The market has been chugging along so far this year (S&P 500 +5%) and is showing no real signs of slowing anytime soon even though valuation levels do look stretched. Many valuation indicators signal that the index is approaching historical high ranges, yet there is abundant optimism fueled by potential tax cuts and reduced regulations. One method we use to illustrate the overall attractiveness of the S&P 500 is by comparing the Sales Growth the company needs to deliver over the next 5 years (Implied Forecasted Sales Growth) to justify its current stock price relative to what the company has delivered in revenue growth historically. In the chart below you can see that the overall S&P 500 Index is priced to grow around 11% while the index has delivered around 8% over the previous 5 years. This signals that the index is slightly overvalued yet still within normal historical range (+/- 1.5 StdDev).
While the index does look to be somewhat expensive, we believe there are still plentiful opportunities within the index and using AFG’s Investment Grade model to uncover undervalued securities while avoiding potential torpedo stocks can be an extremely valuable tool for investors. AFG’s Investment Grade methodology is a multi-factor model grounded in Economic Margin methodology that assigns a letter grade of A-F to each company in our database based on the overall attractiveness as an investment opportunity. The Investment Grade model factors in the valuation, momentum and quality characteristics of each firm to come to an overall Investment Grade. This model is also dynamic in nature as the weightings of each factor within the Investment Grade model are adjusted monthly to ensure that the factors that are adding the most value are weighted accordingly. The chart below highlights the performance AFG’s Investment Grade model within the S&P 500 from 1998-2016.
Over the long term, sticking to a strategy of buying buckets of stocks that earn an Investment Grade of A or B and avoiding stocks with F Grades has proven to help investors outperform while providing a steady hand to guide managers through volatile market environments. We have employed AFG’s Investment Grade model to screen for some buy ideas within the S&P 500 and have come up with a list of 15 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.
15 Attractive 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.