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The list of most actively traded stocks in the S&P 500 seems to attract the most attention amongst the investment community and always create a good amount of “Buzz”. We decided to take the list of the most actively traded stocks over the last 50 trading days (excluding financials) and run them through The Applied Finance Group’s (AFG’s) meat grinder to see which are worthy of the hype and are attractive investment opportunities and which you should probably stay away from.

AFG uses a set of criteria in its stock selection process that has proven successful at identifying winners and losers in the market including its proprietary measure of corporate performance (Economic Margin), valuation, management quality and earnings quality among other criteria. Of the companies listed that are heavily traded, AFG believes the companies with expected improvement in Economic Margins, attractive valuations, and a wealth creating management team are the companies that will be the most likely to outperform the market and their sector peers. (register now to receive exclusive buy ideas- it's fast and free!)

The rankings above were provided using AFG’s research product AFGView.com and are ranked based on AFG’s overall investment opportunity signal, valuation signal and expected changes in Economic Margins. The companies must rank as attractive or unattractive in all 3 categories or the firm is listed as neutral.

Below is a brief description of those variables with informative links.

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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AFG Recommendation Performance
9/1998 – 5/2009
Annualized Returns

Source: AFGView client databases from 9/1998 – 5/2009
Universe size: 4,000 to 5,500 firms

Keeping an eye on the big movers in the market does not help investors determine which stocks are poised to continue their upward or downward movement. To help our devoted readers identify the movers that still look fundamentally sound and those to walk away from, ValueExpectations.com has scored each of the top 10 Hot and Cold stocks of the month based on Valuation Attractiveness and Economic Margin Change.

If an investor should consider adding any of these stocks as a holding for a portfolio, one should look for companies with attractive valuations and expected improvements in a company’s Economic Margin (EM) which essentially is a measure of a company’s true economic profitability. As an additional level of analysis, we also recommend understanding the embedded expectations that are priced into each of these stocks.

AFG’s Valuation techniques and understanding of economic profitability have proven to identify mispriced securities in the market and help clients take advantage of mispriced securities. Accurately assessing a company’s profitability and understanding how to answer key questions such as… What is the cash flow generated by the company’s operations? How much capital is required? What are the opportunity costs of this capital? This robust process is what sets AFG’s corporate performance metric Economic Margin (EM) apart from other Value Based Metrics such as an IRR calculation, a CFIRR or a RONA Economic Profit approach.

It is not surprising to see the list of best performers dominated by Tech stocks as professional investors in our last month’s sentiment poll identified Technology as the most attractive sector to bet on in the upcoming months and companies like DOW and EK on their respective best and worst lists as they both have been discussed recently on VE.com. Dow was recently noted as one of the most attractive stocks within AFG’s Basic Materials sector (ranked 2nd most attractive sector amongst professional investors) in mid-august. Eastman Kodak (EK) is just one example of a torpedo AFG’s clients and ValueExpectations.com readers have avoided due to regularly being on AFG lists of stocks to avoid and also a model of poor Earnings Quality (high accruals) one way AFG filters out companies likely to underperform, and more likely to encounter a negative earnings surprise. EK has consistently had a poor EQ score according to AFG’s measure of accruals and continues to be ranked amongst the worst in its sector in Earnings Quality.

About the AFG Screener

Professional investors have many ways to screen and narrow their list of constituents to create a focus list of companies they use to select from to develop their portfolios. In the industry, there are many screeners that are part of subscriptions to databases and investment tools, however, many of them do not provide guidance on the best screening methods to use. Created by The Applied Finance Group (AFG), the AFG Screener tool is a web-based company-screening application located on AFGView.com that is designed to save you time when narrowing your list of constituents. More importantly, AFG’s screener allows you to use proprietary variables that have been proven to outperform, helping investors make better investment decisions.

AFG’s Screener allows clients to find aggregate groups of companies that meet specific criteria from AFG’s entire global universe of over 14,000 securities. Using the Screener, one can find a list of companies that either match one of AFG’s preset screens or one based on a customized screen that you create.

The AFG Screener identifies attractive valuations, strong management teams, corporate performance, and the quality of earnings of a company as well as all traditional financial variables,

Because AFG’s Screener is web-based, clients can gain access from anywhere that has an internet connection, convenience and ease of “one-click screening” with our default screens, various forms of result presentations, and compatibility with Microsoft Excel for further analysis.

How to Use AFG’s Screener

Access AFG custom built screens that many clients regularly utilize that include AFG’s proprietary Economic Margin (EM), valuation and management quality variables along with many others.

Build your own custom screens using any variables you are familiar with such as price multiples and other accounting information by themselves or coupled with powerful AFG variables with just a few clicks of the mouse.

Once you have narrowed your list of constituents to those companies that meet your specific criteria you can easily upload your new list into AFG’s valuation model to analyze each company in greater detail or see how they rank vs. their peers on key AFG variables.

Default / Custom Screens

Whenever a new user is introduced to AFG’s Screener, they are provided with two default screens – AFG’s Default Buy screen and AFG’s Default Sell screen. Using these screens, one can filter companies based on AFG’s buy/sell criteria.

However, the AFG Screener is very intuitive allowing clients to create their own screens based on custom criteria. There are countless combinations that can be used to create a custom screens, as there are over 600 variables to choose from. AFG’s Screener tool can be used to list companies based on Indexes, Sectors, Industries, and previously created Portfolios.

Using Excel / Further Research

AFG screens can also be accessed using AFG’s Excel add-in to combine results with other spreadsheets or to create a report for your investment team. Exporting your information will give you more freedom to read, organize and document your data as well as pull in other variables within AFG’s Excel add-in to easily rank order your list of companies based on the same variables available within the screener.

Example Screen:

Below is a list of 12 companies that resulted from a quick screen that sought to identify those companies within the S&P 500 with attractive valuations, market cap above $1 billion, expected to improve EMs greater than sector peers, and that have a current stock price of under $30. Improving EMS and an attractive default AFG valuation rank is a good place to start when looking for the companies most likely to outperform. This is just one simple example of the capabilities of using AFG’s screener tool to select a focused list of stocks that are the most likely to outperform and a list that is worthy of more time spent on due diligence on the companies that meet the specified criteria.

The Applied Finance Group would also  like to invite professional investors to join AFG’s Market Forecast Project so you can better understand what your peers currently think about the market and cultivate the “wisdom of Crowds” into actionable investment ideas and themes.

Register to View Complete Market Review and Sector Analysis, it's FAST and FREE!

Back in February Valueexpectations.com released a blog highlighting Fidelity’s Low Priced Stock Fund that follows a strategy of only investing in stocks with a share price of under $35. In that blog we provided a list of 30 stocks that we thought were attractively priced according to The Applied Finance Group’s (AFG's) valuation model broken up into three price brackets: under $10, $10 to $20 and $20 to $35.

From Feb 5th 2009 to June 5th 2009 the 30 stocks recommended as a group outperformed the S&P 500 by an average of 36.5%, the 10 stocks under $10 outperformed by 57.1%, the $10 to $20 stocks outperformed by 40.1% and the $20 to $35 stocks outperformed by 12.5% respectedly. 

Joel Tillinghast, the fund’s manager began this fund with a strategy of only investing in stocks under $10. Since this stragtegy began Fidelity has moved the stock price limit to $35 where it currently sits. Tillinghast believes that share price alone is not of importance but the lower priced, smaller-cap universe of stocks experiences the most frequent mispricing’s and also has the least amount of analyst coverage.

As an update to the prior blog on this strategy Valueexpectations.com provided a list of 30 stocks that we believe are attractively priced and do not fit AFG's default sell criteria. Each group is ranked based on valuation attractiveness. AFG's analysis begins and ends with valuation, however along the way there are other key factors AFG considers when looking for buy opportunities: expected Economic Margin improvement, management quality, earnings quality.

Attractively Priced Companies Under $30

The Halloween Indicator in the stock market sometimes defined as “sell in May and go away” is a strategy that is based on the difference in the performance of the market during May to October vs. November to April. The strategy is to invest in the S&P 500 during “the best 6 months” and switch to bonds during “the worst 6 months” to avoid the summer doldrums of small to negative returns. Since January of 1950 the average returns for November to April “good months” is 7.9% compared to the 2.5% average return delivered from May to October ‘bad months”.

Although there is a significant spread in returns between the good and bad months, does this mean you should convert to bonds and go on a vacation until September? There are several views for and against market timing but we feel it is too difficult to identify when to be out and when to be in the market. If you dig deeper into the market performance since 1950, you will find that 20 good and 20 bad months make up a significant part of the market performance. For more information read the following market timing strategy filled with pitfalls.

The market has been up in those worst 6 months 60% of the time since 1989, not as profitable as the best 6 months but still positive. I believe 2009 is a good lesson for many, with all of the inefficiencies and irregularities in today’s market, the mixed macro economic reports, and the belief we are headed toward a recovery, jumping out of the market could mean missing out on making up for some of the losses the market handed us in 2008

However, being invested isn’t enough, identifying quality companies and a good value will put you in an even better position to outpace the general market. Listed below are companies that should be considered as potential investment opportunities. These companies all have a valuation attractiveness near the top of their sector in addition to expected improvement of profitability (Economic Margin) above their sector, and do not follow a wealth destroying strategy defined by AFG’s management quality score.

Attractive companies to consider in each sector instead of selling in may and going away

A brief description of AFG's buy criteria variables is below:
• 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.• Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.• Management Quality – Assess management’s ability to make wealth creating decisions.

 

Listed below are the companies in the Energy & Extraction sector within the S&P 500 Index, ranked in order of valuation attractiveness. Currently, the Energy & Extraction sector has the highest median Value Score of all sectors according The Applied Finance Group’s April 2009 Monthly Market Review and looks to be trading at a significant discount relative to its historic valuation.

All Energy Companies (S&P 500) Ranked By Valuation Attractiveness

Energy Sector - Relative Valuation Chart

The graph above shows the median percentage upside for the Energy sector relative to the overall market across time. Values greater than 1 indicate the sector is more undervalued than the market, while values less than 1 indicate the opposite. The red line identifies the historical median value to provide a basis to understand valuation levels relative to historic norms. This example illustrates that the median Energy company is undervalued relative to the market currently and has been trading at a significant discount to its historic relative valuation, indicating a potentially attractive opportunity.

By using The Applied Finance Group’s (AFG's) Risk Analysis, we have identified the top and bottom two firms in each sector (excluding the Financial sector) according to an overall risk score based on 9 variables (see more detail below). In addition to the risk analysis variables we also added another layer of analysis by evaluating the companies’ Earnings Quality (based on the concept of Accruals) and Altman Z-Score (identifies firms that are at risk of going bankrupt in the next 2 years).

Applied Finance Group’s Risk Analysis is designed to systematically calculate a stock’s risk score based on fundamental relationships between the Quarterly Income Statements and Balance Sheets. The template measures 9 factors to determine Risk: Changes in A/R, Changes in Inventories, Cash Flow vs. Operating Cash Flow, Fixed Payments vs. Pre-Tax Cash Flow, Leverage, Intangibles, Write-offs, Management Quality, and Valuation. Companies with lower scores have less risk. Companies in the Financial Sector were excluded due to their differences in financial statement structure.
 

1. Receivables to Sales - Delta – takes the difference in the median A/R to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

2. Inventories to Sales - Delta – takes the difference in the median Inventories to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

3. AFG’s Cash Flow-Oper. vs. Operating Cash Flow - AFG's Cash Flow-Oper. for a company is net cash that is generated by the continuing and discontinuing operations of the firm. We compare it to the company's Operating Cash Flow to assess its ability to pay its debt.

4. Fixed Payments vs. Pre-tax Payments Cash Flow – This ratio assesses the company’s ability to cover long-term obligations. If the fixed pmts are greater than 50% of the pre-tax payments cash flow, there is chance that this company may not be able to meet its obligations. Obligations less than 30% of cash flow are considered safe.

5. Leverage – Book leverage and Market leverage are analyzed to give us information about the company’s leverage position. Best score is given to the companies with Book Leverage lower than 60%, and negative score to these with Book Leverage higher than 60% and Market Leverage greater than 0.9*Book Leverage.

6. Intangibles as a Percentage of Total Assets – With this score we try to filter through and reward the companies that have grown organically, rather than through acquisitions. Our research has shown that on average companies tend to overpay for acquisitions and thus are rarely a profitable investment. Companies with Intangibles less than 20% of Total Assets get the best score.

7. Write-offs – Shows the number of years with significant write-offs over the last 5 years.

8. Management Quality – Measures a company’s EM+1 and LFY Asset Growth and there is empirical evidence that companies with positive EMs that are able to grow their business tend to outperform companies with negative EMs who continue to invest into unprofitable business.

9. Value Score – Measures a company’s attractiveness from valuation perspective.

Most/Least Risky Firms By Sector S&P 500 (excluding financials)

If you are a professional investor and would like to learn more about this analysis as well as other useful valuation tools click here for a free trial subscription to The Applied Finance Group's research.

Below is a look at the YTD returns, valuation attractiveness and sales growth expectations of the two biggest and smallest companies in each sector within the S&P 500 (excluding financials). This link provides some insight into Applied Finance Group’s (AFG’s) valuation techniques. Also compare the expectations for sales growth to what the companies have delivered historically to see which stocks on this list are most likely to meet or exceed those expectations, and thus be more likely to out-perform.

 Biggest/Smallest Companies (Mkt Cap) By Sector S&P 500 (excluding financials)

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future sales growth of companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

Economic Margin is a measure of economic profitability that identifies how much a company earns above or below its cost of capital. We analyzed all companies in the S&P500 Index based on their historical, current and forecasted Economic Margins to see which firms have the best average of past, present and future profitability. We identified the two most profitable and the two least profitable companies from each sector and have presented them in the table below. As a base of reference, the average firm in corporate America earns a 0 (zero) Economic Margin, or is a “break-even business”. Our research has shown that companies with consistently positive EMs that are also expected to increase their EMs in the future tend to outperfom firms with negative or declining EMs.
<!--[if gte mso 10]> Economic Margin is a corporate performance measure, which helps us identify well managed, wealth creating companies. Although not included in this post, we want to remind you that it is also important to understand the attractiveness of corporations' valuations to make sure we invest in great companies at great prices. (Here is an article by ValueExpectations.com explaining Applied Finance Group’s basic valuation concepts).

Note: Only companies in the S&P 500 were included.

S&P 500 Companies With The Best/Worst Average Profitability (Economic Margin)

Economic Margin (EM) Defined: A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The Economic Margin Framework™ is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital. more EM details (PDF)