Clients of The Applied Finance Group (AFG) ™ have the benefit of utilizing an actively managed model portfolio of 50 stocks carefully selected by both quantitative screening as well as a thorough qualitative analysis performed by our analyst team. This portfolio of 50 stocks is a low turnover portfolio of investment ideas that remains sector neutral and aims to consistently outperform the S&P 500 index. The goal of this portfolio is to serve as a tool for our clients that provides actionable buy ideas in each major economic sector from the S&P500 as well as timely analysis and relevant content on the stocks within the portfolio.
This model portfolio has been successful over the past 10 years in its goal to outperform the S&P 500 index as it has outpaced the index 7 out of 10 years with a cumulative outperformance of over 4500bps, and is currently outperforming by over 500 bps YTD.
The process that is followed in order to identify companies that are worthy of inclusion in the AFG 50 portfolio are listed below.
Intrinsic Value -Identify over/undervalued companies
From the S&P 500 we identify undervalued companies by valuing each firm in the index. This process takes into account capital structure and risk to get an estimate of each firm’s future economic profitability. We then calculate the Net Present Value (NPV) of the economic profit against the current trading price and select the companies with the highest potential for price appreciation as candidates for the AFG 50.
Further Evaluate the List for Quality
Narrow down the list of undervalued companies using other variables:
1) Management Quality. We assess those companies’ management by examining their track record of wealth creation. We evaluate the balance and dynamics between those companies’ economic profitability and growth generation ability in the past and for the future.
2) Earnings Quality. We assess the quality of companies’ earnings by reviewing the percentage of net income that comes from cash flows vs. accruals. We rely on AFG’s standardized rankings to gauge companies’ earnings quality, and make final judgment by incorporating recent corporate events such as acquisitions, cash accumulation, etc., which may affect a company‘s default rankings.
Identify those companies with momentum characteristics
We evaluate Economic Margin momentum and price momentum to understand the trajectory of companies’ future growth and gauge market sentiments.
After narrowing down the S&P 500 to a list of undervalued companies with solid management teams and earnings quality, our team of analysts perform in-depth research for each of the selected companies. Our analysts then build various sets of DCF scenarios to stress test a companies’ valuation attractiveness.
By using fundamental analysis, AFG’s Research Team incorporates a systematic research process to narrow down the investable universe, to help omit human biases and provide a broad perspective on many companies. This process is designed to allow the investment team to focus on quality companies with superior return potential.
Fundamental Analysis – Analyst due diligence and detailed proforma models to determine a refined intrinsic value of the firm.
Qualitative Analysis – Ensure we are selecting the best opportunities in a given sector, industry, and peer group. Analyze how a company may be effected by different macroeconomic and geopolitical factors.
Portfolio Strategy – Select stocks with low correlations to ensure return diversification and limit market risk exposure.
The outcome of this process is has been consistent outperformance and a solid list of companies that can serve as a starting pool of candidates for analysts and money managers searching for investment opportunities. The performance of this portfolio is displayed in the chart below.
Next week we will highlight an individual company that is a current constituent in the AFG 50 and we will display some charts that our clients utilize to better evaluate the attractiveness of a company as an investment opportunity.