Undervalued Tech Stocks From The S&P 500 – Including Apple Inc. (NASDAQ:AAPL) and Cisco Systems, Inc. (NASDAQ:CSCO) by Michael Ghioldi

Over the past few weeks we have discussed the embedded expectations for sales growth that is “priced-in” to the current trading level of the S&P 500 index as well as the expectations embedded in each individual sector within the index. We concluded that the S&P 500 as a whole looks close to fairly valued and that there are still an ample amount of attractive investment opportunities within the index. On a sector level, we concluded that the sectors with the lowest expectations for sales growth relative to the growth that they have delivered historically were Healthcare, Transportation and Technology.

Investors can gain an advantage by understanding the current expectations embedded in a sector or index when searching for investment ideas or allocating across sectors. By focusing more time and effort on the most undervalued sectors with the most reasonable expectations for growth priced in, an investor’s pool of potential constituents will theoretically contain more companies that are likely to deliver adequate returns.

Being that we have identified the Technology sector as one of the sectors with the lowest expectations for sales growth priced-in to its current trading levels, we will dig into this sector and identify some individual companies with reasonable expectations. While it is an effective resource to understand “priced-in” expectations, it is only one of the tools that we utilize to uncover undervalued stocks that are likely to outperform. AFG’s Investment Grade™ methodology is a multi-factor, weighted stock grading model that takes into account many of the other factors we consider essential to properly value individual stocks as investment opportunities. This model attaches a simplified letter grade from A to F to each company in our database to help clients quickly understand how attractive a company is based on valuation, quality and momentum factors.

The chart below is a list of firms from the Technology sector of the S&P 500 identified by our Investment Grade™ model as having a grade of A or B. These companies also have very reasonable expectations for sales growth “priced-in” to their current trading levels, relative to what these firms have delivered in sales growth historically. Based on extensive back-testing, companies that meet the criteria to earn an investment grade of A or B that also have reasonable expectations have proven to be more likely to outperform. We believe this list can serve as a solid starting point for investors looking to add some Technology exposure to their client portfolios.

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S&P 500 Sectors With The Lowest Expectations For Sales Growth by Michael Ghioldi

In our post last week, we discussed the expectations that are currently “priced-in” to the S&P 500 index, or what the index needs to deliver in Sales Growth, EBITDA Margin, and Asset Turnover over the next 5 years in order to justify its current levels. By understanding the embedded expectations an index must deliver to justify its current trading price, investors can develop a “hurdle rate” to quickly determine if the index’s expectations are rich or low. When we compared the current expectations for revenue growth relative to the median growth that the S&P 500 has delivered over the past 5 years, we concluded that the index currently looks fairly valued to slightly overvalued.

When we drill down one step further to the sector level we can help investors identify which sectors have the lowest expectations and thus look undervalued. When allocating across sectors or searching for investment opportunities, focusing on the sectors with the lowest expectations can provide an advantage to investors as these sectors are most likely to meet expectations, contain more attractive investment opportunities for individual stocks and deliver adequate returns.

The chart below displays Implied Future Sales Growth and Historical Sales Growth for each AFG sector in the S&P500. The sectors are ranked from left to right with the most undervalued sectors on the left. The three sectors with the lowest delta between sales growth expectations and historical performance, or the three most undervalued sectors are Healthcare, Transportation and Technology.

We will follow up next week with some individual companies with reasonable expectations from the Technology sector with the lowest expectations that also look attractive from a valuation and Investment Grade standpoint.

To learn more about how we help hundreds of institutional investors refine their investment process, email us at support@afgltd.com. Or sign up for our monthly newsletter which contains market commentary as well as investment ideas, click here to subscribe.

Is The S&P 500 Index Currently Overvalued? - Understanding the Embedded Expectations by Michael Ghioldi

AFG measures the attractiveness of individual companies as investment opportunities in several different ways. We place great amount of importance on obtaining a detailed understanding of a company’s valuation, momentum and quality characteristics to come to realistic conclusions on the attractiveness of a company. One thing that sets us apart from other research providers and analysts is the ability to understand the expectations for revenue growth that are embedded in a company’s current stock price. Much like earnings, when a company delivers 20% revenue growth, how does one determine whether that is a good or bad number?  It depends on the expectations that were priced into the stock or the expectations of the market that reveals if the company has over or under delivered.   

By understanding the embedded expectations a company must deliver to justify their current trading price clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low.  By gaining a better understanding of the embedded expectations built in to security prices relative to what a company has delivered historically, one can gain some insight into the “priced-in” expectations for Sales Growth, EBITDA Margin, and Asset Turnover a company has to deliver in the future to justify its current trading price. 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. 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, 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. 

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 9% over the next five years, while over the past five years these companies have grown at just under 7%.  From this vantage point it looks as though the S&P 500 industrial firms are currently fairly valued to slightly overvalued.

The index is currently within normal historical range (between +/- 1.5 std dev.) and we believe that attractive investment opportunities are available within the S&P 500 index. In one of our next articles on www.AFGIndexes.com we will take this analysis one step further, to the sector level, to see which sectors within the index have the highest/lowest expectations priced in to their current price points

Poor Earnings Quality Companies (Russell 1000) - Including Kate Spade & Co (NYSE:KATE) and Sunedison Inc (NYSE:SUNE) by Michael Ghioldi

When stock investors are searching for potential companies to own, it is important to understand the quantity of earnings a firm is generating in order to value its businesses. While it is important to investors to see a company grow its earnings, a savvy investor would like to feel confident that the company’s earnings are repeatable and accurately represent the company’s operations.

Understanding the quality of a company’s earnings can have a great deal of influence on whether investors can have confidence in their projections of the company’s future performance. One way in which we determine the quality of a company’s earnings is to understand the level of accruals the company has on its books. If a company has an extremely high level of accruals relative to its industry peers, it is likely that the company will not receive full payment from all customers, which leads to potential poor earnings quality. Our studies show that companies with a high amount of accruals have proven to encounter far more negative earnings surprises and inferior returns than firms with lower levels of accruals.

Accruals are the difference between Cash Flow and Net Income, essentially the percentage of net income which is owed to a company from their customers (accruals), to what they have already received in cash. By avoiding companies with high levels of accruals, you can eliminate some of the possibility of owning a company that may misrepresent its ability to continue to generate earnings growth.

The Applied Finance Group’s Earnings Quality metric provides our clients a way to filter out companies with the highest levels of accruals from their list of constituents. As you can see in the charts below, we have broken down the Russell 1000 Index into quintile buckets based on accrual levels. The F rated firms have the highest level of accruals (lowest quality of earnings) and the A rated firms have the lowest level of accruals (highest quality of earnings). Both Year to Date (12-27-13 to 7-15-14) and since we began tracking the performance of this metric (1998-2014), you can notice a distinct trend that by avoiding the companies with the highest level of accruals you will avoid many torpedo stocks. This metric helps investors avoid companies that are the most likely to encounter negative earnings surprises and most likely to underperform peers with higher quality earnings.

A company with poor EQ does not necessarily mean a company is not an attractive investment opportunity as other metrics such as valuation, momentum and other quality metrics need to be taken into account. This list does serve, however, as a list of companies that contain characteristics found in companies that tend to underperform. Below we have provided a table of companies from the Russell 1000 index that have the highest level of accruals that should be monitored closely before owning.

To learn more about how we help hundreds of institutional investors refine their investment process, email us at support@afgltd.com. Or sign up for our monthly newsletter which contains market commentary as well as investment ideas, click here to subscribe.

25 Attractive Asia-Pacific Stocks by Michael Ghioldi

The Applied Finance Group (AFG) provides a consistent approach to valuing securities and understanding the expectations embedded in stock prices regardless of the size, sector, style or geography of a company. AFG’s Economic Margin framework and Investment Grade methodology help professional investors, corporations, and consulting firms to better understand the true economic profitability a firm is earning as well as identify under and overvalued securities.

By systematically making several adjustments to “as-reported” accounting data and converting this data into a complete set of economic financial statements we can see what a company is earning above or below its true cost of capital. This process of analyzing companies from an economic standpoint helps to better understand the true underlying economic vitality of a company and also provides more comparability between companies with vastly different characteristics.

Once we are looking at companies on a level playing field, we can then utilize one consistent methodology for identifying attractive and unattractive stocks regardless of the companies’ individual characteristics. AFG’s Investment Grade™ methodology takes into account a company’s valuation, economic performance as well as quality and momentum factors. After analyzing these factors, we attach a simplified letter grade of A through F to help investors looking for investment ideas to easily identify which companies look attractive and which companies look like potential torpedo stocks.

By focusing on the A & B rated stocks when developing a starting pool of candidates to potentially add to client portfolios, investors can put themselves in a better starting position to outperform.

While many money managers look to use ETFs to gain exposure in global markets, many are looking to buy individual securities to add an additional edge on their competitors. In this exercise we filtered through the main indices in the Asia-Pacific region (Japan, China, Singapore, and Australia) and identified some companies that earn an Investment Grade of A.

The list of 25 companies below from the Asia-Pacific region meet our Investment Grade criteria to earn an A grade. This list is a solid starting point for money managers looking for investment ideas that provide some exposure to the Asian markets.

15 Attractive Large-Cap Dividend Payers – Including Deere & Company (NYSE:DE) and Pfizer Inc. (NYSE:PFE) by Michael Ghioldi

Our main focus at The Applied Finance Group is helping our clients identify undervalued securities in all segments of the market while avoiding potential torpedoes. Our Investment Grade methodology takes into account several factors to help understand how well a company is run and what a company is worth. While most of our focus is on the valuation of a firm, we do also pay attention to what is working in the market and any trends that could help money managers gain an advantage.

One trend that we would like to point out is the success that companies paying the highest dividend yields have done well so far this year. We broke up the Russell 1000 Companies into quintile buckets based on dividend yield and as you can see in the chart below the two top quintile buckets have delivered healthy returns and outperformed the index as well as the companies within the lower dividend paying quintiles.

To provide our readers with a focus list of companies we have filtered through the Russell 1000 for not only companies paying a healthy dividend but also for companies that earn an Investment Grade of “A” or “B” as these companies tend to be more likely to outperform. In coming up with our list we limited our focus to companies that pay a dividend yield above what could be earned by purchasing a 10-year US Treasury note (current yield 2.53%). Our first priority is to encourage our clients to own companies that look attractive from a valuation standpoint according to our model, however, we view a steady dividend yield is an added bonus.

The list of 15 companies below meet our Investment Grade criteria to earn an “A” or “B” grade that also pay a healthy dividend. This list is a solid starting point for money managers looking for investment ideas that provide a steady income stream.

AutoZone, Inc. (NYSE:AZO) – A Consistent Wealth Creator by Michael Ghioldi

AFG’s primary metric used to understand how well a firm is performing and shed light on the underlying economic vitality of a company is called Economic Margin™ (EM). The EM framework was created for the purpose of measuring a company’s economic profitability; that is, did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? In the simplest terms, an Economic Margin is how much a company is earning above or below its true economic cost of capital.

This measure considers 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 positive EM are generating Operating Cash Flow beyond the cost of the capital employed, thus creating investor wealth. 

Understanding a company’s EM levels and expected changes in EM levels can provide investors an advantage in the market as AFG has proven through rigorous backtests and research that a company’s EMs are highly correlated to its market performance. AFG’s Wealth Creation Report (WCR) allows you to visually analyze a company’s historical EM levels, current EM and expected change in EM based on projections built out by AFG’s default valuation model. A company that earns above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Back-tests have proven these companies to be more likely to outperform companies following a wealth-destroying strategy (negative Economic Margins and growing assets).

The Wealth Creation Report is a compilation of 3 charts that visually tell the story of whether or not the firm and its management team have been creating wealth for its shareholders. The 3 parts of the chart are outlined below.

  1. The first chart is a summary of a company’s economic performance (EM’s) over time, as well as insight into how analyst EPS forecasts project AFG’s default EMs over the next two years.


  2. The second part of the chart is the Asset Growth chart which allows additional insight not only the growth of a company, but how that company’s growth strategy has affected their economic performance.


  3. This data can then be used to identify how the stock has performed in relation to the market as it displays the company's cumulative total return relative to the cumulative market-weighted average total return of the largest 2000 companies for the equivalent time period.

Below is an example of AutoZone, Inc. (NYSE:AZO), a company AFG considers to be a consistent wealth creator, identified by using AFG’s Wealth Creation Report. As you can see in the chart AZO has been able to maintain positive EM levels that have grown over time, grown its asset base and increased its asset growth over the last few years. AZO is also projected to continue to grow in 2015. In the bottom chart you can see that this strategy has paid off as it continues to outperform the overall market significantly. If AZO is able to maintain or improve its EM levels and continues its pace of growth, we believe the firm will be likely to continue to deliver positive returns and outperform its peers and benchmarks.

AutoZone, Inc. (NYSE:AZO) - Wealth Creation Report

5 “A” Rated Companies From The S&P 500 – Including Deere & Company (NYSE:DE) by Michael Ghioldi

AFG’s Investment Grade™ model is an effective tool for money managers when filtering through constituent lists searching for attractive investment ideas or to eliminate potential torpedo stocks. The AFG Investment Grade is a multi-factor, weighted model that ranks companies based on valuation, quality, and momentum and attaches a simplified letter grade from A to F to each stock in our database of over 4500 securities. 

Several adjustments are made to “As-Reported” data taken from company SEC filings to view companies from an economic standpoint. This provides some insight into what a company is earning above or below its true economic cost of capital. Two major benefits of making these adjustments and taking a more economic view of a company is gaining a more complete view of a company’s underlying economic vitality as well as improving comparability across sectors, market-caps, styles, and countries.

This model not only takes into account valuation, economic performance, quality and momentum factors but also applies different weightings to each factor on a monthly basis based on what is currently working in the market. By applying different weights to each factor we are able to take advantage of current market trends as well as reducing the risk of being overly affected by one economic factor in a negative way.

While there are shifts in the model’s weightings, valuation is usually always a heavily-weighted factor as our valuation metrics have proven successful in all market environments and tend to add the most value when identifying stocks poised to outperform.

By attaching a 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.

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 AFG Universe so far in 2014 while the chart on the bottom shows how well the model has worked within the universe over a longer time horizon (1998 to 2014). In both time periods there is a nice monotonic relationship from A graded companies to F graded companies. D and F grades also underperform the overall universe while the A’s, B’s and C grade companies outperformed the overall universe. 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.

In the table below you will find 10 companies, 5 “A” rated companies and 5 “F” rated. If you are searching for companies to potentially add to a portfolio we recommend looking into the 5 “A” rated firms as a starting list of ideas. If you happen to own or are considering adding any of the “F” rated companies, we recommend taking a cautious approach as these firms are flagged as potential torpedo stocks by our model.

To learn more about how we help hundreds of institutional investors refine their investment process, email us at support@afgltd.com. Or sign up for our monthly newsletter which contains market commentary as well as investment ideas, click here to subscribe.