KO

Coca-Cola Co (KO) announced its acquisition of the North America operations of its top bottler, Coca-Cola Enterprises Inc (CCE) at a value totaling approximately $12.2 billion, by assuming $8.8 billion of CCE debt and relinquishing its 34% equity ownership in CCE, valued at $3.4 billion. This acquisition, which is expected to close in the 4th quarter of 2010, is largely viewed as a strategic reversal to close a competitive gap after a similar deal by Pepsi Co, which just completed the purchases of its largest bottlers, Pepsi Bottling Group Inc (PBG) and PepsiAmericas Inc (PAS). In a concurrent agreement, CCE also agrees to buy Coke’s bottling operations in Norway and Sweden for $822 million. CCE will also have the right to acquire Coke’s 83% equity stake in its German bottling operations 18 to 36 months after closing for fair value.

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.

Rank within Sector Ticker Name Sector Valuation Signal EM Change Signal Berkshire Hathaway's Holdings (ex. Financials) (NYSE:SNY) SANOFI-AVENTIS ADS Health Attractive Positive (NYSE:WMT) WAL-MART STORES INC Consumer Services Attractive Positive (NYSE:UNP) UNION PACIFIC CORP Transportation Attractive Positive (NYSE:BNI)  BURLINGTON NTH SANTA FE Transportation Attractive Positive (NYSE:GSK) GLAXOSMITHKLINE PLC Health Attractive Positive (NYSE:BDX)  BECTON, DICKINSON & CO Health Attractive Positive (NYSE:NLC) NALCO HOLDING CO Basic Material Attractive Positive (NYSE:NRG)  NRG ENERGY INC Utilities Attractive Negative (NYSE:COP)  CONOCOPHILLIPS Energy and Extraction Attractive Negative (NYSE:NSC) NORFOLK SOUTHERN CORP Transportation Attractive Negative (NYSE:JNJ) JOHNSON & JOHNSON Health Attractive Negative (NYSE:PG) PROCTER & GAMBLE CO THE Consumer Non Durable Attractive Negative (NYSE:LOW)  LOWE'S COMPANIES INC Consumer Services Attractive Negative (NYSE:KFT) KRAFT FOODS INC CL A Consumer Non Durable Fairly Valued Positive (NYSE:KO) COCA-COLA CO Consumer Non Durable Fairly Valued Negative (NASDAQ:COST) COSTCO WHOLESALE CORP Consumer Services Fairly Valued Negative (NYSE:HD)  HOME DEPOT INC Consumer Services Fairly Valued Negative (NYSE:NKE)  NIKE INC CL B Consumer Non Durable Fairly Valued Negative (NYSE:CEG) CONSTELLATION ENERGY GRP Utilities Unattractive Positive (NYSE:WPO)  WASHINGTON POST CO Consumer Services Unattractive Positive (NYSE:IRM) IRON MOUNTAIN INC Consumer Services Unattractive Positive (NYSE:USG)  USG CORP Capital Goods Unattractive Positive (NYSE:KMX)  CARMAX INC Consumer Services Unattractive Positive (NYSE:GE) GENERAL ELECTRIC CO Capital Goods Unattractive Negative (NYSE:UPS)  UNITED PARCEL SERVICE B Transportation Unattractive Negative (NYSE:ETN)  EATON CORP Capital Goods Unattractive Negative (NYSE:IR) INGERSOLL-RAND PLC Capital Goods Unattractive Negative (NYSE:IR) WABCO HOLDINGS INC Consumer Durable Unattractive Negative (NYSE:GCI) GANNETT CO INC Consumer Services Unattractive Negative

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Every year Fortune releases a list of the 40 best companies to invest in now to retire on. This long-term portfolio is designed to protect your hard-earned nest-egg as you approach retirement.

Last year Fortune’s portfolio of 40 best stocks to retire on returned -23.07% from 6-20-08 to 6-16-09, relative to the -30.8% returned by the S&P500 during the same time period. This year they are replacing 23 stocks to form the new portfolio.

Provided below are the 40 stocks recommended by Fortune as the best stocks to retire on in 2009 and our outlook of these companies from a valuation perspective based on The Applied Finance Group’s valuation model.

 Fortune's 40 Best Stocks to Retire On - 2009

Related Stock Article:
Is Apple a Buy Hold or Sell?, Click Here to View

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

 

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

 

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

 

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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.

Fortune released a list of 40 companies in June 2008 that they labeled as the 40 best stocks to retire on. Although ValueExpectations.com’s research is focused on long-term investing, we believe reviewing companies on a ongoing basis helps to avoid potential pitfalls with bad investments and allows one to take advantage of companies that might be mispriced. For this reason we have ranked all companies in the Fortune 40 portfolio based on Valuation Attractiveness.

Good companies don’t always make good investments! If you believe this is a list of quality companies then that is a wonderful start. But understanding what you are paying for those companies is equally important. Few would argue that Mercedes Benz produces an excellent engineered vehicle and a quality product. However, if that Mercedes Benz cost $1,000,000, it may be a great vehicle, but not necessarily a good price.

As a review of the performance of this list since release, Fortune’s portfolio has returned an average of -28.64% since its release which is about 6.3% spread above what the S&P 500 delivered on average during the same time period. Although this portfolio did outperform the S&P 500, had you invested in these 40 companies in equal parts on the date of release, your $100,000 retirement nest egg would now be worth somewhere around $70,000.

Fortune 40 Companies To Retire On

 

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.

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.

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

Recently Berkshire Hathaway released a letter to its shareholders, which outlined last year’s activities and provided insights on their outlook going forward with an overview of the company's major holdings.  Below is a list of Berkshire's major holdings (excluding Financials) and ValueExpectations.com’s recommendations for these companies.

We will revisit this later in the year to see how ValueExpectations.com's recommendations fared.

 

Applied Finance Group's quantitative process is centered on their proprietary Economic Margin Framework. The core of AFG’s quantitative process starts with evaluating a company's corporate performance and the expected improvement on a relative basis, assessing the valuation attractiveness of the company, and determining if a firm is following a wealth creating or wealth destroying strategy.

A brief description of those 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 it's peers.
Management Quality – Assess management’s ability to make wealth creating decisions.

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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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

 

 

 

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.

Here is a list of companies, two from each sector within the S&P 500 that are expected to improve their Economic Margins (EM) the most over the next two years along with the bottom two in each sector expected to have their EM’s deteriorate the most. Companies expected to improve their EM’s more than their sector peers have proven to be more likely to out-perform. Improving EM’s coupled with low expectations priced-in for sales growth are the companies on this list that may be worth a look as a potential investment.

Also included in this table is the implied sales growth priced-in over the next five years in order to justify the stock’s current trading price compared with their achieved 5 Year Median Sales Growth. Ask the question are the expectations for sales growth realistic compared with what revenue growth the firm has delivered in the last five years.

If you would like to learn more about the Economic Margin methodology or Value Expectations feel free to contact an AFG representative to schedule a web-demo at support@afgltd.com.

 

S&P 500 Companies with the Biggest Forecasted Change in Economic Margins