Understanding “Value Expectations” By Sector

Two weeks ago we discussed the importance of understanding the expectations for revenue growth that are “priced-in” to a company’s current trading levels to develop “hurdle rates” to determine which companies look most likely to meet current expectations in relation to their historical growth rates or your own projections for growth. The Value Expectations interface is a valuable for money managers as it essentially “reverse engineers” what a company needs to deliver in sales growth over the next 5 years (assuming 5 Year Median Margins and Asset Turns) in order to justify its current trading price and allows users to quickly filter through a list of constituents and identify companies with low expectations. By aggregating this data for an entire index we can track the overall expectations of the index through time and begin to identify the attractiveness of the index as a whole and effectively communicate the underlying expectations to our clients and readers. In the article two weeks ago, we concluded that the median company in the index is priced to grow revenue by around 11% over the next 5 years, while the median company in this group has delivered just under 8% on average over the past 5 years signaling that current expectations are quite lofty.

Although expectations are currently high, they remain within normal range (within StdDev+/-1.5) and we maintain that normal exposure to large-cap stocks is still a safe bet and there are plenty of attractive opportunities to be had in the current market. One way to begin to identify attractive companies to consider as investment opportunities is to drill down a step further to the sector level to determine which sectors within the S&P 500 have low expectations for revenue growth priced in.

The chart below highlights the Implied Sales Growth for each sector within the S&P 500. The blue bar represents what each sector as a whole need to deliver in sales growth to justify current trading levels, the gray bar is the actual median sales growth achieved by the same group of companies over the past 3 years, the green dot represents the delta between expectations/historical sales growth. The sectors are displayed left to right from lowest to highest expectations. From this point of view, the Financials sector currently has the lowest expectations currently priced in.

Drill down even further to the industries within the Financial sector to see what sub-universe of the sector looks most attractive. The Consumer Finance sub-sector has the lowest “hurdle rate” to beat expectations for revenue growth and looks like the likeliest group to be able to deliver adequate returns for investors.

The final step in this process is to uncover which individual companies make up the most attractive Sub-Universe: Consumer Finance, in the most attractive sector: Financials. The 5 companies below all look to have very low “hurdle rates” to beat expectations relative to what they have delivered in growth historically. It is not surprising that these firms all earn AFG Investment Grades of A or B as they all look attractive from a valuation perspective and all have very low expectations for sales growth. Not only do these companies look attractively priced and have low expectations, but this group of companies and the sector as a whole are likely to benefit from the current administrations recent actions and talks of deregulation of the Financial industry as a whole.