There are many ways to skin a cat, especially true in the business of picking securities and identifying the most attractive segments of the market. One approach to identifying stocks likely to outperform is to understand the expectations for revenue growth that are imbedded in the stock’s current levels. We perform this analysis using AFG’s Value Expectations interface which incorporates Economic Margin methodology to essentially “solve for” what a company needs to deliver in sales growth over the next 5 years (assuming 5-year median Asset Turns and EBITDA margins) to justify its current trading price. Companies that have extremely low Value Expectations for growth relative to the growth they have delivered historically tend to outperform. This essentially helps investors create an over/under scenario that helps to provide a comparison between their own projections for sales growth, historical sales growth and the Implied Sales Growth expectations.
This process not only helps investors to create a “hurdle rate” for individual companies and identify the companies with the lowest expectations, it also allows us to aggregate this data and identify the most attractive sectors in an index to improve your hunting grounds and track an entire index to identify when it begins to trade outside of normal valuation levels and entry/exit points. Last week we posted an article highlighting the expectations of the entire S&P 500 index since the 1990’s. Currently the S&P 500 looks to be slightly overvalued yet still within normal ranges (+/- 1.5 StdDev), signaling that there are still opportunities to be had within the index although the index is beginning to look expensive on the whole.
Today we will drill down to the sector level to identify the sectors in the index with the lowest expectations to identify where we believe the most opportunities exist. The chart below displays the actual sales growth delivered by each sector (gray bar) relative to the expectations (Implied Sales Growth) each sector needs to deliver in sales growth to justify current levels (blue bar). The sectors are displayed in order from most attractive (lowest expectations) to least attractive (highest expectations) from left to right with the most attractive sectors on the left. Although entire index is somewhat overvalued, the financial, technology, and healthcare sectors currently look to have lowest expectations.
If we drill down into one of the sectors (Info Tech in this example) we can identify which industries/sub-sectors have the lowest expectations within the sector. Again, the sub-sectors are displayed from left to right with the most attractive sub-sectors on the left. Currently the Internet Software and Services sub-sector looks to have lowest expectations of all the sub-sectors within information technology sector.
To drill down one further step, we can view the individual companies within the Internet Software and Services sub-sector along with each companies Investment Grade. Both Facebook and Google belong to this sector and earn an Investment Grade of A.
While this approach to identifying investment ideas may not be a traditional approach, understanding the expectations imbedded in stock prices has proven to be effective at identifying companies likely to outperform and be a strong indicator of future performance.
If you would like to learn more about Implied Sales Growth expectations and how this approach can benefit your firm email us at Sales@afgltd.com.
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