MCK

With over $20 billion worth of blockbuster drugs losing patent protection by the end of 2011 (over $100 billion in the next 5 years), many investors frantically attempt to analyze how much market share generic pharmaceutical manufacturers will snatch away from branded pharmaceutical manufacturers. Even within the generics industry, competition is often fierce, as companies hurry to optimize manufacturing and distribution capabilities in order to offer low prices for the copy-cat drugs. Instead of debating the value propositions between branded and generic drug companies, and the implied victors of this long-anticipated war, of which the generics have been winning countless battles, the pharmaceutical distributors look to be obvious winners.

The example we have provided is McKesson Corp. (NYSE:MCK) a company that currently looks undervalued according to AFG’s default valuation model. An important fact to note is that AFG has shown it slightly over-tracks McKesson Corp. (accuracy score of 66) yet the company still looks very attractive relative to its sector peers from a default valuation perspective. Also, McKesson Corp. has a current AFG Value Score of 94, meaning the company ranks in the top 94th percentile of companies in the AFG universe in valuation attractiveness. Companies AFG identifies as undervalued have proven through back-tests to be more likely to outperform than those companies with an unattractive default AFG valuation rank.

The market environment over the last few years has been muddled by many things including but not limited to corporate scandals, major bankruptcies and the overall effect of the recession. These recent events have been a constant black cloud over the confidence investors have in the markets as well as in individual companies in Corporate America. Investors tend to find some solace in their investments when the company proves to be reliable and transparent in their management as well as accounting practices. Avoiding companies that make poor management decisions and that tend to experience earnings blow-ups are one of the major advantages experienced by clients of The Applied Finance Group (AFG). AFG has an expertise in understanding management’s strategies and its ability to create wealth for shareholders, as well as an expertise in looking beyond traditional accounting numbers to see the true profitability companies earn. The 23 companies listed below have met all of the criteria to make them look like the most reliable investment opportunities within the Russell 1000 index including Hewlett-Packard Co. (NYSE:HPQ) and Medco Health Solutions (NYSE:MHS)

A list of attractive stocks from within the Health sector that meet AFG’s definition of attractive based on Valuation, Corporate Performance, Management Quality and other key criteria AFG uses to identify the stocks that are most likely to outperform from within each sector. The Health sector has consistently ranked as the 2nd best sector to invest in (next to Technology) over the next year according to participants of The Market Forecast Project, a monthly survey of professional money managers.

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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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.

Since March 9, 2009, the S&P 500 experienced quite a recovery, going from 676 to 813, or just over a 17% rebound. To put that into perspective, the market historically delivered 8% average annual returns. In the table below we provide a list of the top and bottom 10 performers since the March 9th rebound began, to give you an idea of who the new Bulls and Bears are. In the list you will find each company’s attractiveness from a valuation standpoint, as well as an analysis of sales growth expectations imbedded in these companies’ stock prices. Compare the expectations for sales growth to what they 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. This list contains companies from the S&P 500 excluding all financial companies.

 

Top & Bottom Returns (S&P 500 excluding financials) Since March 9, 2009

 

*Scott Goto Arts

 

*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.

Earlier in the week we highlighted the most attractive style and sector universes from our Monthly Market Review. As a follow up to that article we are providing a list of the 10 most undervalued stocks in the S&P500. All companies listed met The Applied Finance Group's (AFG's) Buy screen (criteria explained below) and are in the bottom half of their sector in Market Value/Invested Capital (MV/IC) which by definition qualifies the companies as part of the AFG Value Universe.

 10 Most Undervalued Stocks In The S&P500

 

When identifying buy ideas AFG looks for companies with the most valuation upside compared to their sector peers, above sector median expected Economic Margin change, and a management quality score that reflects a management team following a wealth creating strategy.

 

A brief description of AFG'sbuy 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 it's peers.

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

Value Universe: Companies in the AFG universe, which have MVIC at the bottom 50% of the
universe and have EPS estimates.

Market Value/Invested Capital - The firm's average total equity, debt and other obligations divided by net invested capital

*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.

Recent Market Review:  Obama, the Budget and the “Un” Stimulus package

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Below is Value Expectations’ analysis of the companies in the S&P 500 with the 10 best and 10 worst returns for 2009 YTD (excluding financial companies). Comparing the sales growth expectations priced in (VE sales growth) to what the company has delivered in sales growth historically allows us to see which firms have the most reasonable sales growth expectations implied by their current trading prices and thus are more likely to outperform. Will the companies with the best returns be able to maintain their momentum for the remainder of 2009? Will the companies with the worst returns be able to turn things around? We will track the S&P500 winners and losers in the year ahead and provide you with regular updates.

10 Worst S&P 500 Companies 2009 YTD

 

10 Best S&P 500 Companies 2009 YTD

*data as of close Feb. 20, 2009

 

*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.

Here are the best and worst performing stocks in the S&P 500 for the month of January excluding financials. Compare the implied sales growth priced-in to justify the current trading price (VE Sales Growth) vs. what the company has delivered in sales growth the past 5 years (5 Year Median Sales Growth) to see if the expectations are realistic for the company to achieve. The more realistic the expectations are compared to what has been delivered the more likely the firm will be to out-perform.

 

Top 10 stocks in January (excluding financials) and Sales Growth Expectations

 

Worst 10 stocks in January (excluding financials) and Sales Growth Expectations

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