10/17/2017

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By Chris Austin

In a recent article we discussed in detail the daily battle portfolio managers face of balancing their time and energy between marketing efforts to grow their business vs. focusing on portfolio management and equity selection. This battle is especially tough for small to mid-sized RIA’s without a team of analysts and a limited research budget. These types of time restraints and research limitations are why AFG developed a set of analyst focus lists, one of those products is the AFG Quarterly Focus List.

The AFG Quarterly Focus List (QFL) is different from our turn-key focused solutions such as the AFG50 (50 core holdings) or AFGHD (diversified dividend strategy) as the QFL focuses on 5-7 buy ideas that have attractive valuations and have a catalyst that can drive their market value in the near-term future.

Each company in the QFL must have very attractive valuations according to our analysts’ model and the near term catalyst must be clearly identified for each recommendation. The QFL serves as a quarterly idea generator for investors looking for timely investment opportunities that are built upon AFG’s consistent process for equity selection and are modeled in detail by our analysts using AFG’s methodology and modeling tools.

As a benefit to our readers, we will focus this month on highlighting the performance achieved by the QFL since inception and take an in-depth look, using AFG research tools, at Lam Research Corp. (LRCX) a recent recommendation in the portfolio.

This exercise will provide a brief overview of AFG’s methodology and research tools and how to go through a step by step analysis of determining whether companies are worthy of consideration in a client’s portfolio.  Although this process is detailed below, those that use this analysis are provided the benefit of a consistent process that saves valuable time sorting through investment ideas so one can concentrate and focus on the best opportunities in the market.

AFG’s Quarterly Focus List

Objective

The objective is to highlight 5-7 buy ideas we find most compelling for the near term future. This list is released on a quarterly basis and an individual company may only remain in the list for a maximum of 2 consecutive quarters.

What is Unique?

The near term catalyst must be clearly identified for each recommendation, and the recommendations must have very attractive valuations.

Universe

Market capitalization should be greater than $1 billion in general, but will focus on recommending names with market capitalization greater than $2 billion.

Benchmark

The Russell 1000 index.

Return Calculation

The list’s quarterly return is an equal weighted return of each stock in the list. The list’s return is the cumulative return of its quarterly returns. (Price returns only.)  Release Dates: The beginning of January, April, July, and October.

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Step 1:  Quickly Identifying Investment Opportunities

The first step in the selection process begins with an unbiased approach to screening to identify attractive companies using AFG’s Investment Grade model.  AFG’s Investment Grade is a robust multi-factor weighted model that focuses on valuation attractiveness, economic momentum, management and earnings quality.  Portfolio managers can start with a default buy list created by AFG or they can use our screening tools to incorporate other characteristics of companies a portfolio manager finds attractive to narrow the focus list. This allows managers to concentrate on companies that meet their specific criteria and spend more time analyzing companies worthy of consideration.

One area we believe is currently poised for growth is in the semiconductor space.  If we screen for companies that meet AFG’s criteria for investment there are a few companies that meet that criteria but after due-diligence, we have identified Lam Research Corp. (LRCX) as a company that is one of the most attractive in its space.

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Step 2: Drill down into each factor using EquityInsights.com

Once we have identified a set of companies to evaluate, EquityInsights.com allows analysts and portfolio managers to efficiently drill down into each factor using a set of charts and information to exclude companies further.  Below is the review process using LRCX.

Company Snapshot

The first place we direct our clients to get a helicopter view of the investment attractiveness of any firm is on the Company Snapshot page. This page clearly lays out the overall Investment Grade a firm earns A-F as well as the Investment Grades for each of the individual factors that make up the overall Investment Grade. These factors are split into 3 main categories, Valuation, Momentum and Quality. This helps provide an instant understanding of how our model views the company as an investment opportunity and also gives some insight into what factors are driving the overall Investment Grade. On the Company Snapshot page example below for Lam Research Corp. you can see that the company receives attractive grades across the board, and looks especially attractive from a valuation standpoint.  Each factor is systematic and proprietary to AFG with the exception of price return which is the smallest weighted factor in the model.  Valuation is the largest indicator of alpha and gets the most weight which is why we consult our clients to anchor on valuation.  Quality is used as a catalyst to value along with improving operational momentum.

lrcx-snapshot

Intrinsic Value

To understand how well our model has tracked Lam Research Corp. through time, we provide a chart that shows AFG’s valuation value vs the actual stock price through time.  Since AFG has not changed our methodology since inception 21 years ago, this data is a representation of the valuation attractiveness of the company at any given point in time.

As displayed in the Intrinsic Value chart below, AFG’s model has done a good job tracking LRCX and the firm has recently begun to look very undervalued. The blue bars in the chart represent the annual trading range for LRCX, while the grey dotted line represents AFG’s Intrinsic Value for the firm.

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Wealth Creation Report

AFG’s Wealth Creation Report can help shed some light on a company’s ability to create wealth for its shareholders as it displays the firm’s Economic Margin (EM) levels (economic profitability) in relation to its asset growth. Companies that can earn consistently positive EMs like LRCX, which is not an easy feat, should be encouraged to grow their asset base to maximize profits. If the firm is unable to earn back its cost of capital (Negative EM), we believe that the firm should focus on fixing its profitability issues and earn the right to grow. Negative EM firms that attempt to grow assets often destroy wealth for shareholders as they are just expanding a losing business. It is not a surprise to see that the 3rd chart in the Wealth Creation Report which measures the return vs. the market shows that LRCX has been a long time outperformer. The company has consistently been profitable (High EMs), consistently grown its asset base (which we believe is the ideal management strategy you’d like to see employed as a shareholder), and finally, the market has rewarded LRCX. In the few times that EMs turned negative for LRCX, you can see the company’s focus was not on asset growth, but fixing its EM levels, which is exactly how management should react in those situations.

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Step 3: Sensitivity Analysis and Model Building

By using AFG’s Value Expectations interface, an analyst can quickly identify expectations priced into the firm without going through the rigorous process of building out their own model.  Sorting through a number of companies in the semiconductor space, you will quickly realize that Lam has some of the lowest expectations built into their current market price.

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If we simply use conservative 3yr EBITDA margins and asset turn levels, you can see that Lam must simply grow revenue at 7% the next five years to be fairly valued at their current 108.47 stock price.  By using consensus estimates on our system, 7% revenue growth is a low hurdle for a company that is poised to grow revenue in the 20% range next year.

Step 4: Qualitative Assessment & Near-Term Catalyst

Overview

Lam Research Corp. provides the tools to create the chips created by companies such as Samsung and Micron.  Lam’s products “are designed to help its customers build smaller, faster, more powerful, and more power-efficient devices that are used in a variety of electronic products, including mobile phones, wearables, tablets, computers, automotive devices, storage devices, and networking equipment.”

In FY 2016 (ending June 30, 2016) the company had sales of US$5.9 Billion generating EBITDA of US$1.36 Billion. In FY 2016, Lam had 4 customers that each contributed at least 10% of Lam’s total revenue – Micron Technology, Samsung Electronics, SK Hynix and Taiwan Semiconductor Manufacturing Company. 3 of the 4 are big NAND and DRAM memory manufacturers while Taiwan Semiconductor is the world’s largest semiconductor foundry making primarily logic chips. In FY 2016, LAM derived 68% from Memory and 32% from Foundry/Logic.  As most chip fabrication facilities are located in Asia, approximately 80% of its total revenue is derived from Asia and rest split between US & Europe.

The company tried to merge with a competitor, KLA-Tencor (announced October 2015) however the deal was called off on October 2016 as the US Department of Justice seemed hesitant to approve the deal as the combined company would have had too much influence in the semiconductor equipment market. The thesis for the merger was to combine Lam’s leading etch technology with KLA’s leading yield monitoring and process control systems. Though management felt that had the deal been completed, the combined company would have saved $250 Million in cost synergies and $600 Million in additional incremental revenue by 2020, managements of both firms decided to end the merger to avoid prolonged distraction as the 2 were still doing well and expected to continue to do well as independent firms.

Catalyst: During its recent analyst meeting, the company was very bullish in its growth prospects as it sees their addressable market increasing, especially as more products have some form of digitization. The company believes the technology inflections in the industry, including FinFET transistors, 3D NAND, multiple patterning and advanced packaging have led to an increase in their served addressable market for their deposition and etch products. Lam believes that, over the longer term, demand for their products should increase as the proportion of customers’ capital expenditures rises in these technology inflection areas and it continues to gain market share.

While the latter is the longer term catalyst for Lam, the short-term catalyst is the most recent bullish earnings call from Micron Technology. Micron stated that it expects to see continued sales growth and that the company is transitioning to 3D NAND. Micron forecasted that it expects to spend approximately $5 Billion on new CapEx in 2017 which should benefit Lam as MU is one of the largest players in memory.  Lam should also benefit as the other big memory companies continue their transition to 3D NAND.

The company is very confident in its growth as the company increased its dividend payout by 50% to 0.45 per share quarterly and implemented a $1Billion share buyback over the next 12-18 months.  The company expects to increase its sales 54% to approximately $9 Billion by 2020 generating cash from operations of $2.25 Billion (66% increase from FY 2016).  That is much higher than most analysts have estimated.  Building a relative conservative revenue growth compared to company projections, 15% for FY2017 and 4% thereafter with EBITDA margins increasing to 25%, we get a target price with very good upside.

In conclusion, we believe that shares of Lam Research Corp. (LRCX) are currently trading at a discount to their default intrinsic value and LRCX has been following a management strategy of wealth creation. LRCX meets all of the quantitative criteria to earn an Investment Grade of A. LRCX also meets all of the qualitative criteria our analysts put forth in order for a company to be added to the QFL. In summary, LRCX looks attractive within our model from a default basis and also looks to be doing all of the right things qualitatively and that is why LRCX has been added to our most recent QFL.

Step 5: Building a Custom Model

After analyzing the quantitative output and doing the qualitative evaluation of a company, analyst can then incorporate their assessment into a custom model.  This process can be done quickly using AFG’s Value Expectations interface or one can completely reconstruct inputs in the balance sheet and income statement to get a more finite pricing based on their inputs.

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Based on our analyst proforma model, Lam currently has an upside of 30%.  Assuming the near term catalyst comes to fruition, Lam is a company you should consider as an investment opportunity for your client portfolios.  If you are not a current client or have not received a trial of AFG’s EquityInsights.com interface, we would like to provide the opportunity to evaluate a company with you that you currently own or are thinking about investing in and we will also provide the complete list of names for the current Quarterly focus list.

About Chris Austin

Partner at The Applied Finance Group
Focus areas:  Portfolio Consulting, Business Development
Joined AFG in 2003



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Torpedo Logo

The majority of the themed-portfolios and research products that we offer at AFG revolve around identifying undervalued stocks that look like attractive investment opportunities we think our clients or readers should consider adding to portfolios. While it is very important for money managers to discover the next attractive investment opportunity poised to deliver solid returns, it is just as vital to be able to identify and avoid potential torpedo stocks that could blow up your portfolio. For this reason, we will identify 12 S&P 500 stocks that have characteristics commonly found in companies likely to underperform.

We utilize AFG’s multi-factor Investment Grade model to assign a simplified letter grade (A-F) and identify the companies to own and avoid based on overall Investment Grade. Several of the individual factors within the model have successful track records as exclusionary variables on a standalone basis, as they consistently flag companies that underperform. AFG’s Earnings Quality Grade which flags companies with very high levels of accruals and Management Quality Grade which flags companies following a wealth-destroying management strategy are two factors that have consistently helped to identify potential torpedoes. The chart below highlights the performance achieved by the Investment Grade model since inception. Investors who avoid F Grade stocks and only own A Grade companies have tended to do very well.

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Being that the Investment Grade model has been so successful at identifying companies that tend to underperform, as evidenced by the performance of “F” Grade companies, we want to provide a list of companies that have been flagged as potential torpedoes. The 12 companies listed below all currently earn an Investment Grade of “F” and also look very overvalued from a valuation perspective. This list can serve as a red flag for investors who may own any of these companies or are considering adding any of these names.

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