The 50 Best Stocks to Own In The S&P 500 - AFG 50 Performance Update by Michael Ghioldi

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.  

Avoid These Russell 1000 Potential Torpedo Stocks by Michael Ghioldi

The most important tool that is utilized by our clients our Investment Grade™ model that 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. The Applied Finance Group’s™ (AFG’s) Investment Grade methodology takes into account several factors including Valuation, Economic Margin Momentum, Earnings Quality and Management Quality. The weightings of each variable are adjusted monthly based on which variables are recently adding the most alpha as well as when market conditions change.

This process that takes into account several factors helps our clients identify investment opportunities while avoiding any huge swings in performance of any of the individual variables. Applying different weights to each variable allows us the flexibility to better position our model to generate the most alpha when market conditions change or when one of our variables is working really well.

The Investment Grade model is not only a valuable part of our client’s stock selection process when search for undervalued stocks likely to outperform, but also an extremely valuable tool to help identify potential torpedo stocks to avoid. The charts below highlight the performance the Investment Grade model has achieved YTD along with its long term performance (1998-Present). 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” have saved themselves many headaches.

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 15 companies from the Russell 1000 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.

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.

20 Attractive ADR Investment Opportunities by Michael Ghioldi

There are several benefits to investing in foreign companies as well as diversifying your investments across multiple countries and economies. Beyond the obvious benefit of spreading risk across multiple countries to help avoid any huge economic swings or currency issues, other benefits include taking advantage of emerging markets where growth opportunities are more abundant, benefitting from comparative advantages in another country based on materials/labor, and during times when the U.S. economy is less attractive than others.

ADR’s (American Deposit Receipts) are shares of foreign stock issued by a bank in the U.S. which purchases a bulk number of shares of the foreign company and then sells the shares in dollar denominations on U.S. exchanges. Utilizing ADR’s as a way to gain exposure to foreign markets allows US investors the ability to participate in foreign economies without the high fees and confusing currency conversions of purchasing the local shares of the stock.

When investors are searching for attractive ADR’s to own, screening for companies utilizing The Applied Finance Group’s (AFG’s) research can be a valuable tool. AFG employs 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.

Once adjustments are made to view companies on a similar platform we can then utilize one consistent methodology for identifying attractive and unattractive stocks. 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.

AFG’s Investment Grade™ model is a multi-factor, weighted model that grades companies on the basis of Valuation, Economic Margin Momentum, Price 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.

The list below contains 20 attractive ADR’s that meet the criteria to earn an Investment Grade™ of “A”. Companies that earn an AFG’s Investment Grade™ of “A” have proven through backtests and live model portfolios to be companies more likely to outperform peers and benchmarks.

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.

Undervalued Tech Stocks From The S&P 500 – Including Apple Inc. (NASDAQ:AAPL) and Cisco Systems, Inc. (NASDAQ:CSCO) by Michael Ghioldi

Over the past few weeks we have discussed the embedded expectations for sales growth that is “priced-in” to the current trading level of the S&P 500 index as well as the expectations embedded in each individual sector within the index. We concluded that the S&P 500 as a whole looks close to fairly valued and that there are still an ample amount of attractive investment opportunities within the index. On a sector level, we concluded that the sectors with the lowest expectations for sales growth relative to the growth that they have delivered historically were Healthcare, Transportation and Technology.

Investors can gain an advantage by understanding the current expectations embedded in a sector or index when searching for investment ideas or allocating across sectors. By focusing more time and effort on the most undervalued sectors with the most reasonable expectations for growth priced in, an investor’s pool of potential constituents will theoretically contain more companies that are likely to deliver adequate returns.

Being that we have identified the Technology sector as one of the sectors with the lowest expectations for sales growth priced-in to its current trading levels, we will dig into this sector and identify some individual companies with reasonable expectations. While it is an effective resource to understand “priced-in” expectations, it is only one of the tools that we utilize to uncover undervalued stocks that are likely to outperform. AFG’s Investment Grade™ methodology is a multi-factor, weighted stock grading model that takes into account many of the other factors we consider essential to properly value individual stocks as investment opportunities. This model attaches a simplified letter grade from A to F to each company in our database to help clients quickly understand how attractive a company is based on valuation, quality and momentum factors.

The chart below is a list of firms from the Technology sector of the S&P 500 identified by our Investment Grade™ model as having a grade of A or B. These companies also have very reasonable expectations for sales growth “priced-in” to their current trading levels, relative to what these firms have delivered in sales growth historically. Based on extensive back-testing, companies that meet the criteria to earn an investment grade of A or B that also have reasonable expectations have proven to be more likely to outperform. We believe this list can serve as a solid starting point for investors looking to add some Technology exposure to their client portfolios.

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 Sectors With The Lowest Expectations For Sales Growth by Michael Ghioldi

In our post last week, we discussed the expectations that are currently “priced-in” to the S&P 500 index, or what the index needs to deliver in Sales Growth, EBITDA Margin, and Asset Turnover over the next 5 years in order to justify its current levels. By understanding the embedded expectations an index must deliver to justify its current trading price, investors can develop a “hurdle rate” to quickly determine if the index’s expectations are rich or low. When we compared the current expectations for revenue growth relative to the median growth that the S&P 500 has delivered over the past 5 years, we concluded that the index currently looks fairly valued to slightly overvalued.

When we drill down one step further to the sector level we can help investors identify which sectors have the lowest expectations and thus look undervalued. When allocating across sectors or searching for investment opportunities, focusing on the sectors with the lowest expectations can provide an advantage to investors as these sectors are most likely to meet expectations, contain more attractive investment opportunities for individual stocks and deliver adequate returns.

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 Healthcare, Transportation and Technology.

We will follow up next week with some individual companies with reasonable expectations from the Technology sector with the lowest expectations that also look attractive from a valuation and Investment Grade standpoint.

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.

Is The S&P 500 Index Currently Overvalued? - Understanding the Embedded Expectations by Michael Ghioldi

AFG measures the attractiveness of individual companies as investment opportunities in several different ways. We place great amount of importance on obtaining a detailed understanding of a company’s valuation, momentum and quality characteristics to come to realistic conclusions on the attractiveness of a company. One thing that sets us apart from other research providers and analysts is the ability to understand the expectations for revenue growth that are embedded in a company’s current stock price. Much like earnings, when a company delivers 20% revenue growth, how does one determine whether that is a good or bad number?  It depends on the expectations that were priced into the stock or the expectations of the market that reveals if the company has over or under delivered.   

By understanding the embedded expectations a company must deliver to justify their current trading price clients can develop a “hurdle rate” to quickly 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.

Aggregating this data for an entire sector or index is one way in which we determine the overall attractiveness of the “market” (S&P 500 index for this discussion) and one way that we communicate with our clients where investment opportunities are present. We view the implied sales growth as the “hurdle rate” to get an idea of whether a company or index is able to deliver the growth necessary to provide an adequate return for its investors. When implied sales expectations are high (high hurdle rate) for a company or index, it becomes difficult to deliver the growth required for investors to obtain a satisfactory return on their investment.  On the contrary, when expectations are low (low hurdle rate) a company has a much easier time meeting the growth requirements to deliver adequate returns to its investors. 

The chart below displays the current and historical implied sales growth expectations embedded in the market price for the S&P 500 index (industrial firms - excludes Financials and Utilities) and we compare those expectations to the sales growth these stocks have delivered over the past five years. The main point to draw from this chart is simple – the market has priced the median S&P 500 industrial company to grow its sales at around 9% over the next five years, while over the past five years these companies have grown at just under 7%.  From this vantage point it looks as though the S&P 500 industrial firms are currently fairly valued to slightly overvalued.

The index is currently within normal historical range (between +/- 1.5 std dev.) and we believe that attractive investment opportunities are available within the S&P 500 index. In one of our next articles on www.AFGIndexes.com we will take this analysis one step further, to the sector level, to see which sectors within the index have the highest/lowest expectations priced in to their current price points

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.