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.

Attractive Small Cap Stocks From The Russell 2000 (INDEXRUSSELL:RUT) by Michael Ghioldi

In last week’s article we examined the overall valuation attractiveness of large-cap stocks (Russell 1000) and small-cap stocks using AFG’s valuation metric. While we concluded that the large-caps continue to look like the much more attractive space, as it has for the last 2 years, we did end the moratorium on small cap stocks that we’ve been writing about for the same timeframe. Small caps have finally retreated from their most expensive levels in 20 years and are now trading within its normal valuation ranges. With that in mind, we have decided to provide a list of 20 attractive small cap stocks from the Russell 2000 index. This list can serve as a starting point for investors who may be looking to add small caps to their portfolios.

While the majority of our clients tend to focus mostly on large-cap companies, AFG has an excellent track record at identifying undervalued companies within the small-cap space. This is proven by the success of our small-cap model portfolio we call the AFG 100. The AFG 100 is a long-only, sector neutral, actively managed model portfolio of 100 stocks benchmarked against the Russell 2000 index. Since inception (2007), the AFG 100 has outperformed its Russell benchmark in 7 out of 8 years with a total outperformance of over 1000 basis points (2007-2016).

The companies listed below meet the criteria to earn an Investment Grade of A and also look attractive from a valuation perspective. Our backtests have 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 starting position to outperform. These companies contain several characteristics inherent in companies likely to outperform.

Russell 2000 – Attractive Ideas

If you would like to learn more about our Investment Grade methodology or how our research and tools benefit professional investors, email us at sales@afgltd.com and an AFG rep will contact you.

Are Small Cap Stocks Cheap Enough To Buy Again? Russell 2000 (INDEXRUSSELL:RUT) Valuation Check by Michael Ghioldi

Although we rarely make major calls for investors to exit certain segments of the market or drastically reduce exposure to a specific index or group of companies, one call that we made to our readers and clients beginning in March of 2014 was to reduce exposure to small cap stocks. Our valuation metric (Percent to Target) that tracks the valuation levels of entire indices signaled that the Russell 2000 index looked extremely overvalued at the time. Not only did the small caps look overvalued, but the valuation of the index as a whole was quickly approaching bubble-level territory. Only twice in the past 20 years had the Russell 2000 been overvalued to that extent.

On three separate occasions we suggested to our readers that the large cap space (Russell 1000) was much more attractive from a valuation standpoint than their small cap counterparts (Russell 2000). We also suggested investors consider greatly reducing exposure to small cap companies or exit the space completely. Since the original call in March of 2014, the Russell 1000 has significantly outpaced the Russell 2000 by over 16%.

We gather data on the valuation upside of every company within the Russell 1000 and Russell 2000 indices on an aggregate basis to determine the valuation levels of each index as a whole. When overall valuation levels approach +/-1.5StdDev, it signals that the index is extremely over or undervalued and outside of normal ranges. The Russell 2000 index had been trading near its -1.5 StdDev line for nearly two years and the subsequent tanking of the index has not been surprising.

Our most recent update of valuation levels within both indices shows us that although Large Cap stocks (Russell 1000) still look slightly more attractive than small caps (Russell 2000), small caps are now within the range of normal valuation levels and we are no longer recommending reduced exposure to small cap equities.

In upcoming articles we will highlight companies we believe are attractive investment opportunities from both indices that currently earn attractive AFG Investment Grades and attractive valuation ratings to serve as a starting point for investors looking to add positions in both the large and small cap spaces.

Why we like Spirit Airlines Incorporated Stock (NASDAQ:SAVE) – Good Business Model, Great Value by Michael Ghioldi

Overview: Spirit Airlines is a Florida-based low-fare airline offering affordable travel to a customer base that is purely focused on price. Spirit operates more than 300 daily flights to 56 destinations in the U.S., the Caribbean, and Latin America with an all-Airbus fleet that includes 29 A319, 42 A320, and 5 A321. The company also provides optional air related products and services at an extra cost, including baggage check fee, boarding pass fee, overhead bin fee, and additional costs for on-board food and beverage purchases. The success of Spirit’s business model has driven the airline to initiate an aggressive growth strategy. We like SAVE for the following reasons:

Ultra-Low Cost Leader: Spirit has taken the #1 position as the lowest cost airline in 2014, toppling Allegiant Travel from the top spot. Spirit’s cost per available seat mile (CASM) in 2014 of 5.9 cents vs. Allegiant’s 6.6 cents shows that the company has identified and implemented more cost savings than its peer. Moreover, in Q3 2105, Spirit’s CASM has further improved to 5.4 cents surpassing all the low cost operators in the airline space. The company’s success in achieving very low operating costs is passed on to customers enjoying low air fares and its top position has attracted competition from other airlines. Competing airlines have lowered their airline ticket prices in an attempt to better compete with Spirit. However, we believe that Spirit will be able to endure lower prices for a longer time than the more-costly legacy airlines can.

Aggressive Growth Plan: SAVE increased its seating capacity 18% in 2014 when it purchased 4 aircraft, the first time in the company’s history, where its previous reliance was solely on leasing aircraft. In 2015, Spirit expects to purchase 15 Airbus aircraft to increase its fleet to 80. By 2021, the company expects to have more than 140 aircraft in its fleet. In addition to a bigger fleet, Spirit will launch service into new markets. The growth strategy hopes to leverage its ultra-low cost business model into more regions with more aircraft in order to increase sales and enhance its Economic Margins over a larger asset base. We generally view companies with positive Economic Margin companies who choose to grow its assets as wealth creators. We believe that SAVE has the capability to meet its target customers’ demands, while being pragmatic stewards of its investors’ capital.

Bare Fare Business Model: SAVE competes solely on the basis of price. The company prides itself for offering an absolute bare airline ticket price, where customers can choose which ancillary service they will pay for separately. Everything above the fare price is added at extra cost, allowing a targeted sliver of frugal customers to prefer Spirit Airlines over the competition. The company targets customers who want to pay the lowest possible price to get from an airport in one location to another airport in another destination, a target market that most legacy airlines have avoided to attract.

CEO Replaced: On January 5, Spirit announced the replacement of CEO Ben Baldanza with prior board member Robert Fornaro. The board of directors may have decided on this surprise change in leadership because, although the company is growing its number of seats and the price to fly has maintained competitive, the company’s ticket revenues have flattened. Double-digit sales growth has recently been attributable to ancillary add-on fees. New CEO Fornaro is likely to maintain its ultra-low cost leadership and make minor changes to improve customer satisfaction, which is ranked at poor levels, while continuing to implement the aggressive growth strategy already under way. SAVE shares reacted positively to the news with a 6% increase.

Catalyst: The main catalyst for SAVE is the drastic decline in fuel costs. With the recent decline in crude oil prices, from $80/bbl in January 2014 to about $60/bbl in January 2015 and lower still to $36/bbl in early January 2016, the price for jet fuel has also fallen. Gulf Coast Jet fuel prices on NYMEX were trading at $1.70/gal in January 2015, falling to $1.03/gal in early January 2016. Over the past year, fuel costs have declined about 40%, a major boom for profits for the airline industry. Given that SAVE’s fuel cost is the company’s largest operating expense, representing 40% of total operating costs over the past three years, recent fuel cost declines are expected to help the company continue to attract its targeted price-conscious customers. We believe that SAVE will remain a low cost leader in the airline industry and its shares will increase in subsequent quarters. Our model suggests SAVE currently has a significant amount of upside based on its current trading price.