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The chart below contains 10 of the cheapest stocks in the S&P 500 based on AFG’s valuation metric which has proven through vigorous back-testing to identify companies that are more likely to outperform than their sector peers. AFG’s valuation techniques also help investors identify and take advantage of mispriced securities in the market. One way investors can identify over or undervalued stocks is by using AFG’s Intrinsic Value Chart, which displays a company’s intrinsic value relative to its trading range and helps entry/exit points. Below is an example of Apollo Group (NASDAQ:APOL) one of the companies from our list of the 10 cheapest S&P 500 companies using AFG’s Intrinsic Value Chart to illustrate how well we have tracked the company as well as a visual representation of the company’s trading range relative to its default intrinsic value.

With almost 5 months of 2010 in the books, we decided to take a look at the total returns for the S&P 500 broken down by-AFG defined sectors (excluding financials) to see which sectors have outperformed/underperformed the index so far this year. You will notice in the chart below that the Energy, Utilities and Health sector seem to be dragging down the returns of the overall index, while the Consumer Durable and Capital Goods sectors are leading the way.

When narrowing the market to a focus group of stocks to choose from, The Applied Finance Group (AFG) has a core set of principles we concentrate on to develop a group of stocks that are more likely to outperform the market.

ValueExpectations.com emphasizes evaluating a company’s ability to earn a spread above their cost of capital using a very robust measure of corporate performance, Economic Margin. After evaluating a firm’s ability to create wealth VE.com then determines what price we are paying for the company using a modified discounted cash flow model. If we had to simplify performance, a very elementary way to evaluate performance can be Return on Invested Capital ROIC and valuation which can be simplified by using earnings yield. This is the approach Joel Grenblatt uses in his book, The Little Blue Book that Beats the Market.

In January VE.com highlighted a list of stocks based on Joel Greenblatt’s Magic Formula Investing Strategy from 1998-2004 Greenblatt’s simulated returns were 30.8% a year, relative to a 12.4% annual return for the S&P 500 and was only down in one year in that time-span.

In our article posted on January 9, 2009 we listed our best 30 “Magic Formula” companies which has earned returns comparable to the tests conducted by Mr. Greenblatt. From Jan. 9, 2009 to Dec. 14, 2009 the 30 companies we recommended from our “Magic Screen” have returned a solid 32.06% spread above the S&P 500. Since our last “Magic Formula” portfolio was successful we have decided to run the screen again for a new list of companies to see just how consistent this strategy is.

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A look at Greenblatt’s formula for successful “Magic Formula Investing”:

1. Establish a minimum market capitalization (usually greater than $50 million).

2. Exclude utility and financial stocks

3. Exclude foreign companies (American Depositary Receipts)

4. Determine company's earnings yield = EBIT / enterprise value.

5. Determine company's return on capital = EBIT / (Net fixed assets + working capital)

6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).

7. Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.

8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

9. Continue over long-term (3-5 year) period.

Mr. Greenblatt was a student of both Ben Graham and Warren Buffet and tried to include valuable insights from each investor in his “Magic Formula.” His Magic Formula was a screen that percentile ranked two variables: Return on Invested Capital (quality) and Earnings Yield (valuation). The idea is simple, buy the best companies at the best price and then hold on to them for one year. The Little Blue Book recommends selecting the top 30 firms from the “Magic Formula.” That formula ranks each company by variable and then puts a 50% weight on each.

Ticker  Company Name Sector Market Cap ROIC Earn Yield (NYSE:PM) Philip Morris Intl Inc Consumer Non Durable $96,066 265% 26% (NYSE:LO) Lorillard Inc Consumer Non Durable $12,671 111% 13% (NYSE:RAI) Reynolds American Inc Consumer Non Durable $15,560 116% 14% (NYSE:NOV) National Oilwell Varco Capital Goods $18,530 38% 17% (NYSE:ABC) Amerisource Bergen Corp Health $7,198 82% 12% (NASDAQ:APOL)  Apollo Group Inc Cl A Miscellaneous $9,602 164% 12% (NYSE:GD)  General Dynamics Corp Capital Goods $27,261 69% 12% (NYSE:BF.B)  Brown-Forman Corp Cl B Consumer Non Durable $8,335 124% 18% (NYSE:TSS)  Total System Services Consumer Services $3,439 50% 16% (NYSE:DNB)  Dun & Bradstreet Corp Consumer Services $4,285 -395% 10% (NYSE:LLL) L-3 Communications Hldgs Capital Goods $9,873 55% 12% (NYSE:MCK)  Mckesson Corp Health $16,880 43% 12% (NYSE:PFE) Pfizer Inc Health $148,488 17% 11% (NYSE:MO)  Altria Group Inc Consumer Non Durable $40,753 1693% 20% (NASDAQ:CEPH) Cephalon Inc Health $4,414 32% 12% (NYSE:OMC)   Omnicom Group Inc Consumer Services $11,681 -178% 10% (NYSE:DO) Diamond Offshre Drilling Capital Goods $13,503 37% 14% (NYSE:LLY)  Eli Lilly & Co Health $40,928 47% 15% (NYSE:SNI) Scripps Networks Intr In Consumer Services $6,692 77% 10% (NASDAQ:BIIB) Biogen Idec Inc Health $14,133 46% 11% (NYSE:FRX)  Forest Laboratories Inc Health $9,563 22% 13% (NYSE:RTN)  Raytheon Co Capital Goods $20,479 67% 14% (NYSE:DPS) Dr Pepper Snapple Grp Consumer Non Durable $7,131 71% 10% (NYSE:HRS) Harris Corp Technology $5,964 57% 11% (NYSE:MHP) Mcgraw-Hill Co Inc Consumer Services $10,886 129% 11% (NYSE:FLR) Fluor Corp Capital Goods $7,252 46% 20% (NYSE:LH)  Laboratory Cp Am Hldgs Health $7,961 108% 10% (NYSE:LH)  Moody'S Corp Consumer Services $6,281 -2400% 9% (NYSE:FLS) Flowserve Corp Capital Goods $5,398 40% 11% (NYSE:GME) Gamestop Corp Cl A Consumer Services $3,671 69% 17%

 

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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.

 

ValueExpectations.com recently posted, “Dividends are falling, so stocks have less value?” which gave some insight on our thoughts on the effect dividends have on stock values. We concluded that dividends alone are irrelevant in estimating a company’s value.

As a follow up to that article we have identified a dozen companies that pay a dividend and have the fundamentals to support the dividend. We looked at several fundamental factors to flush out companies that may be at risk of reducing their dividend in the near future. The end result, was a list of companies with:

-Positive Future Economic Margins
-Low Financial Debt
-High Management Quality
-High Valuation Score
-High Dividend Yield

 

Solid Companies That Pay A Dividend:

 

*AFG’s Value Expectation interface 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 above table displays the implied future sales growth of these mining companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

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With a new administration ready to take office in the U.S., many big decisions will need to be made regarding homeland defense and the defense budget. These decisions will have a great effect on defense stocks. Some believe Obama will cut the defense budget by 10-25% which may be detrimental to the sector. Another take is that the Military will become more evolved with better technology greatly benefitting a firm like Aerovironment who build high tech unmanned aircrafts that have sophisticated cameras to help give the military an advantage without putting any human lives at risk and to be more reliant on technology rather than recruiting. If you have a bullish outlook on defense spending increasing due to conflicts going on in the Middle East, Russia, Israel etc. you may want to go on the offensive with defense stocks.  Here is a list of defense stocks that are favored by Zachary Scheidt on SeekingAlpha.com and others that believe defense spending will increase, and our outlook on these firms. Companies listed are ranked by valuation attractiveness.

Defense Stocks and their Sales Expectations & Valuation Attractiveness

*denotes less than 5 years historical sales numbers available

VE Sales Growth calculated for these firms on 1-11-09

In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

Using AFGView.com, we screened for firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet

According to Forbes.com, Cramer and a few other financial blog-sites the following qualities are usually found in stocks that do well in economic downturns of extended time periods.

• Consumer necessities
• Ability to pay a dividend
• Ability to add employees as other firms cut back
• Productivity increases as market goes down
• Healthcare stocks
• Legacy Companies – high quality company with long business history
• Involved in Military
• Oil industry
• Infrastructure
• Companies that sell used goods
• Generic products
• Overseas exposure

The following companies all have one or more of the above qualities to help them survive and perform well in an economic downturn. This table provides the implied 5 year sales growth priced-in to the stock to justify its current price along with the 5 year median achieved sales growth. Compare the revenue growth priced-in to what the company has been able to deliver in the past 5 years to see if the expectations are reasonable enough for the company to meet. Companies with reasonable expectations compared to what they have achieved are the most likely companies on the list to out-perform.

Stocks with Recession Resistant Qualities & Sales Growth Expectations