2014 Best & Worst Performing Stocks and Sectors - S&P 500 by Michael Ghioldi

As 2014 winds down, we will take some time to review which sectors and individual companies have been the best and worst performers in 2014. The S&P 500 index as a whole has delivered just over 6% YTD and we would like to identify which sectors/companies have been the biggest drivers of those returns and which have been the biggest drags.

In the chart below we have divided the S&P 500 up by AFG Sector to provide some insight into which sectors have been the best and worst performers of 2014. As you can see the Health, Transportation and Utilities sectors have fared well this year while Energy, Capital Goods, and Basic Material have struggled.

Next we will highlight the top 20 and bottom 20 performing companies in the index. We will use AFG Investment Grade methodology and Valuation metrics to identify a few companies from each list that we find attractive going forward as well as highlight a few companies that we consider to be potential torpedo stocks heading in to 2015.

The chart below displays the 20 biggest gainers of 2014 YTD that have led the index in returns. We have highlighted two companies from this list that we believe still look attractive and have some more room to run which are Avago Technologies Ltd (NASDAQ:AVGO) and Actavis plc (NYSE:ACT). We have also highlighted two that we think will have the most trouble keeping this pace up in 2015, which are Mallinckrodt PLC (NYSE:MNK) Vertex Pharmaceuticals Incorporated (NASDAQ:VRTX).

The next chart shows us the S&P 500’s biggest losers of 2014 YTD. We have also highlighted from this list two companies that we like as investment opportunities that look most likely to turn things around which are Freeport-McMoRan Inc. (NYSE:FCX) and Chesapeake Energy Corporation (NYSE:CHK). Two companies that we think will continue to struggle as they have poor Investment Grades and look overvalued according to AFG’s valuation model are Coach Inc. (NYSE:COH) and Owens-Illinois Inc. (NYSE:OI).

S&P 500 Potential Torpedo Stocks – Including Dow Chemical Co (NYSE:DOW) by Michael Ghioldi

When managing clients' money, it is just as important for professional investors to be able to avoid potential torpedoes in the market, as it is to discover the next attractive investment opportunity poised to deliver solid returns. By utilizing AFG’s Investment Grade™ methodology when filtering through large lists of companies searching for investment ideas you can quickly identify firms to avoid as they contain characteristics inherent in companies likely to underperform.

The Investment Grade™ model designates a letter grade (A through F) for every company in our database of stocks, based on the how attractive the company is as an investment opportunity. AFG’s Investment Grade methodology takes into account several factors including Valuation, Economic Margin Momentum, Earnings Quality and Management Quality.

The Investment Grade model is an extremely valuable tool to help identify potential torpedo stocks to avoid. By eliminating companies with poor management teams, poor earnings quality and unattractive valuations from your list of constituents you can focus your time and effort on companies more likely to outperform and save many headaches. The performance chart below shows how well the Investment Grade model has achieved its intended purpose of identifying undervalued companies to invest in as well as flagging potential torpedo stocks to avoid. As you can see investors utilizing a process geared around AFG’s Investment Grade that avoid companies with a letter grade of “D” or “F” and invest in companies with a letter grade of “A” or “B” have enjoyed solid spreads in returns.

Since we spend a sufficient amount of time providing our readers with lists of attractive investment opportunities, it is now time to provide a list of companies that rank poorly according to key AFG criteria as companies we recommend avoiding.  By eliminating the companies that earn “D” and “F” grades from your portfolios and constituent lists you are avoiding companies that have been flagged by our model for containing several negative characteristics common in companies likely to underperform. We flag companies with the most unattractive valuations, management teams that follow a wealth destroying strategy and companies with high levels of accruals.

The list below contains 10 companies from the S&P 500 that earn an AFG Investment Grade of “D” or “F” that look overvalued and unattractive according to our model. We recommend paying extra close attention to these firms if you own these companies or are considering owning these stocks.

Using ADR’s To Gain Exposure To Foreign Markets – Including Shire PLC (LON:SHP) by Michael Ghioldi

Investors often seek out diversification for their investment portfolios in order to spread some risk around and to avoid any huge swings in one specific country or segment of the market. One way investors can gain some exposure to foreign markets and international stocks is by purchasing ADRs, or American Depositary Receipts. ADRs offer a convenient and cost effective way to invest in the global economy, regardless of the company’s country of origin. ADR’s give investors the opportunity to take advantage of the comparative advantages of other countries for labor, materials or specific skill sets. Investing in ADR’s allows investors the ability to diversify across multiple countries and economies and hedge against complete exposure to the dollar, without dealing with the fees and conversion hassles when purchasing shares on foreign exchanges.

Using AFG’s research and Investment Grade™ model to identify the most attractive ADR investment opportunities provides a distinct advantage as it utilizes a consistent approach to valuing securities regardless of a company’s individual characteristics including its country of origin. Our goal is to create a set of economic financial statements for companies that work well across time, industries, sectors, market capitalizations, and regions.  By focusing on the true economic profitability a firm is earning and making several adjustments to “as-reported” accounting data we can better understand the true underlying economic vitality of a company and also better compare companies with vastly different characteristics.

AFG’s Investment Grade™ methodology takes into account a company’s valuation, economic performance as well as quality and momentum factors to determine which companies look attractive or unattractive as investment opportunities. The model designates a letter grade (A through F) for each of the factors mentioned above and then applies an overall letter grade to each company based on its overall attractiveness as an investment.

The list below contains 15 attractive ADR’s that meet the criteria to earn an Investment Grade™ of “A” or “B”. Companies that earn an AFG’s Investment Grade™ of “A” or “B” have proven through backtests and live model portfolios to be more likely to outperform.

Attractive Small Caps From The Russell 2000 Index by Michael Ghioldi

While the majority of our clients tend to focus most of their attention on large-cap companies, AFG has an excellent track record at identifying undervalued companies within the small-cap space. This is proven by the success of our small-cap model portfolio we call the AFG 100. The AFG 100 is a long-only, sector neutral, actively managed model portfolio of 100 stocks benchmarked against the Russell 2000 index.

Since inception (2007), the AFG 100 has outperformed its Russell benchmark in all 7 years with a total outperformance of over 2000 basis points from December 2007 through 2014. Year to date the AFG 100 is outpacing the Russell 2000 by over 400 basis points.

Utilizing AFG’s Investment Grade™ model and valuation metrics to filter through large lists of companies or entire indices can help our clients to save time and to focus their attention on the most attractive companies. These two metrics have proven to be very effective at identifying undervalued companies while at the same time helping avoid potential torpedo stocks.

The charts below reflect how AFG’s Investment Grade model and valuation metrics have performed within the Russell 2000 index. The top chart highlights how AFG’s Investment Grade has performed in the small-cap index both year to date and over a longer time horizon (1998-2014). The next set of charts displays how well AFG’s valuation metric has performed over the same two time horizons. Looking at both metrics and both time periods you can see that A & B grade companies (most attractive) outperformed the overall universe while the D and F rated companies (least attractive) underperformed the index significantly. Our backtests have proven that by eliminating D and F graded companies from your list of constituents and using A and B graded companies as a starting pool of companies to own, investors can put themselves in a better starting position to outperform.

The companies listed below meet the criteria to earn an Investment Grade of A and also look attractive from a valuation perspective. This list can serve as a solid starting pool of companies for investors searching for investment ideas within the small cap space. These companies contain several characteristics proven through vigorous backtests to be inherent in companies likely to outperform.

Attractive Stocks from The Most Attractive Sectors – Including McKesson Corporation (NYSE:MCK) by Michael Ghioldi

Two weeks ago we discussed which S&P 500 sectors looked most attractive based on the embedded expectations for revenue growth each sector needed to deliver to justify their current levels. We concluded that based on embedded expectations, the Technology and Healthcare sectors looked to have the most realistic expectations “priced-in”. To take this analysis a step further, we have filtered through both sectors using AFG’s Investment Grade model to identify some attractive investment opportunities from these sectors.

AFG’s Investment Grade Model is a multi-factor, weighted model that grades companies on the basis of Valuation, Economic Margin Momentum, Earnings Quality and Management Quality. AFG’s Investment Grade™ model designates a letter grade (A through F) for each of the factors mentioned above and then applies an overall letter grade to each company based on its overall attractiveness as an investment.

Once we have screened the Technology and Healthcare sectors of the S&P500 using AFG Investment Grade criteria, we have identified 10 companies from the two sectors that contain many of the characteristics inherent in companies likely to outperform sector and industry peers. These companies are all trading well below their intrinsic value (undervalued), have competent management teams that understand how to create wealth for their shareholders and earn an overall AFG Investment Grade of A. We believe that these companies deserve an in-depth look when looking to add exposure to either the Tech or Healthcare sectors and can serve as an excellent starting list for investors looking for potential investment ideas.

To learn more about how we help hundreds of institutional investors refine their investment process, email us at support@afgltd.com. Or sign up for our monthly newsletter which contains market commentary as well as investment ideas, click here to subscribe.

AFG Quarterly Focus List Recommendation – B/E Aerospace Inc. (NASDAQ:BEAV) by Michael Ghioldi

The Applied Finance Group provide a number of solutions for finding new investment ideas.  One of those products, AFG's Quarterly Focus List (QFL), is a favorite among clients looking for hot topic investment ideas. 

The QFL has the following attributes: 

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 we 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.) 

Below is an example of a company that is a current recommendation in the latest Quarterly Focus List, B/E Aerospace Inc. (NASDAQ:BEAV).

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Which S&P 500 Sectors Are Most Attractive? by Michael Ghioldi

Understanding what the embedded expectations for revenue growth a company must deliver to justify its current trading price is a valuable tool that allows an investor develop a “hurdle rate” to determine if the company’s expectations are rich or low. By gaining a better understanding of the embedded expectations built in to security prices relative to what a company has delivered historically, one can gain some insight into the “priced-in” expectations for Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.

When implied sales expectations for a company are high relative to the growth the company has delivered historically (high hurdle rate) it becomes difficult to deliver the growth required for investors to obtain a satisfactory return on their investment. When we compile the data for embedded expectations for sales growth on an aggregate basis for an entire sector or index, we can better understand the overall attractiveness of the sector or index. This also helps us to communicate with our clients where investment opportunities are more likely to exist.  

The chart below displays Implied Future Sales Growth and Historical Sales Growth for each AFG sector in the S&P500. The sectors are ranked from left to right with the most undervalued sectors on the left. The three sectors with the lowest delta between sales growth expectations and historical performance, or the three most undervalued sectors are Technology, Healthcare and Financials.

We will follow up next week with some attractive investment ideas from a valuation perspective from within these sectors with low hurdle rates.


To learn more about how we help hundreds of institutional investors refine their investment process, email us at support@afgltd.com. Or sign up for our monthly newsletter which contains market commentary as well as investment ideas, click here to subscribe.


10 Russell 1000 Companies With Poor Earnings Quality – Including General Motors Company (NYSE:GM) by Michael Ghioldi

When narrowing down a list of potential portfolio constituents, it is beneficial to eliminate companies with characteristics that tend to lead to underperformance. One metric that helps us to eliminate potential torpedo stocks from our pool of potential companies to own is Earnings Quality, or the amount of accruals a company has on its books.

Accruals are the difference between Cash Flow and Net Income, essentially the percentage of net income which is owed to a company from their customers (accruals), to what they have already received in cash. Being that companies have an astounding amount of leeway in preparing their financial statements, a dollar of net income often times does not represent a dollar of cash flow.

The Applied Finance Group (AFG) score’s the quality of each company’s earnings to determine which are or are not sustainable into the future. If a company has an extremely high level of accruals relative to its industry peers, it is likely that the company will not receive full payment from all customers, which leads to potential poor earnings quality. Whether it is stuffing channels with excess inventory, delaying bill payments or other “creative” accounting techniques to manipulate earnings, companies with a high amount of accruals have proven to encounter far more negative earnings surprises and inferior returns than firms with lower levels of accruals.

As you can see in the charts below, we have broken down the Russell 1000 Index into quintile buckets based on accrual levels. The F rated firms have the highest level of accruals (lowest quality of earnings) and the A rated firms have the lowest level of accruals (highest quality of earnings). Both Year to Date (12-27-13 to 9-26-14) and since we began tracking the performance of this metric (1998-2014), you can notice a distinct trend that by avoiding the companies with the highest level of accruals you will avoid many torpedo stocks. This metric helps investors avoid companies that are the most likely to encounter negative earnings surprises and most likely to underperform peers with higher quality earnings.

A company with poor EQ does not necessarily mean a company is not an attractive investment opportunity as other metrics such as valuation, momentum and other quality metrics need to be taken into account. This list does serve, however, as a list of companies that contain characteristics found in companies that tend to underperform.