Where in the World is Alpha by Michael Ghioldi

As a global research firm, one of the most common questions we get is how attractive international markets are vs US domestic stocks.  The US has been on one of the largest bull runs since 2009 and the EAFE had mirrored the performance of US stocks up until the ‘European Crisis” in 2011.  The US continued to enjoy strong growth with a little help from the fed while the international investment horizon was murky and difficult to navigate with each region having their own macro-economic set of issues.

We have learned through the financial crisis as well as the European Crisis that markets are aligned and we are truly in a global market environment.  No longer is the question simply large cap vs small cap or growth vs value.   If investors are trying to get the most alpha for their clients they would be negligent not to look across overseas at international securities not traded on US exchanges. 

Before we begin to evaluate US vs International let’s first address US large-cap markets.  US markets are within the normal valuation band and are fairly valued.  Although there are industries and companies that are trading much like it was 1999 there are still a number of attractive investment opportunities. 

As far as international markets, their valuation levels are far from a clear buy signal.  However, what we are now seeing in international markets are monetary policies that mimic the QE programs in the US.  Discount rates and risk have converged for international markets and we no longer see international markets as a clear risk environment compared to the US.  Currently international markets have an implied discount rate of 100 bps in excess of those in the US meaning you are compensated for investing internationally with a 1% higher rate of return.  With international policy providing the free flow of cash it would not be unrealistic to believe we should apply the same risk for US stocks as we do with their large cap international counterparts.  In fact, roughly 40% of cash flow comes oversees from the top companies in the S&P500. 

The Applied Finance Group evaluates economic performance and quality but valuation is the most telling when addressing attractiveness of a group of companies.  By taking the median percentage upside of international stocks and netting out the median percentage upside of large cap US stocks we can conclude that this is a good time to invest internationally vs US stocks. 

Cuban Calls Tech Bubble, Is it 1999? by Michael Ghioldi

As investment professionals, we are bombarded with calls on the market.  Last week Warren Buffet discussed the banks and this week Mark Cuban provided his thoughts on the tech sector.  This bold call prompted MarketWatch to identify his thought as the call of the day. 

 “If we thought it was stupid to invest in public Internet websites that had no chance of succeeding back then, it’s worse today”

Market calls are sensational and when coming from a well know person such as Mark Cuban it makes for interesting news.  However, as a research firm we caution against dramatic calls because they are very difficult to time and need significant indicators to support such a call.  By evaluating the market using historical relative valuations you can see that the dotcom tech bubble of the late 1990’s/early 2000’s had much more downside than we see today.  For example, Cisco Systems had a market capitalization of 273 billion in 2000 sporting a 118 P/E, while today its market capitalization is 149 billion with a 15 P/E.

Above is the large cap universe of tech stocks and their attractiveness from 12/1991 to 3/2015.  During the tech bubble it is clear that the tech sector was extremely overvalued in 1999 leading up to the tech bubble burst which sent the NASDAQ from $5,000 to $2,000 (the average company was 72% overvalued).  Today tech is not inexpensive but it is far from being overvalued based on relative valuations. 

The tech sector has changed significantly since the dotcom bubble, today characterized by extraordinarily profitable firms, critical to everyday activities and needs; rather than a talking puppet hawking dog food.   However, it would be correct to say many companies in the tech sector have future implied expectations that are unlikely to be met, causing them to underperform the market.  When you look at tech on an aggregated basis we are far from the “Danger Will Robinson” phase of a bubble.  However, we respect Mr. Cuban’s call and expertise on tech bubbles and would advise you to review and understand the future expectations embedded in each of the technology stocks in the portfolio’s you manage/advise.  AFG helps hundreds of investment professionals with such activities regularly.

The Applied Finance Group partners with RIA’s to help leverage their research process so they have more time to work with existing clients and prospects.  To learn more about AFG’s upcoming research workshops, visit www.economicmargin.com/events.  For a free trial to AFG’s research, email sales@afgltd.com, with Tech Stocks in the subject line.

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).