The main benefit of The Applied Finance Group’s™ (AFG’s) research process and tools is helping our clients identify undervalued stocks and avoid potential torpedo stocks using a consistent approach. A large part of AFG’s stock selection process utilizes a multi-factor, weighted model that grades companies on the basis of Valuation, Economic Margin 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.
As market conditions change different weights are applied to each factor that goes into the overall grade. This ensures that our model is not overly affected by one economic factor and to also benefit from what has been working in the market, taking advantage of variables that have added the most value to portfolios in the prior 1 month period. 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.
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 Russell 1000 Index™ in 2014 while the chart on the bottom shows how well the model has worked within the index over a longer time horizon (1998 to 2014). As you can see, over a longer time period, there is a nice monotonic relationship from “A graded” companies to “F graded” companies. Our extensive research has 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 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’ and a few companies that currently have an Investment Grade of ‘F’.
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 5 ‘A’ Grade companies as well as 5 ‘F’ Grade companies. We believe that the 5 ‘A’ Grade companies contain many of the characteristics inherent in companies proven likely to outperform sector peers and index benchmarks, while the 5 ‘F’ Grade firms have many qualities of potential torpedo stocks and should be avoided or viewed with extra caution.