NOV

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.

 Click Here - If you are a professional investor and would like a review of your portfolio by an AFG representative or to discuss companies AFG find attractive that fit your investment style.

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In yesterdays article we provided an update of the performance of our annual HOT STOCK LIST:

We also provided an update of the performance of the Toreador Large Cap Fund, TORLX which uses AFG’s Economic Margin Framework as part of its investment philosophy.

As you may note, both have done very well!

Today we decided to provide a Buy/Sell list to VE’s registered visitors applying some of these same investment principles: Economic Margin, Management Quality, and a company's Percent to Target (the deviation between a stock's current trading price and its current default target price according to AFG).

Below is a preview of the list which includes a Buy/Sell Recommendation on each Stock. The complete list, accessible to Value Expectations registered users, contains around 500 Stocks.

Source: The Applied FInance Group

To download the complete list click here.

The Applied Finance Group’s (AFG’s) Earnings Quality variable is an important indicator of companies that may be more likely to have negative earnings surprises and underperform due to high amounts of accruals. With many firms under pressure to meet sales expectations in the current environment, it is important to watch out for those firms that may be trying to pad their sales numbers, ie. Channel stuffing (sending excess inventory to stores that cannot sell their products).

The EQ score ranges from 1 to 100, 1 being the best EQ score resulting from the lowest accruals, and 100 being the worst EQ score indicating the highest accruals. Because high EQ score companies (bad Earnings Quality) are more likely to have negative earnings surprises, you may want to avoid these firms. Our back-test indicates that the EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

We screened the S&P500 to identify those firms with the worst Earnings Quality (EQ), which may be possible torpedoes. The Chart Below displays the 14 firms along with their EQ scores and our valuation analysis.

Earnings Quality: Accruals

•An accrual is the difference between Cash Flow and Net Income.

•Net Income = Cash Flow + Accruals

•Low Accrual companies outperform high accrual companies

Two ways to approach accruals:

1. Cash Flow Statement
•Difference between Net Income and Cash Flow

2. Balance Sheet
•Change in Net Operating Assets from Period t-1 to t
•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

 14 Worst Earnings Quality Firms

Here is a look at how well the Earnings Quality variable works when you split top half vs. bottom half in each sector/style.

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

Here is a look at an example of a poor Earnings Quality company that has a negative earning surprise and thus underperforms.

Eastman Kodak

If you like this article, you might be interested in stocks that fit our Buy Reccomendations: Click here to read

A brief description of some other AFG's insights:

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.
AFG's Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

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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To identify potentially attractive investment ideas, AFG usually uses a combination of proprietary variables to develop of focused group of potential buy ideas that meet criteria based on valuation, economic performance, management quality, and Earnings Quality. In December of 2008 ValueExpectations.com released a list of companies narrowed only by the valuation properties of the company using AFG’s Value Score (defined below). Our valuation techniques have proven successful through time at identifying mispriced securities and helping our clients identify investment opportunities resulting in outperforming their chosen benchmark. .

The ValueExpectations.com blog posted in December 08 (High Value Score Stocks - S&P 500) contained these high Value Score companies (DDS, S, NOV, MTW, SII, WFR, CHK) had returned 40% above the S&P 500 as of our 3-26-09 performance update and a recent check of that performance on 5-5-09 was even better, currently these companies have returned an astounding 64.5% above the return of the S&P 500 during the same time period (12-29-08 to 5-5-09).

In this exercise we used valuation independent of other key proprietary variables we use to identify good investment opportunities. Although valuation works well on a stand-alone basis, it works even better when used with AFG’s Economic Margin, Management Quality, and Earnings Quality variables.

Listed below are the top 10 companies in the S&P 500 (excluding Financials) based on AFG Value Score alone. These companies all look the most attractive from a valuation perspective relative to the rest of the index.

AFG High Value Score Stocks

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

AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

In our March Monthly Market Review we released a series of graphs representing the valuation attractiveness of each sector relative to its historical norms and to the entire AFG universe. Below is a graph representing the Capital Goods sector which is attractively priced when you compare against its historical trading ranges (red line) and when comparing against the overall AFG Universe (represented by the value of 1). Only in 1998 has the sector looked more attractive since our valuation tracking started in 1996. Listed are 10 companies in the Capital Goods sector that meet AFG’s Buy Criteria and look attractive from a valuation standpoint. Also listed below the graphs are an explanation of AFG’s Buy Criteria and AFG’s Percent to Target Charts.

Capital Goods Relative Valuation Chart

10 Capital Goods Companies (S&P 500) With Attractive Valuations

Percent to Target Chart -This graph shows the Percent to Target Current (Valuation Attractiveness) 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. This example illustrates that the median Large Cap company is undervalued relative to the market currently and has been trading at a discount to its historic relative valuation, indicating a potentially attractive opportunity.

A brief description of The Applied Finance Group'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.

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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

AFG Market Forecast Project
Insights From
Professional Investors
 
The Applied Finance Group would 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. 
Click here to learn more

There are many ways professional equity investors use to narrow their list of investment constituents; by size, value, growth, sales growth, earnings growth, etc. When ValueExpectations.com looks for investment opportunities or to avoid potential torpedoes, we start with a focus on accessing Valuation, Corporate Performance (Economic Margin), and Management Quality of companies. These variables have proven very successful in finding winners and avoiding losers in different market caps, different styles, and different economic sectors, helping professional investors make sound stock selections in the past 13 years. These and many other proprietary variables can be screened on Applied Finance Group’s (AFG’s) institutional product www.AFGView.com.

Enjoying an accomplished methodology and process of selecting stocks doesn’t prevent us from learning how other people are identifying their fishing pool. We recently came across SA Editor Eli Hoffman's recommended list of stocks based on a set of variables that , he believes benefit both growth and value investors as these companies contain characteristics both investors will find attractive. These stocks were identified by what the author calls “a powerful screen and helps find strong companies at great values”.

Eli Hoffman's screen includes the following criteria:

• Only companies identified as Buys by Zack’s
• Companies with the highest 5 year historical earnings growth rates (top 20% all Zack’s Buy Rec.)
• Lowest P/E ratio (bottom 20% all Zack’s Buy Rec.)
• Trading over $5 a share
• 10 day avg. share volume of 50,000 shares or more

As the AFG methodology has also proven effective in identifying attractive stocks regardless of their Growth or Value characteristics, we thought it would be interesting to check the valuation attractiveness of Mr Hoffman’s stocks via AFG’s Value Expectation application. 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 following table displays the implied future sales growth of Mr Hoffman’s companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

Companies recommended by Mr Hoffman appear to have pessimistic future sales growth implied by their current stock prices, when compared to their historical sales growth, and appear to be undervalued from AFG’s valuation perspective. Before making a wise investment decision, however, we also need to understand a company’s corporate performance (Economic Margin), management quality, competitive advantages and valuation attractiveness relative to its industry and sector peers. AFG’s institutional product helps investors to gain considerable insight regarding those aspects through its proprietary framework and we will provide a detailed tutorial of this process next week. 

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Fidelity’s Low Priced Stock Fund, which launched in 1989 (18 Billion AUM) and is managed by Joel Tillinghast, follows a simple strategy… Only invest in stocks with a share price under $35. This strategy first started with Tillinghast only investing in stocks below $10 a share, but later he moved the limit up to $35 a share. He argues that share price alone is not important but that the small-cap universe contains the most frequently mispriced stocks and the least amount of analyst coverage.

Although his fund at best has been a market performer as of late, Tillinghast had taken advantage of such mispricing’s during the last 15 years, averaging an 11% annual return compared to the 6% return earned by the S&P 500 over the same period. The fund had been closed to investors since 2003, but was recently reopened in December. Fidelity says they reopened the fund to get more cash inflow to be able to take advantage of all of the investment opportunities they see in the market.

Below is a list of the top holdings in Fidelity’s Low Priced Stock Fund as well as stocks that AFG believes are attractively priced in three price brackets: under $10, $10 to $20, and $20 to $35. 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.

In Joel Greenblatt’s 2006 book, The Little Blue Book that Beats the Market, he presented his “Magic Formula” used in his hedge fund, Gotham Capital. Mr Greenblatt tested his formula between 1988 and 2004. The results were incredible, with only one down year, the magic portfolio would have returned 30.8% a year, against a 12.4% annual return for the S&P 500.

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. He also recommends one year holding periods, so we thought this would be a great time to get this list out. 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. Below is a definition of each variable.

Variable 1: Return on Invested Capital = EBIT / (Net Working Capital + Net Fixed assets)

Variable 2: Earnings Yield = EBIT/EV

The table below shows the top 30 firms with their market implied sales growth expectations. Enjoy!

Applied Finance Group’s (AFG’s) Value Score defined - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

These stocks all have an AFG Value Score above 95 which means these companies are in the top 5% in percentage upside relative to the universe based on AFG’s default target price. All of these companies also have lower sales growth numbers priced-in to justify the current stock price (VE Sales Growth) than what the company has achieved in the last 5 years (5 Year Median Sales Growth). Low expectations for sales growth compared to the actual sales growth achieved is a good sign the company can beat those expectations and will be more likely to out-perform. Low expectations coupled with attractive default AFG Valuation is a good starting point when looking for possible investment opportunities. Although these companies may not be able to achieve the same levels of sales growth they have experienced in the past 5 years, the expectations are so low that they do not have to return to those numbers to beat the very low expectations.

High Value Score (AFG) Stocks & Their Sales 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

EQ is important in this current market environment because so many companies are feeling pressure to meet their sales expectations. Many companies are channel-stuffers, which is one form of accruals that often leads to negative earnings surprises. A recent poster-child for this example of sending excess inventory to stores that could not sell their products would be Crocs and the way they tried to pad their sales numbers.

Earnings Quality: Accrual

•An accrual is the difference between Cash Flow and Net Income.

•Net Income = Cash Flow + Accruals

•Low Accrual companies outperform high accrual

 Two ways to approach accruals:

1. Cash Flow Statement

•Difference between Net Income and Cash Flow

2. Balance Sheet

•Change in Net Operating Assets from Period t-1 to t

•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

 We screened the  S&P500 to identify those firms with the worst EQ scores. The score is given from 1-100, 1 being the best EQ company, 100 being the company with the highest amount of accruals and the worst EQ. Because high EQ companies are more likely to have negative earnings surprises, this is a group of companies you may want to avoid. The EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

After running our screen we identified 14 firms as the worst Earnings Quality firms. You can set yourself up for success and save time by narrowing your list of constituents to only those that meet our standard valuation, Economic Margin and Management Quality checks and following that up by filtering out those companies most likely to have negative earnings surprises (high EQ). The Chart Below identifies the firms that met our screen criteria, along with the EQ score and our VE analysis.

Worst 10% Earnings Quality Companies In the S&P 500

Universe Size: 4,000 to 5,000 Firms

Source: Applied Finance Group Database from 9/1998-5/2008

 This variable does not add any value for companies within the financial sector and those companies are automatically screened out when using this variable.

Recently we also screened the S&P 500 to identify investment opportunities and identified over 150 companies (industrials) that have negative sales growth expectations embedded into their current market valuations. These companies include high quality companies such as: COH, DOW, CAH, TGT, JNJ, UTX, SBUX, and WAG, among others. If you would like to Read our study Click Here