PEP

With a major week of earnings right around the corner, we thought it would be useful to our readers to provide an analysis of the companies set to report in the first half of next week. This analysis contains a breakdown of each company's default recommendation according to AFG's Buy/Sell criteria, a look at their valuation attractiveness, and a look at the direction their Economic Margin's are expected to head in the upcoming year. The three companies that look the most attractive based on these criteria are Pfizer, Advanced Micro Devices and Boston Scientific.

A company's Economic Margin (EM) is a measurement of a their true earnings above or below their cost of capital. EM also corrects distortions caused by accounting policies to give a more accurate assessment of a company's real value. It is important to understand the direction a company's EM's are heading because, by knowing this, one can get a complete assessment of how profitable a company can be in the future. The EM Framework addresses profitability, competition, growth and cost of capital. When factoring in each of these variables, investors can fully assess a company's value. 

Below is the list of companies reporting earnings in the first half of the upcoming week along with a closer look at Boston Scientific:

 According to the chart below, BSX's intrinsic value is above its current stock price, which leads us to believe that Boston Scientific is undervalued right now. 

 According to the Wealth Creation chart below, BSX has shown a positive Economic Margin and is forecasted to improve that margin in the upcoming year.

Source: Www.EconomicMargin.com 

AFG's Buy/Sell criteria factor in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the 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.

AFG's default valuation is a good place to start because it is a simple metric that gives a more accurate outlook on a company's value while correcting distortions.

- - - - - - - - - - -

AFG’s Intrinsic Value Chart identifies how far a stock’s intrinsic value (target price assuming immediate decay) deviates from its trading range, which helps you recognize potentially mispriced stocks and pursue long and short opportunities.

• The blue bars represent the high and low trading range for a stock for 1 year.
• The red dotted line represents AFG’s historical Intrinsic Value through time.
• When the red line (Intrinsic Value) is above the blue bars (trading range), the company looks to be undervalued.
• When the red line (Intrinsic Value) is below the blue bars (trading range), the company looks to be overvalued.

AFG’s Intrinsic Value Chart also contains a company’s Value Score (ranked valuation attractiveness), Economic Margin Change (expected increase/decrease in economic profitability), and Accuracy score (how well AFG’s default valuation has tracked the company).

Wealth Creation Report: displays a company’s Economic Margins (what a company earns above or below its cost of capital) through time as well as a projection of their expected future levels. The second graph shows how a company has grown their assets over time and also contains a projection of how they will grow their assets next year. AFG’s view on wealth creation starts by looking for profitable companies that are also growing their assets to make the most of that profitability.

Investment Insights from your peers, 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

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)

Join Value Expectations... it's FAST and FREE!

Jim Jubak (Jubak’s Journal – MSN Money) recently released an article outlining 5 major missteps a company can make on the road to recovery during a recession and provided 5 stocks he believes avoided such missteps and are primed for success when the market returns to normalcy - COH, PEP, QCOM, FLS, NUE. According to Jubak, he likes these companies because they all have good debt to equity ratios, solid balance sheets, and they have not been “beaten up so badly that they will spend the first year of the market recovery patching holes”. Jubak currently has 50% of his portfolio “Jubak’s Picks” in cash and the other 50% in stocks and does not expect the market to bottom for another 6 months or more, but believes these 5 stocks will be solid performers when the market does finally return. ValueExpectations.com has taken Jim’s 5 shipshape companies and analyzed them using The Applied Finance Group’s (AFG's) valuation model and buy criteria.

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. 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.

Jubak's 5 shipshape stocks for the turnaround

Click Here for a closer look at some of The Applied Finance Group's valuation concepts.

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

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

As a new administration takes office, investors will be looking for companies that will benefit most from Obama taking office. Which stocks will your “Obama Portfolio” consist of? Will you load up on infrastructure, health-care, alternative-energy, or green companies? If Obama’s big plans are carried out, these are a few areas that may see a direct benefit. Karim Bardeesy from The Big Money put together a list of stocks they feel will benefit from the new administration and are comparing their “Obama Portfolio” to one created by Jim Cramer. Here we will look at both portfolios and compare their sales growth expectations to see which of these firms will be more likely to out-perform. We will re-visit at a later date to see which “Obama Portfolio” will have provided the better return.

 The Big Money's "Obama Portfolio" and Each Company's Sales Expectations

*denotes less than 5 years historical sales numbers, ** = 2 years *** = 3 years

Jim Cramer's "Obama Portfolio" and Each Company's Sales Expectations

VE Sales Growth calculated for these companies on 1-21-09

For the past 26 years Steven Halpern, editor of thestockadvisors.com has gone to well known and respected advisors once a year to find out which stocks they like for the coming year. Take a look at the list of stocks advisors liked in 2008 and their performance. Also listed are the picks of 75 prominent advisors for 2009 along with sales growth expectations for the companies to justify their current price (VE Sales Growth) which can be compared to what they have delivered in revenue growth over the past 5 years(5 Year Median Sales Growth). These companies are worth a look because they are in favor of well-respected advisors, but the companies that also have low expectations for sales growth priced-in to their stock are especially worthy of a close review.

2008 Blogger Picks Conservative and 2008 Performance

2008 Blogger Picks Speculative and 2008 Performance

Blogger Picks for 2009 and Sales Expectations

* denotes # of years historical sales numbers available

VE Sales Growth calculated for these firms on 1-6-09

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?

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

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