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Today we will highlight the top performers in the S&P 500 year-to-date (ex. Financials) as well as provide a few company names that look the most attractive and unattractive according to The Applied Finance Group (AFG). AFG’s valuation techniques have proven successful since 1996 at identifying mispriced securities and helping their clients take advantage of those market inefficiencies. Beyond valuation AFG helps clients understand the true economic profitability a company earns by using their Economic Margin methodology.

Economic Margin (EM) corrects distortions caused by traditional accounting policies to give a more accurate assessment of a company's true profitability. It is important to understand the direction a company's EM's are heading because companies expected to improve their Economic Margins have proven to be more likely to outperform than those with EM’s expected to deteriorate. The EM Framework addresses profitability, competition, growth and cost of capital. When factoring in each of these variables, investors can fully assess a company's value.

We are providing a list of the top 25 performing stocks in the S&P 500 index to keep up to date on which companies have lead the way thus far in 2010. Also by using AFG's research and valuation model we have provided further analysis on 8 of the top performing companies, 3 that we find attractive going forward and 5 that we find unattractive, based on valuation attractiveness, expected improvement in economic profitability and the overall investment attractiveness, which is based on various criteria AFG uses when identifying long/short opportunities.

Here are a few companies from the list of top 2010 returns and how we view these companies going forward based on valuation, Economic Margin Improvement, and other criteria AFG uses to value securities.

Below is a look at the valuation attractiveness of Abercrombie and Fitch Co. (NYSE:ANF) according to AFG's Intrinsic Value Chart. ANF is a company that AFG has done a good job tracking and currently looks overvalued. ANF not only has an unattractive valuation but it is also expected to experience a decline in Economic Margins which are 2 of the main ingredients of a company more likely to underperform.

How To Read AFG's Intrinsic Value Chart

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by Christopher Pavese,  Broyhill Asset Management (Guest Contributor)

This simple question, posed by legendary value investor Bruce Berkowitz, puts the consensus concerns surrounding the managed care industry into perspective. The bottom line is that the health insurers are the only shot we have at managing this mess. As much as he might like to, Obama does not have another entity to do it. And our growing government does not have the expertise or efficiency to manage the process.

The bear case for these stocks is well known and well discounted even at today’s levels. Let’s take Humana (NYSE:HUM), for example – 60% of the analysts that cover the company rate it “hold” or worse. To help put this number in perspective, a whopping 1% of the S&P 500 is rated “sell” today. So suffice it to say that the “bad stuff” is in the price. And when the bar is set low enough, it is not difficult to surprise on the upside. Perhaps this is why earnings estimates for the company have been marching steadily higher in recent months. So let’s consider some of the potential “good stuff” that might shift sentiment in the period ahead:

• Roughly three quarters of Humana’s premium revenue is driven by government programs. It’s safe to say that as long as the printing press is still running, Uncle Sam will pay his bills.

• Humana has experienced spectacular growth from these programs driven by Medicare Part D and the trend towards private plans.

• Management effectively capitalized on this opportunity when it was presented. As such, shareholders have been well served by the company’s strategic focus.

• Those receiving insurance through employers has declined this decade, but Medicare enrollments are rising steadily and expected to accelerate as baby boomers enter retirement.

• Humana’s decades of experience in Medicare programs gives the company a competitive advantage in dealing with new government programs for boomers and the uninsured.

• Humana spends much more on SG&A than peers resulting in significantly lower operating margins, and offering plenty of potential to ‘cut the fat’ out of the business.

But rather than throwing darts at potential positive surprises, James Montier recommends turning the process on its head:

Analysts are called analysts, not forecasters, for a reason. All investors should devote themselves to understanding the nature of the business and its intrinsic worth, rather than wasting their time trying to guess the unknowable future . . . Rather than trying to forecast the future, why not take the current market price and back out what it implies for future growth.

This echoes Ben Graham’s words that you don’t need to know a person’s exact weight to know whether they are overweight or underweight . . . The idea of investing without pretending you know the future gives you a very different perspective, and once you reject forecasting for the waste of time that it is, you will free up your time to concentrate on the things that really matter. So, when trying to overcome this behavioral pitfall, remember what Keynes said, “I’d prefer to be approximately right rather than precisely wrong.”

This is an exercise we perform regularly at Broyhill. If nothing else, we think we know what we don’t know. Accordingly, we seldom make forecasts. Lucky for us, accurate forecasting is not a prerequisite for portfolio construction or superior risk adjusted returns. Working backwards from today’s price is more consistent and a much simpler exercise. In analyzing Humana, and most of the managed care space, margin assumptions clearly drive intrinsic value. So it is critical to understand what margin expectations are priced into the stock today. Using consensus forecasts for long term top line growth (recall this is a group that is generally bearish on the industry) we estimate that current prices imply long term EBITDA margins of 2.4% using AFG’s Value Expectations. This implied margin should be viewed in the context of the company’s five and ten year median margins of 4.5% and 3.0%, respectively.

In other words, Mr. Market is already pricing in a near 50% haircut in Humana’s recent EBITDA margins by Uncle Sam. That’s pretty aggressive, even for Obamacare, and leaves plenty of room for upside surprises. We use the matrix below to estimate the stock’s sensitivity to changes in consensus sales and margin assumptions. The bottom line is that investors would require an additional 100 basis point reduction in consensus margin assumptions to justify modestly lower valuations. More importantly, upside surprises offer the opportunity for extremely handsome profits. We can live with those odds.

Source: The Applied Finance Group

Bruce Berkowitz of Fairholme Capital Management tries to kill the company rather than looking for all the information that would support an investment:

We look at companies, count the cash, and try to kill the company . . . We spend a lot of time thinking about what could go wrong with a company — whether it’s a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can’t kill it, maybe we’re onto something. If you go with companies that are prepared for difficult times, especially if they are linked to managers who are engineered for difficult times, then you almost want those times because they plant the seeds of greatness . . . Companies die . . . Here are the ways you implode: you don’t generate cash, you burn cash, you’re over – leveraged, you play Russian Roulette, you have idiots for management, you have a bad board, you ‘de-worsify,’ you buy your stock too high, you lie with GAAP accounting.

Apparently, he was not able to murder Humana. Fairholme owns over 9% of the float.

Christopher Pavese
Broyhill Asset Management
http://www.broyhillasset.com/

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February was a good month. The S&P500 companies reported good Q409 results, with 75% of the constituents beating earnings estimates, and 10% meeting. In addition, the overhang of the widely unpopular health care reform seemed cleared, with Republican candidate Scott Brown elected to the Senate, ending the Democratic Party’s 60-vote filibuster proof majority. Investors’ optimism rose, sending the S&P500 index up by 4%, largely reversing the loss in January. High beta stocks led the way, with the top quintile stocks outperforming the R1000 and R2000 indices by 2.21% and 4.14% in the past month. (Equal weighted return. Please refer to What’s Working portion of the letter.)This has certainly been a much more pleasant start to the New Year compared to 12 months ago. A year ago, we were on a roller coaster ride, witnessing the S&P500 losing 8.6% in January, the worst in history, losing 11% in February, the second-worst on record, followed by a loss of 4.66% on the first trading day of March, another worst in history. Back then, we were attacked by horrific economic news on one front after another: a disheartening GDP decrease of 6.2% in Q4 2008, skyrocketing unemployment, falling home sales and prices, rising credit card defaults, and continuing banking troubles. Amid debates on the merit of “capitalism”, investors were dumbfounded by government’s plans to “save” the economy: the $787 billion stimulus bill, the Homeowner Affordability and Stability Plan, and the President’s ambitious budgets suggesting historical deficits for the country. The Federal Reserve made its own contributions to the rescue efforts, injecting $1.75 trillion into the economy starting in March 2009, including purchasing $1.25 trillion of agency backed mortgage securities and $300 billion longer maturity treasuries.

A year later, the capital markets are in a much better shape and investors are searching for answers to long term fundamentals of the US economy. In the mean time, the outcomes of those rescue efforts are being hotly debated:

1. We have had two consecutive quarters of GDP growth in the 2nd half of 2009 in the US, 2.2% in Q3 and 5.9% in Q4, on an annualized basis. Q3 GDP growth was driven largely by government programs, with both Durable Goods (helped by Cash for Clunkers) and Residential Fixed Investments (helped by First Time Home Buyer Tax Credit) up double digits. Q4 GDP growth was mostly driven by businesses boosting spending on equipment, software, and restocking inventory, while consumer consumption was weaker than expected, registering a growth of just 2%, down from a 2.8% growth rate in Q3. It is widely believed the brisk pace of GDP growth in Q4 is unlikely to continue, unless personal consumption picks up substantially to provide support for consistent business spending.

2. Unemployment was 9.7% in February 2010, flat from January, but was much higher than 8.1% a year ago. The Federal Reserve members forecast the jobless rate would remain in a range of 9.5-9.7% in 2010, improve to 8.2%-8.5% in 2011, and fall to a 6.6%-7.5% range in 2012. Economists say it will take until the middle of the decade for the job market to return to normal, after losing 8.4 million jobs in the Great Recession.

3. Stimulus Bill: Based on the Administration’s sales pitch in January last year that US unemployment would exceed 8.5% without the bill, the stimulus bill has failed miserably. The $93 billion tax cut given out in 2009 in the form of tax rebate geared towards lower income people, didn’t do much about consumer spending. The $159 billion given out to local governments to plug holes in local schools, Medicaid payments, and unemployment-benefits budgets, have relieved some budget pressures at the local level and saved some jobs. Among the remaining 65% of the stimulus money, $190 billion will be tax cuts and $150 billion will be local aids, which we can rather safely expect to generate the same old results witnessed in 2009. Hope is now on the $180 billion for infrastructure spending, which will be stepped up and possibly provide some real boost to the economy in 2010. That said, the bulk of the money for projects such as rail and water will take years to be spent.

4. The $75 billion Home Affordable Modification Program (HAMP) has been widely recognized as a failure. Almost a million homeowners have been on trial mods, ie, short term payment plans. About 25% that received trial loan modifications through the plan are failing to keep up with their new reduced payments, and at least 196,000 borrowers have missed some or all of their required payments. Only one in ten has had their mortgage permanently modified, although HAMP is designed to help 3-4 million Americans. Mortgage servicers were permanently modifying around 100,000 loans a month before HAMP started, and HAMP’s highest monthly total was the 50,000 additional permanent modifications achieved in January 2010. In addition, instead of declining, the number of foreclosed homes increased to a record 2.8 million in 2009, a 21% rise over 2008 and 120% over 2007, according to RealtyTrac. Despite the obvious failure, it is reported that the administration may ban all foreclosures on home loans unless they have been screened and rejected by HAMP.

5. Budget: After generating a $1.4 trillion deficit or 9.9% of GDP in FY09, the US is well on its way to generate deficit of another $1.4 trillion or 10.6% of FY10’s GDP. The White House’s FY11 budget released in early February called for $3.834 trillion in total spending, with a projected deficit of $1.267 trillion or 8.3% of GDP. The Senate extended the nation's debt limit to $14.3 trillion to accommodate the projected gap for the current spending year, which ends September 30, but with another $1.3 trillion hole next year, the nation's debt could reach $15 trillion by October 1, 2011, or about 95% of GDP. The projected $1.3 trillion deficit in 2011, assumes $122 billion extra revenues on overseas earnings from multinational firms, and letting Bush Tax cut expire, which according to the White House will generate $1.2 trillion revenues in the next 10 years. It is important to know that, the FY2011 budget has pension, welfare, and health care outlays accounting for 21%, 12%, and 23% of total spending respectively. In 1950, those percentages were 2.2%, 3.6%, and 2.2% respectively. In 1975, those percentages were 21%, 10%, and 8% respectively. Keep in mind, social security was initially signed into law in 1935 with the first payment issued in 1940. Medicare and Medicaid were established in 1965. History has proved it over and over that entitlement programs don’t just grow in absolute sizes, but grow faster relative to GDP and become larger shares of the overall economy as time passes by. That is exactly why the final push democrats are currently giving to the $1 trillion healthcare bill is extremely disturbing. The last thing the country needs is more deficits and more debt. Deficits can only be tackled through spending cuts and increased tax revenues, driven by GDP growth and tax increases (which we oppose). It is believed median economic growth rates fall by 1% once debt exceeds 90% of GDP, which the US will “accomplish” next year. The $1 trillion healthcare reform program, if passed and implemented, will just make it even harder for the US to reduce debt, in an economic environment with likely slower growth.

6. The Fed’s Quantitative Easing: Becoming the main purchaser of the mortgage market securities, the Fed has successfully kept the average 30 year fixed mortgage rate around 5% in the past year. Together with the government’s first time home buyer tax credit program, low mortgage rates has been widely credited for stabilizing US housing prices, which will have risen 7 consecutive months by December. The Fed will end the agency backed mortgage securities purchase program by the end of March as planned but doesn’t currently anticipate selling any of the mortgage-backed securities in the near term. Questions and doubts abound regarding the Fed’s exit strategy, though the latest 30 year TIPs auction(the 1st auction since Oct 2001) implies a long-term inflation rate of 2.5%, providing some relief to the urgency of Fed’s draining its excess liquidity. Regardless, Fed took its first step of exit by hiking the Fed discount rate by 25 bps in mid February, increasing the difference between the discount rate and the federal-funds rate to 75 bps, although still lower than the 100 bps before the current crisis.

And of course, the world is now flat as we know it and what happens in other parts of the globe is exerting increasing influence on the US economy and capital markets. Late last year, we had a brief shock from Dubai World, the state-controlled company of Abu Dubai, which announced it was seeking to delay debt payments as it negotiates to extend maturities. The event was viewed by some as the start of the final leg of the financial crisis, which had travelled from household default, to bank default, and to sovereign default. Unfortunately, the leg has since increased in size, as the sovereign debt crisis in Portugal, Italy, Ireland, Greece, Spain (PIIGS), has rattled the global markets since last December and accelerated this year centering around Greece.

Last week, the Institute for Supply Management reported that its services index rose to 53 in February, up from 50.5 in January and above the average estimate of economists for 51. The ADP Employment report showed U.S. private employers shed 20,000 jobs in February, fewer than the 60,000 jobs cut in January. The US economy is improving, despite largely failed policies of the Administration. The “unintended” consequences of those policies, however, will still take time to show their impact. In the months ahead, we await to see: how will the housing market react to the end of the Fed agency mortgage security purchase program and the expiration of the home purchase tax rebate incentive? Will private businesses start to hire if the healthcare reform passes which puts stricter requirement on employers to provide health insurance? The 10% comparable store sales gains in February for Nordstrom helped to cheer the market last Thursday, but will wealthier consumers keep their current spending level when a higher tax rate hits their wallets 10 months from now? Answers to those questions will determine consumer confidence, which will in turn affect consumption, the ultimate driver of sustainable GDP growth. Outside the US, will Spain or Italy become the next center of sovereign crisis now that Greece will be bailed out by Germany and France after it agrees to additional spending cuts totaling $6.5 billion? With this much uncertainty, we believe investors should sit tight.

So where does the market go from here? Recently, the market has continued rewarding the speculative companies, lending credibility to the belief that a sustainable recovery is underway. While that may indeed be the case, there are many portents that say otherwise. First and foremost is the battle of wills taking place over the health care reform. While the public is clamoring for something, the majority of the polls indicate that the currently proposed legislation is not the change most desire. The outcome of this legislation in the coming weeks will be important, as it could very well dictate the momentum and tenor for Obama’s remaining term. Put very simply, we think a big driver for the market in the months ahead will be determined by the outcome of this last push for health care reform. Should it pass, we think tougher times are ahead for the market. Our logic is simple: if health care reform passes in its current form, taxes will increase on profits and capital gains beyond the expiration of the Bush tax cuts. Further, a win here by the Administration will likely embolden it to pursue its “Cap and Trade” bill which will create new energy taxes and further reduce corporate profits. Between the current health care reform and a new run at global warming legislation, corporate Economic Margins will be squeezed via lower cash flows and higher cost of capital. That double shock combined with what is currently a fairly priced to over-valued market will likely result in declining multiples and thus share prices. Among the hardest hit stocks under such a scenario will likely be the winning momentum plays of the past 6 months, and high growth stocks. Should this legislation not pass, we expect the economy to continue moving forward, albeit quietly with high single digit unemployment being the norm. In such an environment, the current high beta stock wave may very well continue until a new catalyst reminds investors about the importance of valuation and risk.

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The Applied Finance Group’s (AFG’s) Economic Margin framework helps professional investors, corporations, and consulting firms to better understand the true economic profitability a firm is earning. In addition to corporate performance, AFG’s ability to understand intrinsic value and the embedded expectations in a stock is consistent across different companies, sectors, sizes and countries around the globe. This research process has been used by some of the most well respected firms since 1995 allowing AFG to grow their institutional client base to over 220 institutional investment firms globally that manage over $500 billion in U.S. equities. Because of the need for a more robust valuation model globally, AFG recently released research and investment tools that cover over 30,000 companies in 30 countries and expect to expand coverage over the next few years. If you would like to learn more about AFG’s international research platform CLICK HERE.

In this exercise we filtered through the Nikkei 225 Index and identified those with the most attractive valuations.

Then, we screened these companies based on their earnings quality score, eliminating the highest accrual companies, as they have proven to encounter negative earnings surprises more frequently than companies with low accruals.

The 25 stocks listed below rank highly based on AFG’s measure of valuation attractiveness, are most likely to outperform relative to their sector peers, and seem least vulnerable to run into a negative earnings surprise based on their current level of accruals.

Source: EconomicMargin.com

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions. 

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