When looking for attractive investment opportunities for our model portfolios and buy lists we start by trying to understand which companies are the most profitable ones, as ideally we’d like to uncover profitable firms, that are growing their businesses and trading at a discount to their intrinsic value. We start by measuring profitability levels because we believe that we have created a better mousetrap for measuring corporate performance that can put professional money managers in a superior starting position when analyzing companies.
Unlike traditional accounting-based valuation metrics, AFG’s Economic Margin (EM) methodology focuses on profit from an economic cash flow perspective essentially measuring the return a company earns above or below its true economic cost of capital. This provides for a more complete view of a company’s underlying economic health. Traditional accounting-based valuation methods provide an incomplete view of a company’s value by not accounting for investment to generate the Earnings, Cost of Capital, Inflation or Cash Flow. Because the EM corrects these accounting distortions by considering Asset Life, Asset Mix, Asset Age, Capital Structure and Growth, effectively linking the income statement and balance sheet, EM levels have a much higher correlation with market values than traditional accounting-based metrics.
EM is calculated by dividing a company’s Operating Cash Flow minus Capital Charge by their Invested Capital.
Since EM also incorporates the investors required return on capital within its capital charge, an EM is a direct measure of shareholder wealth creation. A company with a positive EM creates wealth for its shareholders, a zero EM company maintains wealth, while negative EM companies destroys wealth. Companies with the highest EM levels enjoy the highest profit margins but this does not come without some added pressures as competitors often target those market leading firms and eat away at any advantages the firm may have. This makes it very difficult to maintain high EM levels for long periods of time as most of the companies that have very high EMs eventually have their profits deteriorated by the effects of competition.
Essentially the Economic Margin metric helps us do several very important things…
- EM levels help identify profitable firms and provides a more complete view of profitability level
- EM levels help determine the appropriate growth strategy for firms (non-profitable firms should not grow)
- EM is used as a function in our valuation model to address the effects of competition (avoids perpetuity assumptions inherent in other DCF style models)
One important tool that we provide our clients that helps to better understand a company’s strategy for wealth creation and how the company has performed as a result is AFG’s Wealth Creation Report (WCR). We will provide a brief explanation of the WCR and what the chart tells investors, as well as an example of Apple’s WCR as they have been a market darling for quite some time.
Wealth Creation Report explained:
The first chart in the WCR shows the Economic Margin (EM) of a company now, in the past, and future projections and helps determine a firm’s growth strategy.
Economic Margin Chart:
- level of EM’s. Whether positive or negative to see if company is profitable or not
- Volatility- tells you whether you can expect consistency in EM level or be aware if they are on an upswing or downswing
- Latest Trend in EM (EM change) companies with improving EM’s are more likely to outperform the market.
The second part of the WCR, now that you can see whether the company is profitable or not, is the Asset Growth chart. This part of the WCR is used to better understand what management is doing to take advantage of their profitability or if adjustments are being made for the lack thereof.
Asset Growth Chart:
- Steady State Growth – shows what the company can afford to grow while maintaining constant capital structure and not taking on any additional outside funds.
- Actual growth –The actual asset growth the company has experienced.
If a company is profitable you want to see them growing their asset base to maximize their profitability, conversely if the company is not profitable you would like to see management to divest losers and focus on its core-competencies to get profitability back on track before attempting to grow.
These two charts used in combination will tell you whether the company is following a wealth-creating strategy or not.
Return vs. Market Chart:
The bottom chart is a relative return chart shows the company’s cumulative total return relative to the largest 2,000 companies in the AFG universe.
As you can see in the chart below, AAPL has done an excellent job at creating wealth for its shareholders for quite some time. They have maintained very high EM levels for over a decade and have continuously grown their asset base over the same timeframe. It is no surprise that APPL has delivered excellent returns for investors and has significantly outpaced the market as a whole.
Apple Inc. (AAPL) – Wealth Creation Report
It is an impressive feat to be able to maintain high EM levels for long time periods (+5 years) such as Apple has, as this means that you must maintain whatever comparative advantages you may have while at the same time staving off the competition. Firms that can maintain the highest EM levels in a sector or index for a substantial amount of time tend to generate a significant amount of wealth for shareholders. With that being said, we have put together a list of the top 20 companies from the S&P 500 in terms of 3, 5 and 7 year EM averages. These companies have been able to deliver the EMs amongst the highest in the index over the past 7 years.
20 Highest EM Companies (S&P 500) – 3, 5, & 7 Year Averages
While the firms on this list make for a great starting pool of candidates to perform further due diligence and valuation analysis on when searching for long term investment ideas as these companies represent those which have created the most economic profitability. EMs alone however do not tell the whole story from an investment perspective. For the complete picture AFG uses valuation, quality, as well as momentum for selecting companies we consider buy opportunities. Professional money managers who would like to further analyze the companies on this list using AFG’s Equity Research Platform feel free to send us a note at sales@afgltd.com and we can schedule a call to take a more detailed look at these firms through an AFG lens.
