least appealing stocks in the Russell 1000 and may pose significant risk to investors in bear market conditions. All of these companies have been assigned an investment grade of “F” and have also received an “F” Grade for Management Quality.
We will start by briefly explaining AFG’s Investment Grade and Management Quality score and how our Economic Margin Framework serves as the backbone of both grades.
Our Economic Margin (EM) Framework works as an alternative to accounting-based valuation methods, providing us with an economic cash flow perspective. Using EM Framework, we are able to determine how profitable a company is by better understanding how much the firm earns above or below their true economic cost of capital, giving a better view of the underlying company’s economic strength. Positive EM’s suggest the return a company is earning above their cost of capital, while negative EM’s suggest the return below their cost of capital. This framework allows us to create valuation models as well as make judgements on management quality.
AFG’s Investment Grade is calculated by using a dynamic weighted grading system that factors in the Valuation, Quality, and Momentum of each company and provides a simplified letter grade based on the rankings within the three major factors. 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.
For our Management Quality score, we utilize the Economic Margin framework to come to unbiased judgements of management’s ability to create wealth for its shareholders. We focus on identifying and flagging firms that are not earning back their cost of capital (negative EM) and yet are still growing their business. A management strategy of growing a losing business without somehow first fixing the profitability issue is a strategy that most often destroys shareholder value.
To help showcase how our Economic Margins Framework leads us to a decision on management quality, we will look at YELP as an example. Over the last 3 years Yelp has only been able to generate positive EMs one year but has grown significantly over this time period.
It isn’t surprising to see that YELP delivered -51% returns since 2014 by continuously growing at the expense of their EMs. Management’s strategy of asset growth in relation to its level of Economic Profitability has resulted in a lot of pain for YELP shareholders.
In evaluating management, investors want decision makers that can grow and maintain a profitable business, or recognize when profitability has been lost and begin to scale back in order to regain profitability. As seen above, YELP is following what we label as a “Wealth Destroying” strategy. We assign two grades in regards to management quality; A and F. As described in the images below, “A” graded firms are either able to maintain economic profitability or recognize that they are not profitable and begin to divest some of their unprofitable assets. “F” grade firms are not economically profitable but still attempt to grow those assets, in turn destroying shareholder value. YELP has an “F” grade for Management Quality. Our management quality metric works well as an exclusionary variable, as the firms flagged as “F” have proved historically to underperform their “A” ranked peers and index benchmarks.
If you currently own or are considering adding these companies to your client’s portfolios, beware that they raise multiple red flags in AFG’s system that have been proven to identify torpedo stocks.
10 Stocks to Avoid – Russell 1000