Poor Earnings Quality Companies (Russell 1000) - Including Kate Spade & Co (NYSE:KATE) and Sunedison Inc (NYSE:SUNE) by Michael Ghioldi

When stock investors are searching for potential companies to own, it is important to understand the quantity of earnings a firm is generating in order to value its businesses. While it is important to investors to see a company grow its earnings, a savvy investor would like to feel confident that the company’s earnings are repeatable and accurately represent the company’s operations.

Understanding the quality of a company’s earnings can have a great deal of influence on whether investors can have confidence in their projections of the company’s future performance. One way in which we determine the quality of a company’s earnings is to understand the level of accruals the company has on its books. 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. Our studies show that 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.

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. By avoiding companies with high levels of accruals, you can eliminate some of the possibility of owning a company that may misrepresent its ability to continue to generate earnings growth.

The Applied Finance Group’s Earnings Quality metric provides our clients a way to filter out companies with the highest levels of accruals from their list of constituents. 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 7-15-14) 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. Below we have provided a table of companies from the Russell 1000 index that have the highest level of accruals that should be monitored closely before owning.

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.

25 Attractive Asia-Pacific Stocks by Michael Ghioldi

The Applied Finance Group (AFG) provides a consistent approach to valuing securities and understanding the expectations embedded in stock prices regardless of the size, sector, style or geography of a company. AFG’s Economic Margin framework and Investment Grade methodology help professional investors, corporations, and consulting firms to better understand the true economic profitability a firm is earning as well as identify under and overvalued securities.

By systematically making several adjustments to “as-reported” accounting data and converting this data into a complete set of economic financial statements we can see what a company is earning above or below its true cost of capital. This process of analyzing companies from an economic standpoint helps to better understand the true underlying economic vitality of a company and also provides more comparability between companies with vastly different characteristics.

Once we are looking at companies on a level playing field, we can then utilize one consistent methodology for identifying attractive and unattractive stocks regardless of the companies’ individual characteristics. AFG’s Investment Grade™ methodology takes into account a company’s valuation, economic performance as well as quality and momentum factors. After analyzing these factors, we attach a simplified letter grade of A through F to help investors looking for investment ideas to easily identify which companies look attractive and which companies look like potential torpedo stocks.

By focusing on the A & B rated stocks when developing a starting pool of candidates to potentially add to client portfolios, investors can put themselves in a better starting position to outperform.

While many money managers look to use ETFs to gain exposure in global markets, many are looking to buy individual securities to add an additional edge on their competitors. In this exercise we filtered through the main indices in the Asia-Pacific region (Japan, China, Singapore, and Australia) and identified some companies that earn an Investment Grade of A.

The list of 25 companies below from the Asia-Pacific region meet our Investment Grade criteria to earn an A grade. This list is a solid starting point for money managers looking for investment ideas that provide some exposure to the Asian markets.

15 Attractive Large-Cap Dividend Payers – Including Deere & Company (NYSE:DE) and Pfizer Inc. (NYSE:PFE) by Michael Ghioldi

Our main focus at The Applied Finance Group is helping our clients identify undervalued securities in all segments of the market while avoiding potential torpedoes. Our Investment Grade methodology takes into account several factors to help understand how well a company is run and what a company is worth. While most of our focus is on the valuation of a firm, we do also pay attention to what is working in the market and any trends that could help money managers gain an advantage.

One trend that we would like to point out is the success that companies paying the highest dividend yields have done 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.

To provide our readers with a focus list of companies we have filtered through the Russell 1000 for not only companies paying a healthy dividend but also for companies that earn an Investment Grade of “A” or “B” as these companies tend to be more likely to outperform. In coming up with our list we limited our focus to companies that pay a dividend yield above what could be earned by purchasing a 10-year US Treasury note (current yield 2.53%). Our first priority is to encourage our clients to own companies that look attractive from a valuation standpoint according to our model, however, we view a steady dividend yield is an added bonus.

The list of 15 companies below meet our Investment Grade criteria to earn an “A” or “B” grade that also pay a healthy dividend. This list is a solid starting point for money managers looking for investment ideas that provide a steady income stream.

AutoZone, Inc. (NYSE:AZO) – A Consistent Wealth Creator by Michael Ghioldi

AFG’s primary metric used to understand how well a firm is performing and shed light on the underlying economic vitality of a company is called Economic Margin™ (EM). The EM framework was created for the purpose of measuring a company’s economic profitability; that is, did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? In the simplest terms, an Economic Margin is how much a company is earning 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. 

Understanding a company’s EM levels and expected changes in EM levels can provide investors an advantage in the market as AFG has proven through rigorous backtests and research that a company’s EMs are highly correlated to its market performance. AFG’s Wealth Creation Report (WCR) allows you to visually analyze a company’s historical EM levels, current EM and expected change in EM based on projections built out by AFG’s default valuation model. A company that earns above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Back-tests have proven these companies to be more likely to outperform companies following a wealth-destroying strategy (negative Economic Margins and growing assets).

The Wealth Creation Report is a compilation of 3 charts that visually tell the story of whether or not the firm and its management team have been creating wealth for its shareholders. The 3 parts of the chart are outlined below.

  1. The first chart is a summary of a company’s economic performance (EM’s) over time, as well as insight into how analyst EPS forecasts project AFG’s default EMs over the next two years.

     

  2. The second part of the chart is the Asset Growth chart which allows additional insight not only the growth of a company, but how that company’s growth strategy has affected their economic performance.

     

  3. This data can then be used to identify how the stock has performed in relation to the market as it displays the company's cumulative total return relative to the cumulative market-weighted average total return of the largest 2000 companies for the equivalent time period.

Below is an example of AutoZone, Inc. (NYSE:AZO), a company AFG considers to be a consistent wealth creator, identified by using AFG’s Wealth Creation Report. As you can see in the chart AZO has been able to maintain positive EM levels that have grown over time, grown its asset base and increased its asset growth over the last few years. AZO is also projected to continue to grow in 2015. In the bottom chart you can see that this strategy has paid off as it continues to outperform the overall market significantly. If AZO is able to maintain or improve its EM levels and continues its pace of growth, we believe the firm will be likely to continue to deliver positive returns and outperform its peers and benchmarks.

AutoZone, Inc. (NYSE:AZO) - Wealth Creation Report

5 “A” Rated Companies From The S&P 500 – Including Deere & Company (NYSE:DE) by Michael Ghioldi

AFG’s Investment Grade™ model is an effective tool for money managers when filtering through constituent lists searching for attractive investment ideas or to eliminate potential torpedo stocks. The AFG Investment Grade is a multi-factor, weighted model that ranks companies based on valuation, quality, and momentum and attaches a simplified letter grade from A to F to each stock in our database of over 4500 securities. 

Several adjustments are made to “As-Reported” data taken from company SEC filings to view companies from an economic standpoint. This provides some insight into what a company is earning above or below its true economic cost of capital. Two major benefits of making these adjustments and taking a more economic view of a company is gaining a more complete view of a company’s underlying economic vitality as well as improving comparability across sectors, market-caps, styles, and countries.

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.

While there are shifts in the model’s weightings, valuation is usually always a heavily-weighted factor as our valuation metrics have proven successful in all market environments and tend to add the most value when identifying stocks poised to outperform.

By attaching a letter grade to several thousand companies, our clients are able to quickly review the Investment Grade of a client holding or screen through thousands of companies for A Grade companies to use as a starting pool of potential candidates to own in their client 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 AFG Universe so far in 2014 while the chart on the bottom shows how well the model has worked within the universe over a longer time horizon (1998 to 2014). In both time periods there is a nice monotonic relationship from A graded companies to F graded companies. D and F grades also underperform the overall universe while the A’s, B’s and C grade companies outperformed the overall universe. 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 10 companies, 5 “A” rated companies and 5 “F” rated. If you are searching for companies to potentially add to a portfolio we recommend looking into the 5 “A” rated firms as a starting list of ideas. If you happen to own or are considering adding any of the “F” rated companies, we recommend taking a cautious approach as these firms are flagged as potential torpedo stocks by our model.

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.

Our Take On The Best & Worst S&P 500 Companies of 2014 YTD – Including Southwest Airlines Co (NYSE:LUV) by Michael Ghioldi

As we approach the halfway point of 2014, it is time to review which companies have been the leaders of the pack in the S&P 500 index and which companies have been the biggest losers so far this year. The S&P 500 as a whole has delivered a return of just over 4%, we want to highlight not only which companies have been the biggest drivers and the biggest drags on the index but also highlight some companies we like and dislike going forward from each group.

The chart below shows the 20 biggest gainers of 2014 YTD that have led the index in returns. These companies have enjoyed some success this year, but which companies do we think can continue to deliver solid returns for the rest of 2014? 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. We have also highlighted two that we think will have the most trouble keeping this pace up for the rest of 2014.

The two companies we like the most going forward (highlighted in green) from the list of biggest gainers based on valuation upside and AFG Investment Grade™ are Allergan, Inc. (NYSE:AGN) and Helmerich & Payne, Inc. (NYSE:HP). The two companies from this list that look the most overvalued (highlighted in red) and also have a poor Investment Grade are Southwest Airlines Co (NYSE:LUV) and Forest Laboratories, Inc.(NYSE:FRX).

The next chart shows us the S&P 500’s biggest losers of 2014 YTD. We have also highlighted (in green) two companies that we like as investment opportunities that look most likely to turn things around. Based on valuation and AFG Investment Grade™, United States Steel Corporation (NYSE:X) and PetSmart, Inc. (NASDAQ:PETM) look attractive despite getting off to such a rocky start this year. Two companies that we think will continue to struggle (in red) as they have poor Investment Grades and look overvalued according to AFG’s valuation model are Whole Foods Market, Inc. (NASDAQ:WFM) and Amazon.com, Inc. (NASDAQ:AMZN).

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.

Which Russell 1000 (INDEXRUSSELL:RUI) Sectors Look Most Attractive? by Michael Ghioldi

One of the ways though which The Applied Finance Group™ (AFG) comes to conclusions on the overall attractiveness of an index or the market is by compiling data on the valuation upside of every company within the index. To determine the valuation level of a company we utilize a metric called Percent to Target. Percent to Target is essentially a comparison of an individual company’s intrinsic value relative to its current trading price.  When a stock trades below its intrinsic value, it has Percent to Target that is positive; conversely, when a stock trades above its intrinsic value, it has a negative Percent to Target. 

By gathering data on the Percent to Target for every company within the Russell 1000, we conclude that the median firm in the index is fairly-valued relative to its historical norm. By reviewing the monthly median valuation levels of the Russell 1000 index over the last 15 years, we can see that while the index does look slightly overvalued it is currently within normal bounds. Although we do see market values slightly in excess of intrinsic values, AFG subscribes to the ideology that unless market valuation levels deviate from intrinsic value levels outside of normal bounds,  it is always best to maintain normal exposure to equities and that there are always attractive opportunities in the market.

Understanding that the Russell 1000 index is close to being fairly valued and that we believe a plethora of attractive opportunities are still present, we will drill down one step further using our valuation metric to understand which sectors within the Russell 1000 look most attractive. By looking at the aggregate valuation levels of each sector within the index relative to market values we can determine which sectors are likely to contain the greatest number of attractive opportunities according to our valuation assumptions.

In the chart below we have separated the Russell 1000 by sector and calculated the median Percent to Target for each sector to determine which sectors look the most undervalued (highest Percent to Target) and which look the most overvalued (lowest Percent to Target).  The three sectors we believe look most attractive are the Energy/Extraction, Healthcare and Consumer Durable sectors.

Now that we have identified the most attractive sectors based on valuation, we can go one step further and identify a few buy ideas. In the tables below you will find 10 attractive investment ideas from the most undervalued sectors (Energy/Extraction, Healthcare and Consumer Durable). This list is a good starting list of companies that are well poised to deliver solid returns and is a good starting point for investors searching for investment ideas.

For more information on our valuation process or other ways in which we help professional investors with their stock selection process, send us an email at support@afgltd.com. Or sign up for our monthly newsletter which contains market commentary as well as investment ideas, click here to subscribe.

Russell 1000 Wealth Destroyers, 15 Companies to Avoid – Including Nucor Corporation (NYSE:NUE) by Michael Ghioldi

When filtering through lists of companies as potential investment opportunities, it is very important to understand a company’s management strategy and management’s ability to create wealth for its shareholders. 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. When a company as a whole is not profitable, it should be focused on fixing the broken parts of its business, first by divesting losers and aiming to improve profitability to earn the right to expand. The best strategy AFG or any investor likes to see is a very profitable business that grows its assets to maximize its profitability.

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 utilizes company EM levels (profitability) along with its investment prospects to understand how they are growing or shrinking their business to determine if a company’s management strategy is one of wealth creation or wealth destruction. This variable is designed to eliminate wealth destroying companies from potential investment candidates. As you can see in the image below we consider a company to be a “wealth destroyer” when it continues to grow its asset base when the company does not earn a profit (negative EM).

Our research has proven that companies with management teams that implement a wealth destroying strategy are more likely to underperform their chosen benchmarks than those companies following a wealth creating strategy. By eliminating these firms from constituent pool’s, investors are able to avoid many potential torpedoes and spend more time and effort focusing on the “wealth creators”. The charts below highlight the performance achieved when utilizing AFG’s Management Quality variable to filter out the bottom half wealth destroying firms. Both from a long term perspective (1998-present) and in 2014 year to date, investors would benefit from eliminating “wealth destroying firms from their focus lists.

In the table below we have listed 15 companies from the Russell 1000 index that are currently following what AFG considers a ‘wealth destroying” strategy and should be treated as potential torpedo stocks.

R1000 MQ company Table.png

To learn more about our valuation methodology and 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.