Is The S&P 500 (INDEXSP:.INX) Index Beginning To Look Overvalued? by Michael Ghioldi

There are several ways in which we approach measuring the attractiveness of individual companies as investment opportunities including analyzing a company’s valuation, momentum and quality characteristics, Earnings Quality as well as management’s ability to create wealth for its shareholders. In order to communicate with our clients the overall attractiveness of an entire sector or index, we often aggregate data based on specific metrics in order to communicate with our clients where investment opportunities are most prevalent.

Along with aggregations of data that analyze the valuation attractiveness, market multiples such as Market Value/Invested Capital, and Economic Margins of an entire index, we also analyze imbedded sales growth expectations of companies in an index. We utilize the imbedded expectations to determine whether or not expectations for revenue growth for an individual company or an entire sector or index are likely to be met/exceeded or extremely lofty and unlikely to be reached based on the historical sales growth a company or group of companies has achieved historically.

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 relative to what it has delivered historically, 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. 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. 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 10% over the next five years, while over the past five years these companies have grown at just over 7%.  From this vantage point it looks as though the S&P 500 industrial firms are currently slightly overvalued. The index is currently within normal historical range (between +/- 1.5 std dev.) although it is approaching a bubble level valuation. Although the index does look slightly overvalued, we continue to believe that attractive investment opportunities are still available within the S&P 500 index and that exposure to the large cap segment of the market (S&P 500) should not be reduced.

15 Large Cap Stocks That Make The Grade – Attractive Investment Ideas Including Target Corporation (NYSE:TGT) by Michael Ghioldi

All of our research, investment products and individual recommendations on investment opportunities utilize The Applied Finance Group’s (AFG’s) Investment Grade™ model to identify undervalued stocks and also to avoid potential torpedo stocks using a consistent approach. AFG’s Investment Grade Model factors in several metrics developed by AFG and grades companies on the basis of Valuation, Economic Margin Momentum, Earnings Quality and Management Quality.

Using these metrics in concert and applying different weights to each metric to come to an overall Investment Grade allows investors to take advantage of the value that each metric adds while protecting portfolios from some of the downside risk when one of the factors is not working well on its own based on the market environment. 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 regardless of market conditions.

By attaching a simplified 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.

To understand the value that using AFG’s Investment Grade model adds, we have provided some charts below reflect how AFG’s Investment Grade model has performed within the Russell 1000 Index™. The top chart highlights how AFG’s Investment Grade has performed within the Russell 1000 Index™ over the last 12 months while the chart on the bottom shows how well the model has performed within the index over a longer time horizon (1998 to 2015). Our research and backtests have shown 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’.

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 15 ‘A’ Grade companies that contain many of the characteristics inherent in companies proven likely to outperform sector peers and index benchmarks. This list can serve as an excellent starting point for money managers looking for attractive investment ideas.

Avoid these 10 Wealth Destroying Russell 1000 Companies - Including Chesapeake Energy Corporation (NYSE:CHK) by Michael Ghioldi

There are several ways which we help our clients sift through large pools of companies to filter out potential torpedo stocks and identify stocks likely to outperform. One of the metrics we utilize to filter out companies likely to underperform is our Management Quality grade. This metric attaches a letter grade of A or F to every company in our database based on a company’s management strategy and management’s ability to create wealth for its shareholders.

Using AFG’s Management Quality grade in the process of screening through large lists of stocks can help investors to identify and eliminate companies which continue to grow their businesses when they are not profitable. Growing a losing business is a strategy that often tends to destroy shareholder wealth. When business units are unproductive and destroying wealth, management teams should not be looking to grow that business unit but instead concentrate on the parts of their company that have been creating wealth.

The way we determine whether a company is profitable or not is whether the firm is able to earn above its true economic cost of capital (positive Economic Margin). Our system punishes companies that attempt to grow their assets if they are unable to earn back its cost of capital (negative Economic Margin) and for good reason as this strategy has proven likely to lead to poor returns.

The Economic Margin metric takes into account 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 negative Economic Margin are not generating Operating Cash Flow beyond the cost of the capital employed, thus destroying investor wealth. When a company is destroying wealth for its shareholders the last thing you want management to do is continue to try to grow a losing business.

We recommend avoiding companies that earn a Management Quality Grade of “F” as these firms have proven in backtests to underperform sector and benchmark peers who earn an “A” grade. By excluding “F” graded firms investors can eliminate many potential torpedoes from constituent lists and spend more time and effort researching the companies with a greater likelihood of outperforming. Regardless of time horizons, market cap, sector or growth/value orientation this metric has proven successful at identifying firms likely to underperform that should be avoided.

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 over the past 1 year, investors would have benefitted from eliminating “wealth destroying” firms from their focus lists.

The table below contains 10 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 wealth as they are not profitable from an economic standpoint, yet continue to grow their assets. These companies have characteristics inherent in companies likely to underperform and should be viewed with a cautious eye.

Why we still prefer LargE Cap stocks over Small Caps – Russell 1000 vs. Russell 2000 by Michael Ghioldi

Back in early 2014 (March 25th) we issued a report that compared the valuation attractiveness of the Russell 1000 (Large Cap) and Russell 2000 (Small Cap) indices using AFG’s valuation metric called Percent to Target. We gathered data on the Percent to Target or valuation upside of every company within both indices on an aggregate basis to determine the valuation levels of each index as a whole. We determined that the Russell 1000 was at a normal valuation level, while the Russell 2000 looked extremely overvalued (approaching -1.5 Std Dev.).

When we published this report we recommended considering reducing some exposure to the small cap space and that we believed that attractive investment opportunities were more prevalent in the large cap space. Since the release of that report the Russell 1000 has delivered over 7% returns relative to the -0.59% returns delivered by the Russell 2000.

Recently, we have updated the same data from the 2014 report on the valuation attractiveness of these two indices and the conclusion remains the same. We believe that the Russell 1000 remains a more attractive place to invest and seek out investment opportunities than the Russell 2000.

The chart below shows the overall valuation level (median Percentage to Target Price) of the Russell 1000 index 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, which looks overvalued, and is trading at a near bubble valuation level (approaching -1.5 Std Dev).

We always believe that using a disciplined valuation will help identify attractive investment opportunities regardless of market cap, sector or index, however, investors may want to consider trimming some exposure to the small cap space as it looks extremely overvalued. We believe that seeking investment ideas in the large-cap space would be more productive as attractive investment opportunities are more abundant in that space.

The Applied Finance Group's 2014 Year End Review by Michael Ghioldi

With 2014 coming to a close, we would like to recap the performance of some of our main research products. The year was pretty solid for users of our research as three out of four of our research products outperformed their respective benchmarks and our Investment Grade metric worked as hoped as the “A” graded companies outperformed benchmarks as well.

AFG 50

We will start by highlighting the performance of our main research product, the AFG 50. This portfolio of 50 large-cap 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 11 years in its goal to outperform the S&P 500 index as it has outpaced the index 8 out of 11 years with a cumulative outperformance of nearly 5000bps, and is currently outperforming by over 600 bps YTD. The chart below highlights the performance achieved by the AFG 50 since its inception.

AFG 100

Next we will highlight our small cap alternative to the AFG 50 which we call the AFG 100. The AFG 100 is a long-only, sector neutral, actively managed model portfolio of 100 small-cap stocks benchmarked against the Russell 2000 index.

Since inception (2007), the AFG 100 has outperformed its Russell benchmark in all 8 years with a total outperformance of over 2200 basis points from December 2007 through December 2014. Year to date the AFG 100 is outpacing the Russell 2000 by over 300 basis points.

AFG’s Quarterly Focus List

AFG’s Quarterly Focus List is another avenue for our clients to find new investment ideas. The objective of this product 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.  The near term catalyst must be clearly identified for each recommendation, and the recommendations must have very attractive valuations. AFG’s Quarterly Focus List outpaced its designated benchmark, the Russell 1000, by over 2000 bps YTD and over 4300 bps since its inception.

AFG's High Dividend (HD) Focus List

AFG's High Dividend (HD) Focus List aims to recommend a list of undervalued equities in the US (may include ADRs) that offers attractive dividend yields. This list has both dividend income and capital appreciation characteristics, as opposed to seeking pure yields. As such, AFG's HD is diversified across 11 sectors with no sector counting for more than 30% of the total stock count.

AFG's HD Focus List may include 25-35 names at a given point of time depending on the availability of attractive candidates. This list targets an annual turnover of 50% or lower, and is rebalanced every quarter. Returns are calculated on an equal weighted basis, and benchmarked against the Russell 1000.

This focus list was the only underperformer as it underperformed the Russell 1000 by 88 bps YTD and has underperformed the Russell 1000 on a cumulative basis by about 600 bps.

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.