GE

The Oracle of Omaha Warren Buffett is generally viewed as the most respected and successful investor in history, and many of our value-oriented readers follow the movements and purchases of Buffett rather closely and for good reason. Berkshire Hathaway, a conglomerate holding company, which Buffett built from a textile company into a major corporation, has averaged a 20.3% compounded annual gain in per-share book value from 1965-2008. There is no doubt about the success Buffett has achieved over the years, and there has even been a recent study done that shows an investor could have earned over 14% returns a year had they purchased each Buffett stock, a month after his investment company disclosed ownership.

We thought it would be an interesting story to show how Buffett’s holdings would rank according to The Applied Finance Group’s (AFG’s) valuation model and Economic Margin Methodology. The companies we believe look the most attractive and that investors should pay the most attention to when searching for long investment opportunities are the companies that have both an attractive default AFG valuation and are expected to improve their Economic Margins at a greater rate than their sector peers.

AFG's track record of identifying winners and losers has proven that companies AFG identifies as undervalued are more likely to outperform, than those AFG ranks as overvalued, and the same holds true for companies with expected improvements in EMs vs. expected declines. The Economic Margin methodology adjusts for common distortions in GAAP accounting practices and helps investors to understand the true economic profitability a company earns above its cost of capital. By understanding the true economic profitability a company earns and by gaining a firm grasp on the expectations embedded in security prices, investors can come to a more refined intrinsic value for a company and thus put themselves in a better position to outperform.

Below is a list of Berkshire Hathaway’s current holdings (excluding Financials) ranked by valuation attractiveness, and followed by expected change in economic margins.

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It is very important to understand a company’s management strategy and management’s ability to create wealth for its shareholders. By using The Applied Finance Group’s (AFG’s) Management Quality score you have the ability to grade management’s ability to make wealth creating decisions and eliminate wealth destroying firms from your list of constituents. AFG’s Management Quality variable is used as an exclusionary variable to get rid of companies which continue to grow their businesses when they are not even profitable (generating negative Economic Margin or negative EM, which is AFG’s way of understanding a firm’s economic profitability). When business units are unproductive and destroying wealth, management teams should not be looking to grow that business unit and concentrate on the parts of their company that have been creating wealth. Instead, the corporation needs to fix the broken parts of its business first by divesting losers and work on improving profitability to earn the right to expand. The best strategy AFG or an investor likes to see is a very profitable business (generating positive EMs) that grows its assets to maximize its profitability.

In the examples below we analyze GE’s Management Quality under the control of Jack Welch from 1980-2001 and under Jeffrey Immelt’s reign as CEO from 2001-2009.

Welch, once the youngest CEO in GE’s history, is highly regarded for his innovative management strategies, leadership style, and a good understanding of how to create shareholder value. From 1980 to 2001, Welch was able to grow GE’s revenues from just over $26 billion a year to $130 billion and took GE’s stock price from around $1.25 a share to nearly $50 a share. Welch streamlined GE and made it a more competitive company in the market through his dedication to identifying and improving ways of adding value to its shareholders as well as numerous successful acquisitions. During the 1990s, Welch transformed GE from a simple manufacturing company to one of the world’s largest conglomerate. He even acquired the NBC network, and turned it into a success. Welch’s compensation/termination policy added to the internal competiveness of its management teams who knew if they ended up in the bottom 10% of performance of managers they would no longer be working for GE and only those in the top 20% received bonuses and stock options.

Jeffrey Immelt on the other hand has not been able to achieve the same success as Welch in his time as CEO so far. To be fair, Immelt took over GE at an unfavorable time, just days before the 9/11 terrorist attacks, which cost GE’s insurance arm over $600 million. Along with 9/11 Immelt also had to deal with last year’s financial crisis and the prolonged economic recession in developed nations, which dealt a huge blow to GE Capital and GE’s Industrial business. Under Immelt the company lost two/thirds of its stock’s value, missed earnings estimates for the first time and has continued to miss, and lost its place as the largest company (by Market Cap) in the U.S. to Exxon Mobil. GE’s stock price has gone from $39/share when he took over to less than $12/share, underperforming the Dow Jones Industrial by nearly 60% (price return). Despite the above-mentioned environment Immelt had to deal with, it is not encouraging as an investor to see Economic Margins evaporate away while other businesses have adapted and been able to change their misfortunes. It is yet to be determined if Immelt can recover but it is certain he has yet to prove his ability to create shareholder value.

Below is a graphic representation of the value of GE’s stock under Welch vs. Immelt. This highlights the importance of strong leadership to increase the value for shareholders’ investments. By understanding a company’s true economic profitability (EM) and relating that to a company’s growth strategy will give investors a much clearer picture of whether a company is likely to create or destroy wealth in the future. As you can see in the chart below GE's Economic Margins have been closely correlated with the subsequent performance of their stocks price. Welch was able to grow GE's EM's from 2 to 12 in his tenure and Immelt has taken that EM level and diminished it to an expected negative EM in 2009.

GE's stock performance under Welch vs. Immelt

Source: www.economicmargin.com
*returns on this chart do not reflect total return (excludes dividends)

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Management Competence Factors
• Have there been any changes in the executive management team?
• Has the company had any significant write-offs or poor earnings quality?
• Has the company recently made any significant acquisitions and, if so, what are the strategic implications and costs?
• How is the company spending any excess cash?
• What did we learn from the company’s most recent earnings call and what was the tone of analyst questions?

Management Quality Score Insights:
• Measures a company’s EM+1 and LFY Asset Growth.
• Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.
• Un-bias quantitative way to analyze a company
• Holds management teams accountable for unprofitable growth

Related article: Why P/E's don't tell the whole story.

With Berkshire Hathaway’s annual meeting just behind us, we thought it would be interesting to provide an analysis of the Oracle of Omaha’s companies (ex. Financials) to give you a better idea of their valuation attractiveness. The companies that rank highest on valuation should be more likely to outperform going forward and could represent an attractive investment opportunity.

Year to date Mr. Buffet’s portfolio has delivered an average return of 5.18% compared to the 12.93% delivered by the S&P 500 Index (as of May 8, 2009). In the future we will measure the performance of each of the three groups of stocks we now label as Attractive, Fairly Valued, and Unattractive, in order to see what type of spreads are achieved between them.

Berkshire Hathaway's Holdings (ex. Financials) Ranked By Valuation Attractiveness

If you want to learn more about AFG's Valuation methodology, click here.

During the election, Teeka Tiwari released two blogs highlighting stocks to own based on who would become the next president. After reviewing the performance of both groups, the companies expected to do well after an Obama win failed to perform while those that were expected to be winners if Mccain won the presidential election did exceptional. The group of companies Tiwari mentioned as the stocks to own if Obama won the presidency returned an average of -26.38% compared to his stocks to own if McCain won the presidency averaged a healthy return of 12.89%. As an analysis of how these firms look as potential investment opportunities currently, ValueExpectations.com has reviewed all of these companies based on their valuation attractiveness, and identified whether the companies landed in the top/bottom half in expected economic profitability for the year ahead using our Economic Margin metric explained below. Companies that are attractive from a valuation standpoint and companies that are expected to improve their Economic Margin relative to their sector are the most attractive from an investment analysis and tend to outperform the market. No companies meet the selection criteria to be considered an AFG Buy Recommendation.

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.

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.

As of 3-11-09 there were 7 companies that enjoyed a AAA credit rating from Moody's based on the company's size, stability and ability to pay back debt. GE was recently stripped of its AAA rating and received a lowered rating of AA+. GE was expecting worse news so the fact that they were also labeled “stable” put some worries of a GE bankruptcy to rest and gave GE’s stock price a boost on the same day its rating was lowered.

Below is a list of the AAA rated companies (excluding Berkshire Hathaway BRK/A), their valuation attractiveness, and their Z-scores (likelihood of going bankrupt in the next 2 years). Which of the AAA companies may be the next to join GE in getting a rating downgrade? Automatic Data Processing (ADP) has the lowest Z-score (the least amount of financial strength) and is theoretically the most likely company to have its AAA rating lowered.

The Altman Z-score defined: 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

 

 Triple-A Rated Companies Ranked By Z-Score

*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.

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Fortune magazine recently put out an article listing the most admired companies in the world.  We took the top 50 firms (excluding Financials, and companies not traded in the US) on their list and put them through Applied Finance Group's quantitative recommendation framework.  Just because these firms are among the most admired companies in the world does not qualify them as the most attractive investment. Being among the most admired is an honor and means you must be doing something right, but might not necessarily mean the share price is currently attractive. 

The following articles which we have posted in the past on ValueExpectations.com will give you a better understanding of what it takes for management to create wealth, understand Management Quality, and see how EPS alone falls short in estimating a company’s value. There are two main characteristics a company must have in order to be a good investment opportunity: (1) the company needs to be a strong economic performer, (2) the company should be attractively priced.   Many people admired the DeLorean, but it was neither a good performing car nor a good priced car. Below we reveal a few "DeLoreans" after looking under the hood.

Top 50 Most Admired Companies According to Fortune

The Russell 1000 Index has lost 44% over the past year and is down 14% year to date. Similarly, the Russell 2000 Index is down 42% for the past 12 months and lost investors 18% since the beginning of this year. With both of these indexes down substantially recently by about the same amount, are large caps more attractive than small caps?

Percent to Target Charts: This graph shows the Percent to Target Current for a universe relative to the overall market. Values greater than 1 indicate the universe 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.

Small Universe: Companies in the AFG universe that have a market cap less than $300 million and EPS consensus estimates are available.

This chart illustrates that the median Small Cap company is currently overvalued, relative to the market. Over the past 6 years, small Caps have been trading at a premium to their historic valuation.

Large Universe: Companies in the AFG universe that have a market cap greater than $2 billion and EPS consensus estimates are available.

This chart illustrates that the median Large Cap company is currently undervalued, relative to the market. Large Caps have been trading at a discount to their historic valuation, indicating a potentially attractive opportunity.

Following is a list of the biggest 10 companies (determined by market cap) in the Russell 1000 and Russell 2000. AFG’s Value Expectations interface, which solves for implied sales growth embedded in a stock price (VE Sales Growth), allows us to understand the embedded 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. An undervalued company is more likely to outperform those companies with high expectations relative to what they have delivered historically. The tables below display the implied future sales growth of these companies assuming their EBITDA margins and Asset turnovers stay at their 5-year median levels.

Conclusion:
Both the percent to target charts and VE analysis show that large caps look more attractive than small cap stocks. The large cap stocks on the list have lower expectations for implied sales growth and the overall universe is currently undervalued. 

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These 5 stocks all ended up on The Street.com’s most searched stocks  list as of Feb. 6th 2009, as investors have been searching for answers for these companies. Sometimes companies trade on news and not fundamentals, when fundamentals are what drives a company’s true value. Investors should focus more on the embedded expectations in the stock’s price and the valuation attractiveness of the firm. Compare the implied sales growth priced-in to justify the current stock price (VE Sales Growth) to what the company has delivered in sales growth historically (5 Year Median Sales Growth) to see which companies have the most realistic chance of meeting or exceeding those expectations. Companies with the most realistic chance of meeting implied sales growth expectations have proven to be more likely to outperform. All 5 companies on this list have low expectations relative to what they have each delivered in sales growth historically. All companies on this list look attractive from a valuation standpoint with the exception of Apple.

One would think that $3 million is too much to pay for a 30 second commercial for the Super Bowl, but maybe not when considering the correlation between the likeability of a company’s super bowl ads and its stock price. Companies that run well-liked commercials have performed relatively well in recent years as investors respond by driving up their share prices not just for the day after the Super Bowl, but for weeks thereafter.

Kenneth Kim, an Assoc. Professor of Finance from the University of Buffalo, studied 102 publicly traded companies that ran 529 commercials in the last 17 Super Bowls, and although the majority of those firms saw a boost after gameday, the companies that saw the biggest boost were the ones with the most liked ads according to USA Today's Ad Meter.

These commercials bring companies into the conscious of consumers as well as investors, and the most liked commercials appear to have had the best effect on the advertising company’s stock performance. From 1996-2007 Super Bowl advertising companies outperformed the S&P 500 by 1.3% and 10 out of the last 12 years.

Let’s take a look at the companies that ran commercials during the 2009 Super Bowl and the implied sales growth expectations priced-in to their stocks. The more realistic the expectations for the implied sales growth are, compared to what the company has delivered historically in sales growth, will give you an idea of which firms are most likely to meet or exceed those expectations. The more realistic the expectations the more likely the company is to out-perform.We will keep an eye out for these stocks short-term to see if any boost in stock performance was realized within the post Super Bowl week.

Company's That Advertised During the Super Bowl with Each Companies Sales Expectations

 ** denotes Sales information gathered from AFG Global Database.

And the best Super Bowl commercial according to USA Today Ad Meter is....

Click Here to view the best Super Bowl Ad of 2009

According to MotleyFool.com, InvestorPlace.com, Jubak’s Journal, Cramer, and FortuneMagazine.com these are the most attractive stocks to own in 2009. Compare the sales growth priced-in to justify the current stock price (VE Sales Growth) to what the company has achieved in revenue growth over the last five years (5 Year Median Sales Growth) to see if what’s priced-in is a reasonable number for the company to meet or exceed expectations. Couple the expectation information with AFG’s ranking for a stock’s attractiveness relative to the universe (Value Score AFG) to find companies that we find attractive on a default basis that also have low expectations for growing sales compared to what they have delivered the past 5 years. Companies with High Value Score’s and low sales growth expectations will be the companies on this list that are more likely to out-perform.

Recommended Stocks for 2009

Related Article: EPS Increased.....Company Underperformed?

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When measuring the implied sales growth expectations priced-in to the eight biggest market cap companies in the Russell 2000 and the S&P 500, the larger cap S&P companies have lower expectations priced-in than the Russell 2000 companies. The median sales growth expectations, for the Russell 2000 is 11.76% compared to the 0.74% median priced-in to the S&P 500 companies. 

Given the bigger presence and management quality of these eight companies in the S&P 500,  we see them as a better investment oportunity based on the low expectations the market has placed into their current stock prices.

Top 8 Market Cap Companies and Sales Growth Expectations

Russell 2000

S&P 500