Expectations Investing: Understanding Future Implied Sales Expectations for Cerner Corporation (NASDAQ:CERN) and Nucor Corporation (NYSE:NUE) by Michael Ghioldi

Understanding Future Implied Sales Growth Expectations:

AFG has a process in which our model “reverse engineers” what a company needs to deliver in sales growth over the next 5 years (assuming 5 Year Median Margins and Asset Turns) in order to justify its current trading price. Understanding these “expectations” for revenue growth embedded in a company’s current trading price are an important indicator in identifying undervalued companies and attractive segments of the market.

Essentially this Future Implied Sales Growth creates a “hurdle rate”, similar to an over/under line in a sporting event, to evaluate how likely a firm is to deliver the growth needed over the next 5 years in order to deliver adequate returns for its shareholders. In most circumstances, if the imbedded future performance is very conservative relative to the company’s historical growth or consensus/personal estimates for future growth, the stock is regarded as undervalued/attractive.

To further explain this theory we will provide company examples of firms with high and low expectations for Future Implied Sales Growth built in to their stock prices.

Cerner Corporation (NASDAQ:CERN): Low Expectations

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 and thus, are more likely to outperform.

In the example below, Cerner Corporation (NASDAQ:CERN) needs to deliver around 5% sales growth over the next 5 years to justify its current trading levels. When you compare the Future Implied Sales Growth of 5% to what the company has delivered median growth of 19% over the previous 5 years. Our model also projects average growth of around 10% over the next 2 years. It seems very reasonable for Cerner Corp. to deliver the growth needed to provide a solid return for its investors.

Along with low expectations for sales growth “priced-in” to its trading price, Cerner Corp. also earns an AFG Investment Grade of “B” with solid marks for Valuation and Management Quality. Cerner Corp. has many of the characteristics we look for in attractive investment opportunities.

Nucor Corporation (NYSE:NUE): High Expectations

On the contrary, 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. 

In the second example, Nucor Corporation (NYSE:NUE), has delivered -2% median sales growth over the prior 5 year period and is projected to deliver around 3% sales growth on average in the next 2 years. It looks extremely unlikely that this firm will be able to deliver the 25% Future Implied Sales Growth built into the company’s current price.

Not only does NUE have a pretty large obstacle to clear as far as sales growth expectations, it also contains several other characteristics inherent in potential torpedo stocks and currently earns an AFG Investment Grade of “D”.

Avoid these potential torpedo stocks – Unattractive Russell 1000 Companies Including Tripadvisor Inc (NASDAQ:TRIP) by Michael Ghioldi

AFG’s Investment Grade model provides money managers a consistent quantitative process for stock selection that helps long term investors navigate through different market environments and outperform benchmarks. By focusing on what we believe are the three most important factors in analyzing the quality of an investment; valuation, momentum and quality and incorporating AFG’s proprietary Economic Margin Methodology we are able to help investors identify actionable investment ideas and put themselves in a better position to outperform.

The Investment Grade model utilizes a unique set of factors that have proven to outperform, adjusts the weightings of each factor according to the amount of alpha generated under the most recent market conditions, and assigns a simplified Investment Grades of A through F. This model, along with many of the portfolio tools that we offer, allow investors to save valuable time when screening for investment ideas and creating focus lists of stocks. Essentially this model is designed to help investors develop a strategy that will help generate more consistent portfolio outperformance by identifying select groups of stocks from any group of companies around the globe, that have attributes that create alpha and outperform.

You can see in the chart below, the value that was added to investment portfolios by using AFG’s Investment Grade model over the past year (4-30-15 to 4-30-16). The chart displays the return spreads achieved by Russell 1000 companies with “A” and “F” Investment Grades relative to the entire Russell 1000 Index™ benchmark over the last year. Eliminating “F” Grade companies from portfolios over the last year would have benefitted investors significantly as they have underperformed by a wide margin.

The list below contains 10 Russell 1000 companies that currently earn an Investment Grade of “F” and look like potential torpedo stocks. These companies contain many characteristics inherent in companies likely to underperform benchmarks and sector peers. We advise extra caution if you own any of these companies or are considering adding any of these to client portfolios.

Russell 1000 - Potential Torpedoes

Investment Grade Factors:

Intrinsic Valuation:  (Robust Approach that Corrects Many Distortions in Traditional Accounting Approaches)

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.

Economic Margin Momentum: (Helps Understand a Firms Improvement in Operations)

Economic Margin is a cash flow based metric 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:  (Robust Approach that Corrects Many Distortions in Traditional Accounting Approaches)

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.

Management Quality:  (Un-Biased Approach to Evaluating Management)

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: (Identify/Flag Companies Likely to Have Negative Earnings Surprises)

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 whether or not those earnings are sustainable into the future.

Price Momentum:  (Measure Changes in Market Sentiment)

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. 

10 Undervalued S&P 500 Stocks – Including AutoZone, Inc. (NYSE:AZO) and Xerox Corp (NYSE:XRX) by Michael Ghioldi

There are several significant differences in the way that we at The Applied Finance Group approach valuing securities, in comparison to traditional accounting based methods and other DCF models. The biggest difference that sets our valuation methodology apart from other models/research providers is that our process begins with a more refined measure of corporate performance (Economic Margins). Economic Margins focus on whether or not the company is profitable from an economic standpoint and if that firm can earn above its true economic cost of capital. Understanding how well a firm has utilized its invested capital and whether or not it is earning above its cost of capital are helpful not only in measuring corporate performance, but also determining if a firm is able to create value for its shareholders.

Once we have a firm handle on whether or not a firm is profitable from an economic standpoint, the next step is to then correct many of the distortions inherent in “as reported” financial statements in order to put companies from different segments of the market on an even playing field. Our valuation framework essentially strives to create a set of economic financial statements for companies that work well across time, industries, sectors, and market caps. We believe that this process puts us in a superior starting position when evaluating the attractiveness of any investment, as we are comparing apples to apples, and not susceptible to many of the shortfalls of traditional accounting approaches to evaluating investments.

Once we are evaluating companies on a level playing field, we then make several company-specific adjustments to come to realistic and insightful valuation conclusions. This includes modelling the effects of competition in order to compete away excess returns over a company specific Competitive Advantage Period, to avoid silly assumptions that a firm can generate the same levels of profit into perpetuity inherent in other DCF models. Other subtle insights are also taken into account such as capitalizing R&D, which is often looked at as an expenditure rather than as an investment. Inflation adjusting the asset base for better comparability between firms. As well as assigning company specific discount rates. These types of adjustments are what set our valuation framework apart and provides our clients significant advantages in the selection of stocks relative to traditional accounting approaches and other DCF models.

This method of valuing companies has proven to consistently help identify companies trading at a discount to their intrinsic value. A significant spread in returns is achieved between companies our model has identified as the most undervalued and the companies that look the most overvalued based on our valuation metric. The chart below highlights the returns achieved within the S&P 500 index from 1998 to 2016. The entire index is broken down into quintile buckets, the “A” bucket contains the most undervalued stocks in the index while the “F” bucket contains the most overvalued stocks. Investors who purchased “A” stocks and avoided the bucket of “F” stocks would have enjoyed a solid spread in returns.

The table below contains 10 companies that are currently identified by our valuation model as undervalued (A Valuation Grade) within the S&P 500 index. This list can serve as a solid starting point for investors looking to add large cap positions to their client portfolios as these firms not only look extremely undervalued according to our model but also exhibit other characteristics common in companies that are likely to outperform.

S&P 500 - 10 Undervalued Stocks

Expectations Investing – Which S&P 500 (INDEXSP:.INX) Sectors Look the Most Attractive? by Michael Ghioldi

Two weeks ago we discussed the importance of understanding the imbedded expectations for revenue growth that a company must deliver in order to justify its trading price. Essentially this creates a “hurdle rate”, similar to an over/under line in a sporting event, to evaluate how likely a firm is to deliver the growth needed over the next 5 years in order to deliver adequate returns for its shareholders. In most circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued/attractive. When we compile this data for an entire sector or index we can identify when an index as a whole looks over/undervalued, or specific sectors where attractive investment opportunities are more likely to exist.

Today we will highlight the current implied sales growth expectations embedded in the current price levels of each S&P 500 sector, compared to the sales growth these sectors have delivered over the past five years. The sectors are ranked from left to right in the chart below (most attractive sectors on the left) based on the delta between the actual sales growth and what the median company needs to deliver to justify its price. The three sectors with the lowest delta between sales growth expectations and historical performance, or the three most attractive sectors are Financials, Healthcare and Consumer Discretionary.

Our research has proven that understanding the expectations embedded in stock prices can be an important indicator to identify undervalued companies and attractive segments of the market. Companies with lower hurdle rates for growth tend to outperform companies with higher expectations.

Why We Like Brinker International, Inc. (NYSE:EAT) by Michael Ghioldi

Overview: Brinker is one of the world’s leading casual dining restaurant companies, which operates two leading brands -Chili's Grill & Bar and Maggiano's Little Italy. Among Brinker’s ~ 1600 total units, nearly 75% are domestic, and the company operates a company owned restaurant/franchise mix of ~60/40. We like EAT because:

Proven Brand with Large Scale: Brinker operates approximately 1600 Chili’s, with nearly 320 units abroad, and 40% being franchised. Chili’s is a 40 year old concept, extremely well known in the US, and well received abroad. The 60/40 company own / franchise model reduces demand for CAPEX while allowing for reasonably fast new unit growth. Maggiano’s has 51 units with a 20 years history, and enjoys faster growth potential than Chili’s domestically.

Strong Operating Margins and Attractive Free Cash Flow Generation: Brinker enjoys the best EBITDA margins when compared to its peers such as Darden, Cheesecake Factory, Texas Road house, etc, partially thanks to the operating mix of franchise. In the past five years, free cash flow generated averaged ~$180 million a year, and is expected to reach $250 million in FY16, ~9% of its latest market capitalization. This ability of strong FCF generation has allowed the company to pay an annual dividend of $1.28 per share, yielding at 2.8%. In the last decade, the company has increased its dividend every year with the exception of FY09.

Plan to Win Again and Vision 2020: From FY10 to FY15, the company’s Plan to Win Together has allowed the Chili’s brand improve margins by 400 bps and grow international locations by 25%. Its Maggiano’s brand also delivered 21 quarters of consecutive positive comparable restaurant sales growth. The company returned $1.4 billion to shareholders during the 5 years, which helped EPS grow 16% CAGR from FY12 to FY15. Currently the company is on track with its Plan to Win Again agenda, which focuses on growing new units and strengthening Chili’s with Fresh Tex, Fresh Mex concepts. Vision 2020 was implemented in FY16Q2, which will take the company to the next stage by revitalizing Chili’s with a new school of thinking, expanding Maggiano’s in the polished casual space, and grow EPS CAGR at 10-15% with superior free cash flow generation. The new school of thinking is to intensely focus on making the Chili’s brand fresh and relevant in today’s fast changing environment, innovate aggressively across Chili’s food, service, and atmosphere to differentiate the brand, and take the market share by leveraging technology to connect with consumers.

Catalyst: EAT stock has been lagging in the past 12 months, due to missed sales expectations for 4 consecutive quarters, though earnings per share have always met or exceeded projections, partially aided by share repurchases. In FY16Q2, Chili’s comps were down 2.8% and Maggiano’s were down 1.8%. However, management said the trend was improving as Q2 progressed and Q3 comps were expected to be closer to flat y-o-y.

Initiatives are put in place to drive traffic and sales growth. Brinker inked a deal with Olo–the leader in digital ordering, and will put Olo's online ordering platform into operation beginning in summer, which would open up great potential for Chili’s To-Go business, including a more robust delivery opportunity. Additionally, Brinker has started integrating its My Chili's Reward program with Plenti—a rewards program by American Express that offers leading brands across multiple categories. It would give Chili’s access to Plenti’s huge database of members that is multiple times larger than Chili’s 7 million members. In addition, Chili’s has implemented actions to improve its My Chili’s reward program focusing on reducing cost and driving incremental usage with heavy users. Most importantly, Brinker remains focused on menu innovation, mainly its core menu items like burgers, ribs and fajitas. The company revamped the existing steak platform with the addition of Sizzling Steak in Jan 2016 and rolled out a new sizzling steak platform in its FYQ3. In fact, Chili’s 2016 is full of new dish introductions.

Overall, we believe comparisons will become easier in the 2H of FY16 for Chili’s and the company has lowered expectations calling for Q3 EPS growth in mid single digits. With multiple initiatives in place especially the new steak menu rollout, we believe Brinker is well positioned to deliver or exceed expectations, which will help shift investors’ sentiments to its attractive valuation and free cash flow generation ability.

Expectations Investing – Is the S&P 500 (INDEXSP:.INX) Currently Overvalued? by Michael Ghioldi

There are several ways in which we communicate with our clients the overall attractiveness of an entire sector or index with aggregations of data that analyze the valuation attractiveness, market multiples such as Market Value/Invested Capital, and Economic Margins of an entire index or sector. One important set of data to understand is imbedded sales growth expectations, or essentially what a company needs to deliver in revenue growth over the next 5 years in order to justify its current trading price.

We view the implied sales growth as the “hurdle rate” to better understand whether a company, sector or index is likely to deliver the growth necessary to provide 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.

When we aggregate the implied sales expectations of every company within the S&P 500 we see that the median company in the S&P500 is priced to grow revenue by around 7% over the next 5 years, while the median company has delivered close to 6% on average over the past 5 years. This signals that the index is currently very close to fairly valued/slightly overvalued.

The chart below highlights current and historical implied sales growth expectations embedded in the market price for the S&P 500 index compared to the sales growth these stocks have delivered over the past five years. When the index approaches abnormal ranges (+/- 1.5 std dev.) it signals that the index is extremely under or overvalued. Most recently, after the major selloff earlier this year the implied sales expectations for the index dipped to nearly 4% (1-15-16), very close to the -1.5 Std Dev. threshold to signal the index was very undervalued. Subsequently the market has rallied tremendously, delivering over 7% returns in the following 3 months.

Now that we have determined that the overall S&P 500 index looks fairly valued based on implied sales growth, we can now highlight a few companies that have high and low expectations.

WYNN – Wynn Resorts, Limited (NASDAQ:WYNN) is a great example of a company that currently has very high expectations for revenue growth priced in to its current trading price. Historically the company has delivered around -2% sales growth (5 year median) while the company needs to deliver around 7% sales growth over the next 5 years to justify its current price. This seems like very lofty expectations relative to what the company has been able to achieve in the past. Not only does WYNN have very lofty expectations for sales growth but also earns an AFG Investment Grade of “F” and looks overvalued relative to sector and industry peers. We believe there are much better options in the hotel/gaming space than WYNN.

XRX - Xerox Corp (NYSE:XRX) is a firm that currently has low expectations for revenue growth imbedded in its current price. Over the past 5 years the company has delivered around -4% (median) revenue growth over the past 5 years. The company is currently priced to deliver nearly -8% revenue growth to justify its current levels. Not only do those expectations look very realistic relative to historical revenue growth, the company also looks very undervalued according to our valuation model and currently earns an Investment Grade of “A”. We believe XRX currently looks like a very attractive investment opportunity.

Quarter 1 2016 Market Report – Russell 1000 Review (INDEXRUSSELL:RUI) by Michael Ghioldi

In early February most of the major US indices were down around 10% and the outlook for the rest of 2016 was bleak at best. Then came one of the greatest quarterly comebacks in market history, that not only erased the significant losses of the year but most major US indices turned slightly positive by quarter’s end. With the rocky first quarter in the books, we will review the overall performance of the Russell 1000 index, highlight the best sectors/stocks of the quarter and evaluate the performance delivered by AFG Investment Grade Factors.

Russell 1000 Performance

The chart below illustrates how bumpy the ride has been for US large cap equities so far in 2016. At one point the index was down 9.7% for the year, and then rallied over 11% in less than 2 months to turn slightly positive.

source: Google Finance

source: Google Finance

Returns by AFG Sector

We averaged the returns of each sector (AFG Sectors) to give some insight into which sectors led the index. Utility companies, Consumer Non-Durables and Basic Materials were the best performing sectors YTD in 2016 while Health, Financials and Tech stocks were the biggest detractors.

AFG Investment Grade Factor Performance

AFG’s Investment Grade model is a multi-factor, weighted model/grading system for stocks that allows our clients to identify companies that are trading at a discount to intrinsic value, following a sound management strategy, higher quality of earnings (accruals) as well as momentum characteristics inherent in stocks likely to outperform. The model takes into account all of the factors mentioned above and then attaches a simplified letter grade from A to F signaling the attractiveness of a company as an investment opportunity based on the overall score.

The chart below illustrates the performance achieved by the four main factors of our Investment Grade model. The spreads below represent the difference in returns of “A” Grade companies vs. “F” Grade companies within the Russell 1000 in Q1-2016. 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 put themselves in a better position to outperform.

Top 25 Stocks

Lastly, we have highlighted the top 25 performing stocks of Q1 2016. These companies have been the main drivers of the Russell 1000’s performance so far this year. Within this group of companies we have identified 3 companies (X, FCX, CTL) that we think still have some room to run and currently earn an Investment Grade of A. Also 3 companies (WYNN, MTW, STR) that we think are overvalued and currently earn an Investment Grade of F.

To learn more about AFG’s Investment Grade Methodology or to review your portfolio holdings, click here.

10 Attractive Dividend Paying Stocks – Including Johnson & Johnson (NYSE:JNJ) by Michael Ghioldi

As U.S. equities have experienced a significant amount of volatility thus far in 2016, companies that pay high dividend yields have performed well so far YTD. With bond yields remaining low and such dramatic swings in the market, high yield stocks are becoming an even more popular segment of the market for investors seeking some stability. Dividend-paying stocks can be used to hedge against big downswings in the market and as a way to gain cash without moving in and out of positions. These stocks that pay high dividend yields (greater than 10 Year US Treasury Note – Currently 1.78%) offer investors two ways to earn a healthy return, via capital appreciation or through the payment of a dividend.

Our goal is to provide investors searching for solid dividend yields a list of companies that not only pay a solid dividend, but also look attractive according to our valuation metrics and Investment Grade methodology. Using AFG’s Investment Grade allows investors to filter companies based on a proven set of characteristics that work extremely well in concert to identify companies likely to outperform sector and industry peers.

AFG Investment Grade helps investors understand;

  • Whether a firm is able to earn more than their economic cost of capital (positive Economic Margin)?

  • Are Economic Margins shrinking or growing?

  • Does the company follow a sound management strategy?

  • Is the stock trading at a discount to its intrinsic value?

  • Are the company’s reported earnings repeatable and an accurate representation of the companies operations?

If your focus is to add some dividend income to your client portfolio we have provided a list of 10 companies that meet our Investment Grade criteria to earn an “A” grade that also pay a dividend above what could be earned by purchasing a 10-year US Treasury note (current yield 1.78%). This list is a solid starting point for money managers looking for investment ideas that provide a steady income stream.

Attractive Dividend Paying Stocks

Alternative to the list of attractive companies provided, AFG puts together a focus list in the context of a portfolio that is centered on the concept of dividend paying companies that have attractive valuations.  AFG calls this focus list the AFG High Dividend Strategy (AFG HD).  The AFGHD is a low turnover portfolio that has exposure in each economic sector, holding anywhere from 25-35 securities.  This focus list marries the idea of high quality companies that pay a dividend but also have capital appreciation characteristics. For information on our High Dividend Strategy Portfolio or any of our other research products, click here for a free trial or email us at sales@afgltd.com.