When AFG created its Investment Grade model for helping investment professionals select individual securities for their clients, it set out to harness the strengths of our Economic Margin (EM) methodology and Valuation metrics. While solely focusing on companies with cheap valuations and positive or improving EMs adds a significant amount of alpha, we noticed that by combining these metrics in a multi-factor, weighted model outperformed more consistently and greatly reduced much of the underperformance during momentum driven market environments and times when valuation is out of favor.
The Investment Grade model incorporates several proven factors that help identify stocks likely to outperform and also help avoid potential torpedo stocks. We grade each company in our universe on its Valuation attractiveness, Earnings Quality, Management Quality, EM Momentum and Price Momentum and then average all of the grades to come to one simplified letter grade from A-F that represents the overall attractiveness of a company as an investment opportunity. While every one of these factors has proven to add value as standalone metrics, the overall consistency and outperformance is best when these metrics are used in concert.
What makes this model dynamic and extremely valuable as a research tool is that the weightings of the factors that make up the overall Investment Grade are adjusted on a monthly basis in order to make sure we are taking full advantage of the metrics that are adding the most value in the current market. The ability to have one consistent approach to valuing stocks that can help money managers navigate different market environments, easily communicate with clients about individual holdings while outperforming benchmarks can be valuable for any money manager.
AFG’s Investment Grade model has improved upon traditional DCF approaches and Earnings based metrics to come up with a more complete approach to analyzing a security. By focusing on companies that are trading at a discount to its intrinsic value, following a wealth-creating management strategy, high quality of earnings (low accruals), and positive EM and Price Momentum characteristics you will identify the stocks with qualities inherent in companies likely to outperform and put yourself in a superior starting position when selecting securities.
Investors who have followed a long term investment strategy of buying “A” & “B” grade stocks and avoiding “D” & “F” grade stocks using AFG’s Investment Grade model have been rewarded over time. The chart below highlights the spreads achieved by our Investment Grade Model from “A” Grade companies to “F” Grade within the S&P 500 from September 1998 through the end of November 2016. You will notice that our “A” Grade stocks have outperformed the “F” Grade stocks by over 8% and there is a nice monotonic relationship from A to F.
Utilizing AFG’s Investment Grade model to screen for buy ideas, we will provide our readers a list of 10 companies from different sectors and industries that currently earn an Investment Grade of “A”. The stocks listed below can serve as a solid starting point for money managers looking for new investment ideas in the Large-Cap space.
10 “A” Graded S&P 500 Stocks
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.
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