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Finding Investment Opportunities with Low “Hurdle Rates”
Often, investors seem to be wearing blinders when making investment decisions. They get caught up in the “story” of a stock or focus too much on short term performance. What is frequently forgotten is that when buying a stock, investors are paying for a set of expectations that are being implied at a given price. If investors want to improve their stock selection process, they must first answer this one simple question “What am I paying for in today’s price?”
Over 20 years ago, The Applied Finance Group (AFG) developed a research application called Value Expectations that has been helping clients answer the core of that very question and removing emotional biases from the equation. The engine behind Value Expectations translates AFG’s proprietary Economic Margin framework, which converts GAAP accounting data into a set of economic cashflow metrics, to a DCF model.
Value Expectations reverse engineers the DCF model to understand the embedded sales growth expectations a stock must deliver to justify its current price. This helps investors leverage their time by avoiding stocks with high expectations and improves performance by focusing on stocks with low expectations which may merit further due diligence.
For example, below is the Value Expectations interface with Coca-Cola (KO), which is telling us that the expectations are very rich. Assuming historical median EBITDA Margins and Asset Turns, KO needs to achieve over 22% sales growth each year for the next five years to justify its current price of $43.48. These expectations are much higher than anything they can realistically achieve.
We can also apply this process to gain insights on any universe of stocks like the S&P 500. The chart below highlights current and historical implied sales growth expectations embedded in the market price for the S&P 500 index compared to the sales growth these stocks have delivered over the past five years.
When the index approaches abnormal ranges (+/- 1.5 std dev.) it signals that the index is extremely under or overvalued. The two biggest extremes in expectations was in 2000 at the height of the euphoria around tech when your doctor was giving you stock tips and in the doom and gloom of 2008 which represented a generational wealth creating opportunity for investors. As of July 31st, 2016 the implied expectations for the S&P 500 are a bit high compared to historical norms, but we don’t perceive any major concerns that should cause any change in allocations in the large cap space. The real opportunities in today’s market, lie within the universe of mis-priced stocks with unrealistic expectations priced in.
Under the Hood – Corporate Performance
To value a company, you must first understand it’s corporate performance. Earnings is a very poor proxy for profitability as traditional accounting-based metrics provide an incomplete view of a company’s performance by ignoring the investment needed to generate the earnings and the cost of capital associated with the investment.
To address these issues, AFG’s proprietary Economic Margin (EM) was developed to evaluate corporate performance from an economic cash flow perspective. Effectively linking the income statement and balance sheet to capture differences in Capital Structure, Asset Age, Asset Life, Asset Mix, Off Balance Sheet Assets and liabilities, Investment Needed to Generate Earnings and Cost of Capital.
The chart below is a bird’s eye view of the EM calculation. The numerator states the economic profit which is then divided by an inflation adjusted invested capital to make it easier to compare against other companies and over time.
Calculating Intrinsic Value and understanding the Value Expectations for stocks
Now that we have created an effective framework to measure corporate performance we can begin calculating intrinsic value. As mentioned at the beginning, when buying a stock, you are essentially paying for its future expected performance. We calculate intrinsic value by forecasting Economic Margins, then discounting those cash flows. Unlike traditional DCF models that lock into perpetuities, assuming nothing in the market will change, we take into account real market forces by incorporating a competitive advantage period (CAP) – the time frame that competition will compete away economic profits. In other words, a better investment decision can be made because the framework provides clarity and structure in understanding a company’s economic profitability, management quality, growth prospects, and competitive advantage period to translate into a valuation target.
With the DCF engine in place, rather than starting by forecasting cashflows, investors can use historical median EBITDA Margins and Asset Turns, to solve for the implied sales growth to justify its current price, as illustrated on the chart below. By beginning your research with insights on what the market is implying, you can leverage your time significantly by focusing your efforts on analyzing those stocks where the expectations significantly deviate from their own historical performance, their peers or your own insights. Once you have identified a short list of stocks with low expectations, you can be much more explicit in calibrating each value driver, or as many other inputs as your time allows, to calculate an intrinsic value based on your forecast.
In conclusion, the market is always speaking loudly to investors and providing guidance with very clear expectations you can leverage. To improve your selection process, before you begin forecasting cashflows, you need to remove the noise and remember to answer “What am I paying for in today’s price?” Alternatively, you run the risk wasting your most precious asset, time.
Navigate the Market by Understanding Expectations
After better understanding our approach to evaluating the attractiveness of a company through AFG’s Economic Margin methodology, the content provided below is to help readers better understand how portfolio managers and analysts take a practical approach to applying these concepts.
Expectations analysis can be performed on a country, index, industry, sector, company, style, market cap or even on a custom set of companies such as a client portfolio. We will begin by addressing expectations analysis from a top down perspective. Secondly, we will address how to uncover parts of the market that are delivering high or low levels of expectations compared to what is priced into that segment of the market.
For example, below is a breakdown of each sector within the S&P500 showing the actual level of Economic Margin’s a typical company is delivering and the expected EM the market currently has priced in.
A quick observation identifies that Staples historically delivers roughly 14% EM’s while the market has an EM level of 23% priced in. We would suggest that investors pay close attention to their investment in the staples sector to avoid over priced stocks or potential torpedoes.
After assessing the sector, we can drill down to the industry level to determine which industries in each sector have high or low expectations.
Given the recent strong performance of Tobacco companies, it’s not a surprise that the industry has very high corporate performance expectations priced in. On the other hand, the big brick-mortar stores have relatively benign expectations priced in, relative to other peer industries in the Staples sector.
DIFFERENT TYPES OF EXPECTATIONS
There are three ways in which we help investment firms understand expectations, the sector and industry charts shown above evaluate expectations based on AFG’s proprietary corporate performance measurement Economic Margin (EM), and a more practical use can be to determine revenue and EBITDA margin expectations.
Each expectation measurement is equally insightful. If you are looking at growth oriented companies and want to better evaluate top line growth cadence, sales expectations might be the best perspective. Alternatively, if you are looking at margin sensitive companies that have steady streams of revenues, understanding the EBITDA margins priced into the companies might be most helpful.
Let’s examine expectations analysis from an individual company’s perspective to gain a better understanding of how a portfolio manager or analyst can apply this to their daily due diligence process on company research. The interface we will use to determine expectations is called Value Expectations.
As an example, let’s take a look at Intel (INTC) sales expectations. At the time of writing this article, INTC was trading at $34.25. By using its 5yr median EBITDA margin and asset turn, intel needs to deliver -3.91% sales growth to justify its trading price. This analysis suggests if we feel comfortable with Intel’s ability to deliver those margins and asset turns, the company has very low sales expectations priced into its stock, relative to what it has been able to deliver historically.
This is a single company example but a portfolio manager can apply similar analysis to review a client or prospective client’s portfolio, and quickly determine which companies might warrant a more thorough review. For example, if Estee Lauder (EL) were a holding, we could quickly identify that the company’s stock price has implied very high expectations. By using a realistic 5% revenue growth and solving for the EBITDA margin priced in, EL must deliver 22.75% EBIDA margin over the next five years to be fairly valued. In reality, EL’s highest level of EBITDA% was 20% achieved back in 2014.
Lastly, we will examine INTC based on their forecasted EMs vs what the market is pricing in. Below are the historical EMs of INTC, and forecasted EMs for 2016 and 2017. INTC is expected to deliver 4.46% EM in 2016 and 2017 while its current trading price is pricing EMs of just 2.74%. Given the company’s ability to consistently deliver EMs above 4% in the remote and recent history, we believe it is safe to say that INTC has low EM expectations priced in.
Stocks to Buy and Sell Based on Expectations
Much of the recent content we have been publishing has been geared around our Value Expectations interface which harnesses the strengths of AFG’s proprietary Economic Margin framework and modified DCF model to better understand the embedded sales growth expectations a stock must deliver to justify its current price. This process allows investors to spend more of their due diligence time focused on stocks with low expectations for sales growth and avoid companies with high expectations relative to what the company has delivered historically.
Today, we will focus on the sales growth expectations embedded in stock prices for individual companies within the S&P 500 to identify those that have low expectations as well as a few with lofty expectations. By understanding the sales growth “priced-in” relative to what the company has delivered historically, you can set a “hurdle rate” to determine whether or not expectations can realistically be met. When expectations are low companies tend to be more likely to outperform those expectations and outperform their benchmarks.
The companies from the S&P 500 listed below have been identified as having either very lofty or very low expectations for sales growth relative to what they have delivered historically, and relative to the expectations of their sector and index peers. The companies with low expectations for sales growth also earn an Investment Grade of “A” which means the company receives the highest grade in our model based on Valuation, Quality and Momentum factors. The opposite is true for the companies we have identified as having high expectations for sales growth, these firms currently earn an Investment Grade of “F”.
S&P 500 Companies with High/Low Sales Growth Expectations
To illustrate this concept, we will take a look at one of the companies from our list of “A” Grade companies with low expectations, Endo International (ENDP). ENDP is currently trading at around $22 a share. By assuming EBITDA margins and Asset Turns remain near their 5 year median levels, ENDP needs to deliver around -26% Sales Growth over the next 5 years to justify its current price. In other words, ENDP has extremely low sales growth expectations priced into its stock in relation to what it has been able to deliver historically. Even when the assumptions for EBITDA and Asset Turns are manipulated to reflect a much more conservative outlook, ENDP still has very low expectations for growth “priced-in”.
By focusing your time and effort on companies with low expectations for growth “priced-in” to current trading levels, that also earn an Investment Grade of “A”, money managers can develop a focus list of companies that have many characteristics inherent in companies likely to outperform benchmarks and sector peers. Once you have identified your focus list, you can also utilize the Value Expectations interface to build out extremely detailed pro-forma financials, determine a target price based on your own assumptions and also stress test your valuation assumptions.
PETER J. SOWDEN, CFA
Atwood & PalmerAssets Under Management – $581 Million
AFG Client Since 2010
- Can you tell us a little about Atwood & Palmer (Who you serve, philosophy)?
a) Atwood & Palmer is an independent RIA. We work with a select group of high net worth clients and some local charitable foundations.
2. You have been a client of The Applied Finance Group (AFG) for over 5 years, what sets AFG apart from other equity research providers?
a) What drew us to AFG was a valuation philosophy that was very similar to our own. In the past, we had done a lot of our own work on ROIC/WACC spreads and discounted cash flow analysis. The AFG methodology married those two together and the software that they provide, allowed us to leverage our time a great deal. We still use our own inputs (assumptions) but the software allows us to create/modify and track intrinsic valuations a lot easier than before.
3. Has AFG helped you reach better investment decisions?
a) Yes – We use their Value Expectations tool a lot in our work. It has not only helped us find interesting investments but also exit investments when some of the economic drivers change.
4. How does AFG’s research process and applications help the investment team save time?
a) We run a lot of screens that employ AFG Company Grades married with some technical analysis. Once we have a list of companies, we can do a quick Value Expectations to see if we are interested in doing further research. This has saved us a lot of time because we are usually able to eliminate a number of opportunities quickly using VE. We then use pro-forma builder to really dig much deeper into the remaining opportunities to see if they are good investments for our clients.
5. Any additional comments about AFG?
a) We have had a great working relationship with AFG. Their on-going training is excellent and we have been very pleased with the additional investments they have made in the platform to make it even better.
6. Atwood & Palmer has grown tremendously over the past five years, any advice you would like to share with growing firms?
a) I think our main advice is to find out what makes your firm unique and then leverage that as much as possible. For our firm, we have purposely elected to work with a small, select group of clients. This has allowed us to spend a great deal of time with our clients above and beyond their investments. By providing this level of service and customized portfolio management, we are able to offer something unique that is important to high net worth clients that they are not able to find at most other firms.
7. We are in an election year, does the outcome play a role in your investment decision process? If so, can you please elaborate?