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.

AFG’s Investment Grade Model – Which companies make the grade? Including Wal-Mart Stores, Inc. (NYSE:WMT) by Michael Ghioldi

The main benefit of The Applied Finance Group’s™ (AFG’s) research process and tools is helping our clients identify undervalued stocks and avoid potential torpedo stocks using a consistent approach. A large part of AFG’s stock selection process utilizes 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.

As market conditions change different weights are applied to each factor that goes into the overall grade. This ensures that our model is not overly affected by one economic factor and to also benefit from what has been working in the market, taking advantage of variables that have added the most value to portfolios in the prior 1 month period. While there are shifts in the model’s weightings, valuation is usually always a heavily-weighted factor as our valuation metrics have proven extremely successful in back-tests as well as in live model portfolios.

The charts below reflect how AFG’s Investment Grade model has performed. The top chart highlights how AFG’s Investment Grade has performed within the Russell 1000 Index™ in 2014 while the chart on the bottom shows how well the model has worked within the index over a longer time horizon (1998 to 2014). As you can see, over a longer time period, there is a nice monotonic relationship from “A graded” companies to “F graded” companies. Our extensive research has 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 position to outperform.

In the paragraphs below, we will provide some insight into the factors that go into AFG’s Investment Grade Model as well as provide a list of a few companies that currently have an Investment Grade of ‘A’ and a few companies that currently have an Investment Grade of ‘F’.

Economic Performance: AFG's’ first step is to recast a company’s financial information into an economic metric called Economic Margin.  Economic Margin is a cash flow based measure that measures the return a company earns above or below its cost of capital and provides a more complete view of a company’s underlying economic vitality.  Economic Margin framework takes into account Cost of Capital, Inflation and Cash Flow to provide a much more accurate representation of management’s ability to create shareholder value and provide comparability across sectors and countries.

Intrinsic Valuation:  When buying a company, investors are paying for existing assets and the company’s future expected performance.  Traditional models that lock into perpetuity are making the assumption that a company’s performance will stay constant forever without facing the effects of competition.  However research shows perpetuity is not economic reality.  Traditional models also do not take into account the concept of sustainable growth – the rate at which a company can grow based on its internally generated cash flow less investments required to maintain and replace its asset base.  AFG's robust methodology combines all 3 factors, economic margin, fade and sustainable growth, to calculate its intrinsic value.

Management Quality:  Absent a management team that understands how to create shareholder value, a “cheap stock” is likely to get cheaper. AFG scores each company’s management team on how its strategy links with its economic reality. Wealth creating firms should focus on growing, while firms that destroy wealth should divest and identify core competencies. This process is designed to flag firms that appear financially unstable well in advance of their bankruptcies.

Earnings Quality: Companies have an amazing degree of latitude in preparing their financial statements. As a result, a dollar of net income may not represent a dollar of cash flow. AFG score’s the quality of each company’s earnings to determine which are or are not sustainable into the future.

Momentum: AFG utilizes both Price and Profit Momentum to invest in companies that are not only undervalued based on intrinsic valuation but also have favorable economic earnings revisions and price movement.   AFG's Profit Momentum translates earnings revisions into economic earnings revisions.  AFG's’ Price Momentum is based on historical price movement in the company’s stock. 

Which Companies Make the Grade? After filtering through the Russell 1000 Index™ using AFG's Investment Grade model, we have provided a sample list of 5 ‘A’ Grade companies as well as 5 ‘F’ Grade companies. We believe that the 5 ‘A’ Grade companies contain many of the characteristics inherent in companies proven likely to outperform sector peers and index benchmarks, while the 5 ‘F’ Grade firms have many qualities of potential torpedo stocks and should be avoided or viewed with extra caution.

Attractive Dividend Paying Stocks From The Russell 1000 – Including Johnson & Johnson (NYSE:JNJ) by Michael Ghioldi

With the market experiencing such volatility as of late, many investors are seeking “safer” investments to protect their portfolios. A common strategy is to seek out well-managed dividend paying companies to provide some stable cash flow, while keeping exposure to equity markets. Dividend paying companies provide investors two ways to earn a healthy return, via capital appreciation or through the payment of a dividend. Dividend-paying stocks can be used to hedge against inflationary pressures, big downswings in the market environment and as a way to gain cash without moving in and out of positions.

While we do understand the benefits of investing in dividend paying stocks, we do not focus on yield alone nor do we seek out companies that pay the highest yield. Our main focus is always to find companies that are able to earn more than their economic cost of capital (positive Economic Margin), following a sound management strategy and that are trading at a discount to their intrinsic value according to our valuation model. AFG’s Investment Grade™ model takes into account all of these factors as well as quality of earnings, momentum factors etc. and attaches a simplified letter grade from A to F signaling the attractiveness of a company as an investment opportunity.

While we remain focused on valuation and identifying well-managed firms we do see a healthy dividend yield as an added bonus for investors. We also like to pay attention to what is working in the market and to help our clients take advantage of any beneficial trends. One interesting trend to point out is that companies paying the highest dividend yields have performed well so far this year. We broke up the Russell 1000 Companies into quintile buckets based on dividend yield and as you can see in the chart below the two top quintile buckets have delivered healthy returns and outperformed the index as well as the companies within the lower dividend paying quintiles.

If your focus is to add some dividend income to your client portfolio we have provided a list of 15 companies that meet our Investment Grade criteria to earn an “A” or “B” grade that also pay a dividend above what could be earned by purchasing a 10-year US Treasury note (current yield 2.17%). This list is a solid starting point for money managers looking for investment ideas that provide a steady income stream.

Alternative to the list of attractive companies provided, AFG puts together a focus list in the context of a portfolio that is centered on the concept of dividend paying companies that have attractive valuations.  AFG calls this focus list the AFG High Dividend Strategy (AFG HD).  The AFGHD is a low turnover portfolio that has exposure in each economic sector, holding anywhere from 25-35 securities.  This focus list marries the idea of high quality companies that pay a dividend but also have capital appreciation characteristics. For information on our High Dividend Strategy Portfolio or any of our other research products, click here for a free trial or email us at sales@afgltd.com.

Large Cap Companies Still More Attractive Than Small Caps – Russell 1000 vs. Russell 2000 by Michael Ghioldi

Earlier this year in March we released an article that provided a comparison between the overall valuation levels of the Russell 1000 index and Russell 2000 index. Our conclusion was that the large caps (Russell 1000) looked much more attractive than their small cap brethren and the Russell 2000 on a standalone basis looked extremely overvalued.

Since March we have tracked the performance of both indices and over the last 6 months the predicted outcome has played out as we thought it would with the Russell 1000 outpacing the Russell 2000 by over 1200 Bps. The chart below displays the performance of both indices over the last 6 months, the blue line represents the Russell 2000 and the red line represents the Russell 1000.

The way in which we determined the overall valuation level of each index for this example is by compiling the valuation upside (Percent to Target) of every company in each index according to our valuation model on an aggregate basis. This provides users of our research the ability to uncover segments of the market that may be under or overvalued as a whole to help focus more attention on segments where undervalued companies are more prevalent.

The current valuation levels for each index remain the same as the Russell 1000 index is trading at a normal valuation level (median Percentage to Target Price) in between +/- 1.5 Std Dev. while the Russell 2000 index is approaching a near bubble level valuation point (- 1.5 Std Dev). Only when an index or segment of the market reaches bubble levels would we recommend reducing exposure levels or exiting out of securities in that segment completely.

The chart below displays the Russell 1000 index median Percent to Target trading at a normal valuation level (in between +/- 1.5 Std Dev).

The following chart displays the overall valuation level (median Percentage to Target Price) of the Russell 2000 index trading at a near bubble level valuation point (- 1.5 Std Dev).

While we do still believe that attractive opportunities are present in the Russell 2000 index, investors may want to consider trimming some exposure to the small cap space as we believe that the large cap segment of the market contains more attractive investment opportunities for investors.

10 Undervalued S&P 500 Companies – Including Gilead Sciences, Inc. (NASDAQ:GILD) by Michael Ghioldi

The main focus of our research process and the main value that we add to our clients is helping our clients come to realistic and insightful valuation conclusions. To understand the value of a firm we first focus on whether or not the company is profitable from an economic standpoint and if that firm can earn above its true economic cost of capital. A clear understanding of how well a firm has utilized its invested capital is a key component and whether or not it is earning above its cost of capital are helpful in measuring corporate performance.

Once we have a firm handle on whether or not a firm is profitable from an economic standpoint, the next goal is to correct some of the distortions inherent in “as reported” financial statements and to put companies from different segments of the market on an even playing field. Our valuation framework essentially strives to create a set of economic financial statements for companies that work well across time, industries, sectors, and market capitalizations. We believe that this process puts us in a superior starting position when evaluating the attractiveness of any investment as we are comparing apples to apples, and not susceptible to many of the shortfalls of traditional accounting approaches to evaluating investments.

Once adjustments have been made and we are viewing companies on an even playing field, our clients are then able to utilize a variable which we call Percent to Target in order to screen for undervalued companies. Percent to Target compares the intrinsic value of a company against its market traded price.  When stocks trade below their intrinsic value, it has Percent to Target that is positive; conversely, when a stock trades above its intrinsic value estimate, it has a negative Percent to Target. 

This variable has done an excellent job at adding alpha to picking stocks whether looking at it from a long term time horizon (1998 to present) or in the shorter term (YTD and 2 month returns). Not only does this variable play a vital role in our process by uncovering undervalued securities, this variable does an extremely good job of identifying potential torpedo stocks as evidenced in the charts below. These charts highlight the performance achieved by our Percent to Target variable within the S&P 500 index. The entire index is broken down into quintile buckets, the “A” bucket contains the most undervalued stocks in the index while the “F” bucket contains the most overvalued stocks. An investor who purchased “A” stocks and avoided the bucket of “F” stocks would have enjoyed a solid spread in returns.

The list of companies below are from the S&P 500 that look undervalued relative to their current price according to AFG’s valuation model. These companies deserve a deeper look as they have the makeup of potentially attractive investment opportunities.

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.

S&P 500 Best and Worst Performers YTD - Including Actavis plc (NYSE:ACT) and United Rentals, Inc. (NYSE:URI) by Michael Ghioldi

With three quarters of 2014 in the books, we will take a moment to review the best and worst performing companies of the year from within the S&P 500. The index as a whole has delivered just under 7% so far YTD, we would like to highlight the companies that have been the biggest drivers as well as the biggest drags on the performance of the index this year. We will highlight the top 25 and bottom 25 performing companies in the index but we will also highlight 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 going forward.

The chart below shows the 20 biggest gainers of 2014 YTD that have led the index in returns. These companies have enjoyed success this year, but which companies do we think can continue to deliver solid returns for the rest of 2014 based on valuation and AFG Investment Grades? And which do we think are most likely to lose momentum? We have highlighted two companies from this list that we believe still look attractive and have some more room to run which are United Rentals, Inc. (NYSE:URI) and Actavis plc (NYSE:ACT). We have also highlighted two that we think will have the most trouble keeping this pace up for the rest of 2014 which are Tenet Healthcare Corp (NYSE:THC) and Windstream Holdings, Inc. (NASDAQ:WIN).

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 Transocean LTD (NYSE:RIG) and Staples, Inc. (NASDAQ:SPLS). Based on valuation and AFG Investment Grade™, both RIG and SPLS look attractive going forward despite getting off to such a rocky start this year. 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 Mattel, Inc. (NASDAQ:MAT) and Discovery Communications Inc. (NASDAQ:DISCA).

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.

Avoid These 15 Companies with Wealth Destroying Management Teams by Michael Ghioldi

When money managers are searching for investment opportunities it is important to have a stringent set of rules or criteria that can help filter through large lists of companies, in order to eliminate potential torpedo stocks and identify attractive companies that are likely to outperform. One way in which we help our clients eliminate potential torpedo stocks from constituent lists is via AFG’s Management Quality metric. This metric helps to quickly understand a company’s management strategy and management’s ability to create wealth for its shareholders.

By incorporating AFG’s Management Quality variable into the screening process one can easily get rid of companies which continue to grow their businesses when they are not profitable, a strategy that tends to destroy shareholder wealth.  When business units are unproductive and destroying wealth, management teams should not be looking to grow that business unit and instead concentrate on the parts of their company that have been creating wealth.

The way AFG determines whether a company is truly profitable or not is based on a company’s Economic Margin. An Economic Margin (EM) is AFG’s proprietary measure of corporate performance.  EM’s measure the return a company earns above or below its true economic cost of capital.  This measure considers three important factors; 1) the amount of Cash Flow a firm is generating, 2) the capital base from which the cash flow is derived, and 3) the opportunity cost of employing that capital.  Firms with a positive EM are generating Operating Cash Flow beyond the cost of the capital employed, thus creating investor wealth. 

AFG’s Management Quality variable takes into account company EM levels (profitability) in relation to its asset growth. By eliminating companies that are unable to earn back their economic cost of capital yet continue to grow their assets, you can avoid owning companies that are likely to destroy wealth and deliver subpar returns.

The charts below illustrate the performance of all of the companies in the Russell 1000 grouped into two buckets, wealth destroyers (“F” Grade) and wealth creators (“A” Grade) in 2014 as well as over a longer term time horizon (1998-2014). It is clear to see that many torpedoes can be avoided simply by eliminating companies that have management teams currently following a strategy of wealth destruction (Negative EMs and Growing Assets) from your list of constituents.

The table below contains 15 companies from within the Russell 1000 index that currently earn a grade of “F” for Management Quality. These companies are currently following what we consider a strategy that is likely to destroy shareholder as they are not profitable from an economic standpoint, yet continue to grow their assets. Proceed with caution if you own or are considering adding any of these companies to client portfolios as they have characteristics inherent in companies likely to underperform.

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.

Attractive Small Cap Stocks – Russell 2000 Investment Ideas by Michael Ghioldi

One of the main value added resources that we provide our clients is the ability to filter through large lists of stocks or entire indices and quickly gauge the attractiveness of each company as an investment opportunity via our Investment Grade™ model. AFG’s Investment Grade™ methodology utilizes 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.

This model not only takes into account valuation, economic performance, quality and momentum factors but also applies different weightings to each factor on a monthly basis based on what is currently working in the market. By applying different weights to each factor we are able to take advantage of current market trends as well as reducing the risk of being overly affected by one economic factor in a negative way.

The charts below reflect how AFG’s Investment Grade model has performed within the Russell 2000 index. The top chart highlights how AFG’s Investment Grade has performed in the small-cap index so far YTD while the second chart shows how well the model has worked over a longer time horizon (1998 to 2014). In both time periods the A’s, B’s and C grade companies outperformed the overall universe while the D and F rated companies 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.

In the table below you will find 20 “A” graded companies from the Russell 2000 Index. These companies contain several characteristics of firms that are likely to outperform index benchmarks as well as sector peers. This list can serve as a solid starting point for investors looking for small-cap investment ideas.