Which S&P 500 Sectors Look Most Attractive? by Michael Ghioldi

Last week we discussed one way in which we look at the attractiveness of a company as an investment opportunity, by measuring the future sales growth (implied sales growth) a company must deliver to justify its current price relative to the revenue growth that the company has delivered historically. We use this to determine if the company has reasonable expectations and the likelihood the company will be able to meet those expectations in order to deliver a reasonable return for its investors.

When we compile this data and look at the median expectations of an entire sector or index, we can make some reasonable assumptions on the attractiveness of the index or sector as a whole. In our previous article we concluded that the S&P 500 index was slightly overvalued to fairly valued, yet plenty of attractive investment opportunities were available on an individual stock basis. Today we will analyze each sector (as defined by AFG) to determine which sectors have the lowest sales expectations relative to what they have delivered historically.

The chart below displays Implied Future Sales Growth and Historical Sales Growth for each AFG sector in the S&P500. The four sectors with the lowest delta between sales growth expectations and historical performance, or the four most undervalued sectors are listed on the left, and they are Technology, Transportation, Energy/Extraction and Healthcare.

When searching for investment opportunities or allocating across sectors, this data suggests that the four sectors with the lowest expectations relative to their historical track record should be the first place to look. We believe that these sectors are likely to meet the expectations embedded in their prices and there will be more investment opportunities for individual stocks.

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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.

Attractive S&P 500 Companies With Over 50% Of Sales In Foreign Markets - Including Yum! Brands, Inc. (NYSE:YUM) and Pfizer Inc. (NYSE:PFE) by Michael Ghioldi

Two weeks ago we discussed the importance of diversification in an investor’s stock selection process and provided a list of attractive ADR’s to gain exposure to different countries/economies.

Another way to gain exposure to foreign markets outside of international Mutual Funds and ADR’s are domestically traded companies that do a significant amount of their business in foreign markets. Investing in companies that are traded here in the U.S. but derive much of their sales abroad allows an investor to capitalize on the higher growth rates available in developing economies without the added risks of trading in a foreign exchange that may not have the transparency, consistency or legal protection that is offered in U.S. exchanges. These companies give you the ability to diversify across several economies and avoid any major problems that may arise due to difficulties or stagnation in the U.S. markets.

The 12 companies listed below all have over 50% of their sales coming from outside of the United States and look attractively priced from a valuation standpoint. These firms also have an AFG Investment Grade™ of “A” or “B” which takes into account momentum and quality factors along with valuation. By adding high quality, well managed and attractively-priced businesses with high foreign exposure to your portfolio you can effectively diversify your investment portfolio across several economies.

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Are The S&P 500’s Current Growth Expectations Too Lofty or Easily Attainable by Michael Ghioldi

There are several ways that The Applied Finance Group tends to look at the overall attractiveness of the “market” (S&P 500 index for this discussion) which shape our views of how we communicate with our clients where investment opportunities are present and though infrequent, making a market call to get in or out of a certain segment of the market.

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, 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 (5 Year Median Implied Sales Growth) embedded in the market price for the S&P 500 index industrial firms (excludes Financials and Utilities). We compare those expectations to the sales growth these stocks have delivered over the past five years (5 Year Median Historical Sales Growth).

When analyzing this data one can think of the implied sales growth expectations as the over/under line on the future sales growth a company must deliver to justify its traded price. 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 point of view 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 plentiful 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.

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Leaders and Laggards of the S&P 500 in Q1 2014 – Including Actavis plc (NYSE:ACT) and Delta Air Lines, Inc. (NYSE:DAL) by Michael Ghioldi

With the first quarter of 2014 in the books, it is a good time to reflect on what has happened so far this year in the market. While the S&P 500 index has returned a modest gain of 1.3% during the first quarter, we want to highlight which companies were the biggest drivers as well as the biggest drags on the index so far this year.

The chart below shows the 20 biggest gainers of Q1 14 that have led the index in returns. These companies are all off to a good start, but which companies do we think can continue to deliver solid returns for the rest of 2014? And which do we think are most likely to run out of steam? We have highlighted two companies from this list that we believe still look attractive and have some more room to run. We have also highlighted two that we think will have the most trouble keeping this pace up for the rest of 2014.

The two companies we like the most going forward (highlighted in green) from the list of biggest gainers based on valuation upside and AFG Investment Grade™ are Delta Air Lines, Inc. (NYSE:DAL) and First Solar, Inc. (NASDAQ:FSLR). The two companies from this list that look the most overvalued (highlighted in red) and also have a poor Investment Grade are Frontier Communications Corp (NASDAQ:FTR) and Forest Laboratories, Inc.(NYSE:FRX).

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The next chart shows us the S&P 500’s biggest losers of the first quarter. We have also highlighted (in green) two companies that we like as investment opportunities that look most likely to turn things around. Based on valuation and AFG Investment Grade™, Celgene Corporation (NASDAQ:CELG) and Peabody Energy Corporation(NYSE:BTU) look attractive despite getting off to such a rocky start this year. Two companies that we think will continue to struggle (in red) as they have poor Investment Grades and look overvalued according to AFG’s valuation model are Cabot Oil & Gas Corporation (NYSE:COG) and Mattel, Inc.(NASDAQ:MAT).

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.

Gaining Global Exposure Through These 20 Attractive ADR’s Including Diageo PLC (NYSE:DEO) and Vodafone (NYSE:VOD) by Michael Ghioldi

Whether it is allocating equity exposure across sectors, market capitalizations or countries, diversification is an important part of many investor’s stock selection process. One of the ways in which we help users of our research is by uncovering attractively priced equities using the same valuation process and metrics regardless of the company’s characteristics or country of origin. We believe that by using one consistent process and focusing on the entire cash flow a company generates to understand company value puts us in a better starting position to uncover attractively priced equities. Using The Applied Finance Group’s Investment Grade™ model we aim to create a set of economic financial statements for companies that work well across time, industries, sectors, market capitalizations, and regions. This process helps investors better understand the attractiveness of an investment by viewing a company’s financials through the same lens, regardless of whether you are looking at a U.S. consumer company or a Japanese Tech firm.

Investing in ADR’s allows investors the ability to diversify across multiple countries and economies and hedge against complete exposure to the dollar, without dealing with the fees and conversion hassles when purchasing shares on foreign exchanges. Other benefits of diversification via ADR’s include avoiding potential currency fluctuations or economic swings in one country, benefitting from comparative advantages in certain countries, be that labor, materials, growth opportunities, or just maintaining exposure to equities at times when the U.S. market is less attractive.

For the reasons listed above, we will provide a list of 20 attractive ADR’s based on AFG’s Investment Grade process which evaluates a company’s valuation attractiveness, management and earnings quality as well as momentum factors.  A letter grade of A-F is assigned to each stock, based on how attractive it is as an investment opportunity. This method has proven successful at identifying winners and helping avoid potential torpedo stocks for nearly 20 years. The 20 ADR’s listed below will help provide equity exposure to 15 different countries and 9 different sectors, however, the one thing they all have in common is an attractive AFG Investment Grade.

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.

Why It Might Be Time To Sell Small Caps – The Russell 2000 Index (INDEXRUSSELL:RUT) Looks Overvalued by Michael Ghioldi

We don’t often make market calls or recommend investors to exit stocks or drastically reduce exposure to equities. We believe that even in overvalued segments of the market there are still attractive opportunities to be uncovered using a disciplined valuation approach. Only when an index or segment of the market reaches bubble levels would we recommend reducing exposure levels or exiting out of securities completely. Not only are our market calls few and far between, there must also be compelling data to back up making a big call on the market.

We gathered 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. What we found was that while the Russell 1000 is currently at a normal valuation level, the Russell 2000 looks extremely overvalued. Only twice since 1998 has the Russell 2000 index been this overvalued and it is approaching bubble levels (outside 1.5 Std Dev).

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 approaching a near bubble level valuation point (- 1.5 Std Dev).

Although you may not need to completely reduce your exposure to the small cap universe and there will always be undervalued individual stocks worth owning, we encourage investors to take a close look at their small cap holdings and consider trimming exposures. We believe there are more attractive equity alternatives for investors in the Large-Cap segment of the market.

10 Attractive Dividend Paying Stocks – Including Merck & Co., Inc. (NYSE:MRK) and Philip Morris International Inc. (NYSE:PM) by Michael Ghioldi

Investing in dividend paying stocks has several advantages as opposed to investing in non-dividend paying companies or other fixed income investments. Yield seeking has long been a successful strategy for investors in search of a steady income stream.  Dividend paying companies tend to be larger, stable, and more mature companies that are financially healthy enough to generate enough consistent cash flow to sustain dividend payments. The Blue Chip companies that dividend investors often hunt for tend to come with less risk and experience less volatility than their smaller non dividend paying brethren.

While there is no fool proof way of beating the market, investing in companies that pay a dividend provides two ways in which investors can garner a healthy return; via capital appreciation or through the payment of a dividend. Dividend-paying stocks can be used to hedge against inflationary pressures, changes in market environment and as a way to gain cash without moving in and out of positions.

In times of market uncertainty, rather than shying away from equities we believe investors should seek out the safety and stability of well-managed dividend paying companies to provide some stable cash flow to your portfolio while keeping exposure to equity markets. While most of our focus at The Applied Finance Group (AFG) is on uncovering undervalued stocks regardless of yield, we believe a strategy of owning larger more stable companies for a long term time horizon is a good strategy. 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.

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 2.6%). This list is a solid starting point for money managers looking for investment ideas that provide a steady income stream.

Companies included in our list are:

Helmerich & Payne, Inc. (NYSE:HP), Dr Pepper Snapple Group Inc. (NYSE:DPS), Philip Morris International Inc. (NYSE:PM), Six Flags Entertainment Corp (NYSE:SIX), Staples, Inc., (NASDAQ:SPLS), JPMorgan Chase & Co. (NYSE:JPM), Merck & Co., Inc. (NYSE:MRK), Pfizer Inc. (NYSE:PFE), Verizon Communications Inc. (NYSE:VZ), Ameren Corp (NYSE:AEE)

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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.

10 "A Graded" Stocks to Own Using AFG's Investment Grade - Including Phillips 66 (NYSE:PSX), Metlife Inc (NYSE:MET) by Michael Ghioldi

A large part of The Applied Finance Group’s (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.

We take data from a company’s SEC filings and make several adjustments to the “As-Reported” data to come up with a complete set of economic financial statements that better display the true underlying economics of each firm. After all of this data flows through the model, the output is a simplified letter grade to help our clients understand how attractive a company is. 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.

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™ over the last year while the chart on the bottom shows how well the model has worked within the index over a longer time horizon. 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.

AFG Investment Grade performance within Russell 1000 Index™.

AFG Investment Grade performance within Russell 1000 Index.

AFG Investment Grade performance within Russell 1000 Index™.

AFG Investment Grade performance within Russell 1000 Index.

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.

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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.

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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.

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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.

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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. 

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After filtering through the Russell 1000 Index using AFG's Investment Grade model, the 10 companies listed below all receive an overall Investment Grade of A. These companies all have the characteristics of companies set to outperform benchmarks as well as industry peers. This list is a solid starting point when looking for companies to add to your portfolios.

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Companies included in our list all have an Investment Grade of A and include LyondellBasell Industries NV (NYSE:LYB), Tyson Foods, Inc. (NYSE:TSN), Kohl's Corporation (NYSE:KSS), Valero Energy Corporation (NYSE:VLO), Phillips 66 (NYSE:PSX), Metlife Inc (NYSE:MET), Celgene Corporation (NASDAQ:CELG), Hewlett-Packard Company (NYSE:HPQ), Oracle Corporation(NYSE:ORCL), The AES Corporation (NYSE:AES).