10 Undervalued S&P 500 Stocks – Including Valero Energy Corp. (NYSE:VLO) and MasterCard, Inc. (NYSE:MA) by Michael Ghioldi

Everything we do at The Applied Finance Group (AFG) ends with valuation, as it is the core of our research process. To come to realistic and insightful valuation conclusions, we must first understand how well a firm has utilized its invested capital and if that firm can earn above its true economic cost of capital. We define what a company earns above or below its true economic cost of capital as Economic Margin (EM) ™.

When you buy a company, you are essentially paying for its current assets plus its future expected performance. AFG determines the valuation of a company by forecasting future levels of its EMs and discounting cash flows back to today’s dollars.  Two major ways in which we separate ourselves from traditional DCF models are that we incorporate the effects of competition by determining the competitive advantage periods (number of years its takes to compete away economic profits), and we assign company specific discount rates (rate at which cash flows are discounted back to today’s dollars adjusted for size and leverage)

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Once we have a firm handle on whether or not a firm is profitable from an economic standpoint, the next goal is to correct some of the common distortions in “as reported” financial statements. As an example, traditional accounting metrics often punish technology and pharmaceutical firms for their R&D expenditures, and inflate retailers’ returns by ignoring their enormous off-balance sheet liabilities such as their operating leases. Our valuation framework essentially strives to create a set of economic financial statements for companies that work well across time, industries, sectors, and market capitalizations. 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 the shortfalls of traditional accounting approaches to evaluating investments.

Many investors focus mostly on a company’s Earnings, while this is important, Earnings alone only account for 50-60% of the overall cash flow of a company. Our valuation process sheds light on the entire cash flow generation picture and helps investors better understand what the company is really worth. Focusing on earnings alone by using metrics such as earnings growth, price to earnings and ROE is helpful yet not sufficient in understanding a company’s ability to create wealth for its shareholders. The end goal is to link a company’s true economic performance to value, and in turn link those values to decisions for the betterment of your portfolios.

We provide money managers with access to a repeatable process of valuing companies that has proven to be effective at identifying investment opportunities regardless of the composition or characteristics of the individual company. To learn more about our valuation methodology and how we help hundreds of institutional investors refine their investment process, email us at support@afgltd.com.

The list of companies below are from the S&P 500 that look undervalued relative to their current price according to AFG’s valuation model. These companies deserve a deeper look as they have the makeup of potentially attractive investment opportunities.

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The Super Bowl and Mid-Cap Stocks- Take the Under! by Michael Ghioldi

Sunday’s game has many unique story lines – Peyton Manning as choker/hero; Richard Sherman as the game’s newest villain; A defensive minded head coach in charge of the most prolific offense in the NFL history; Beast mode; One of the stingiest defenses in the NFL history – the story lines in this game are quite fascinating.  It should be a great game, and I look forward to watching it at my favorite sports book.  There is a similar story line developing in the market with respect to mid-cap stocks.  After an amazing 2013, when returns to the group topped 35%, does the group have a chance to continue its winning streak, or is it time to take the money off the table?  Let’s explore this and the game a bit more.

Last week we discussed why the chatter about stocks being a scary place to invest did not really apply to large-cap stocks.  In a nutshell, while larger capitalization stocks do not present outsized upside opportunities, neither do they suffer from bubble level over-valuations.  In other words, the large cap space will likely be defined by normal volatility, but there is no reason to expect or fear a significant correction unless something unexpectedly goes bad – though as Instapundit.com has noted repeatedly over the past 5 years the economic news seems to consistently have an “unexpectedly bad” tilt, but that is for another column.  Unfortunately that is not the case for mid-cap stocks.  The mid-cap group is approaching near historic levels of over-valuation whether evaluated from the perspective of a rigorous discounted cash flow valuation model or solving for the sales growth expectations embedded in today’s market price.

 AFG values 4500 US stocks every day and has developed a variable called Percent to Target, which compares the intrinsic value of a company against its market traded price.  When stocks trade below their intrinsic value, it has Percent to Target that is positive; conversely, when a stock trades above its intrinsic value estimate, it has a negative Percent to Target.  By this measure, mid-caps are grossly over-valued.  In fact, only twice in the past 15 years have mid-cap stocks been as over-valued as they are today according to this time tested fundamental, bottom-up look at thousands of individual securities. 

AFG Mid Cap Pct to TGT.JPG

Another check on valuation levels is to understand the sales expectations embedded in market prices, a process we call Value Expectations.  In the spirit of the Super Bowl, one can think of those expectations as the over/under line on the future sales growth a company must deliver to justify its traded price.  When implied sales expectations are high for a company, it becomes relatively difficult to deliver the growth required for investors to obtain an adequate return on their investment.  Conversely, when expectations are low a company has a much easier time meeting the growth required to deliver adequate returns to its investors. 

Today, for the median mid-cap stock the bar is set very high for investors to obtain positive returns at current market prices.  The typical mid-cap stock is priced to deliver 17% sales growth over each of the next 5 years, assuming they maintain their average profit margins of the past five years.  That 17% implied sales growth rate compares to past 5 years’ median sales growth rate of 10%.  While it is not impossible for mid-caps to deliver this level of expected performance, it is unlikely, especially considering the lackluster GDP growth expectations for the US economy.

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Returning to our Super Bowl analogy, the line on the game is currently set at 48 points.  A gambler taking the over believes the total points scored in the game will exceed 48 points.  A mid-cap investor buying at today’s prices believes the typical stock will be able to grow its sales in excess of 17% annually for the next 5 years.  In what should be a classic game, the best offense in NFL history will square off against one of the best defenses in the history of the league.  Denver on average scores 37 points a game, while Seattle only gives up 14.  It seems obvious that casino books took the average of what Denver scores and what Seattle gives up and split the difference with the lines on the game implying roughly a 25 to 22 point game.  While Manning had a magical year, Denver has had trouble against teams with physical defenses that jam receivers at the line and can control the clock with a strong run game – Seattle’s specialty.   While my heart wants Manning to get another ring and tie his brother, my brain says this game will be played slow with Seattle dominating time of possession and ultimately winning.  Consequently, I like the under.  Similarly, given the implied sales growth over/under for mid-cap stocks’ at 17% for the next 5 years, against a 10% growth rate baseline, I also take the under, underweight mid-caps.

AFG Mid Cap Universe - 5 Year Median Implied Sales Growth (1-23-14) by Michael Ghioldi

AFG's 5 year median Implied Sales Growth metric which shows the future sales growth a company must deliver to justify its traded price.  When implied sales expectations are high for a company, it becomes relatively difficult to deliver the growth required for investors to obtain an adequate return on their investment.  Conversely, when expectations are low a company has a much easier time meeting the growth required to deliver adequate returns to its investors. 

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To learn more about this chart and our thoughts on the current state of the market, click here.

AFG Mid Cap Universe - Percent to Target (1-23-14) by Michael Ghioldi

The chart below illustrates the median Percent to Target for AFG's Mid Cap Universe. Percent to Target compares the intrinsic value of a company against its market traded price.When stocks trade below their intrinsic value, it has Percent to Target that is positive; conversely, when a stock trades above its intrinsic value estimate, it has a negative Percent to Target score.

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Avoid These Wealth Destroying Companies – Including FedEx Corp. (NYSE:FDX) And Alcoa Inc. (NYSE:AA) by Michael Ghioldi

When screening through a list of possible companies to own in an investment portfolio, it is important to have a repeatable process with a strict set of guidelines in order to continuously identify companies likely to outperform. An important component of our process of identifying the best stocks to own begins with eliminating potential torpedoes from our constituent list. One tool we utilize as an exclusionary metric is Management Quality which identifies companies that investors may want to avoid as they have management teams that are attempting to grow their businesses when they are not profitable.

To understand if a company truly is profitable, we use the Economic Margin methodology.  Economic Margin (EM) measures the return a company earns above or below its 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. 

By understanding the true economic profitability a company is earning, we are able to see more clearly how adept a firm’s management team is at creating wealth for its shareholders.  Firms with positive EMs are generating Operating Cash Flow beyond the cost of the capital employed, thus creating investor wealth.  These firms should maximize their profit opportunity by expanding their capital base.  

If a firm cannot earn back its economic cost of capital (negative EM), it should not be growing its asset base.   Instead, the company needs to concentrate on the parts of their company that have been creating wealth, fix the broken parts of its business by divesting losers, and work on improving profitability to earn the right to expand.

The charts below illustrate the performance of all of the companies in the S&P 500 grouped into two buckets, wealth destroyers (bottom half) and wealth creators (top half).   Wealth creators are firms that have positive EM and are growing their business while wealth destroyers are firms with negative EM and are growing their business. 

You can see that over the past year (12/2012 to 12/2013) and since we began tracking the performance of this metric (9/1998 to 12/2013) that many torpedoes can be avoided simply by eliminating companies that destroy wealth from your list of constituents.

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The 14 companies listed below all are following the path of wealth destruction by attempting to grow while not earning back their cost of capital. Pay extra close attention to these companies if you own them or plan on adding them to a client’s portfolio. These companies also look unattractive overall according to our valuation model and Investment Grade metrics. Be careful with these potential torpedoes.

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Set It and Forget It - Don't Fear the Market Run-Up - S&P 500 (INDEXSP:.INX) by Michael Ghioldi

The New Year brings a natural reflective response to most people, and with regards to investments and stocks in particular a common question lately is whether to stay in the market given its run over the past 4 years.  I believe assets invested in the market should stay in the market” almost” all of the time.  The result of this philosophy is simple; I tune out the majority of talking heads constantly talking about the coming crash.  While the Bearish type commentators sound convincing at a point in time, when one examines their records across time most of them are massive losers.  Investors that tend to try to move in and out of the market tend to directly or indirectly lose significant wealth. 

I understand that pull to time the market is just too great for many people, so I will share two charts I use to make sense of market valuations and provide discipline to any thoughts about reducing market exposure when things get scary.  Taken together, my conclusion is – The market does not look particularly attractive, but it is not over-valued to the point that warrants adjusting target exposure levels. 

The first chart displays the implied sales growth embedded in the market price for stocks with market capitalizations over $6 Billion, or what is commonly considered to be “Large Cap” stocks, and compares those expectations to the sales growth these stocks have delivered over the past three years.

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The main takeaway from this chart is simple – the market has priced the typical Large Cap company to grow its sales at just under 10%, while over the past three years such companies have grown at just over 10%.  From this perspective, I conclude the market is fairly valued.

Another perspective that I like to incorporate into creating my market view is to evaluate the intrinsic value of each company relative to its traded price and determine if the market is over or under valued from a bottom up perspective.  This is displayed in the following chart.

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Going back to 1996, using this approach we see two distinct “bubble” periods – the tech boom of ’99 and the mortgage crash of ’08.  In each instance, market valuations deviated from the intrinsic value of companies by 60% in each instance.  In mid-’09, we issued a study titled “Then and Now” which contrasted the extreme opportunities available to investors in 2009, relative to the train wreck awaiting investors in late 1999 and concluded that the stock market presented a generational opportunity to amass wealth by being long++ the market.  Today, market valuations slightly exceed intrinsic values, but not by enough to warrant any significant actions. 

Earlier I mentioned that market calls should “almost” never be made.  I call that the Max the Miracle Worker rule.  Max from Princess Bride could bring those that were “almost” dead back to life.  Similarly, I begin to get excited about overall market adjustments to portfolios when we see extreme readings on our various macro metrics, for the intrinsic value chart above, I would need to see market prices exceed the intrinsic value of individual stocks by over 15%.  For now at least we are not close that figure, until then I would continue to just “Set It and Forget It”.

CEO Value Maximizers Including Dun & Bradstreet Corp. (NYSE:DNB) & Gilead Sciences (NASDAQ:GILD) by Michael Ghioldi

The following is an excerpt from our most recent annual ranking of CEO’s within the S&P 500 based on Management’s understanding and execution of creating and maximizing value. To view the original article on ChiefExecutive.net click here.

Everyone talks about shareholder value, but markets and managements tend to talk past each other in terms of what true value really is. There needs to be a shared vocabulary and a set of common standards upon which everyone can agree.

Traditional accounting-based valuation methods provide an incomplete view of a company’s value by not accounting for investment to generate the earnings, cost of capital, inflation or cash flow. The Wealth Creation Index (WCI) created in partnership with Applied Finance Group (AFG), a global performance advisory and equity research firm, and Drew Morris of Great Numbers!, seeks to identify real value—as opposed to Generally Accepted Accounting Principles (GAAP) value.

AFG uses a proprietary framework it calls Economic Margin (EM) to evaluate corporate performance from an economic cash flow perspective that is an alternative to accounting-based valuation metrics. EM measures the return a company earns above or below its cost of capital and, thus, provides a more complete view of a company’s underlying economic vitality.

The core of AFG’s framework is the conviction that accurate valuations require understanding how well a firm has used its invested capital. Currently, common measures of corporate performance are based on earnings, such as earnings growth, price to earnings and Return on Equity (ROE). Accordingly, firms will often undertake actions that increase earnings (and taxes)—but that do not create value—in the hope of inducing stock analysts’ upgrades. Many argue that importance placed on the role of earnings is misplaced because earnings are only a part of the shareholder wealth-creation process. EM corrects these accounting distortions by taking into account asset life, asset mix, asset age, capital structure and growth, effectively linking the income statement and balance sheet. EM levels have a much higher correlation with market values.

EM measures the degree to which companies are making money and growing the underlying business over and above its risk-adjusted cost of capital. It’s expressed as a percentage of productive capital and calculated as operating cash flow minus a capital charge—all divided by invested capital. Companies with positive EM—greater than zero—are creating wealth; those with negative EM are destroying it.

There is no single, unified measure that will serve every business leader’s metric. After coming up with the Theory of Relativity, Einstein spent his remaining years searching for a unified field theory that would explain all the known laws of the universe—and he came up empty. So until something like that happens in economic finance, EM comes as close as any business owner can hope in reckoning how every business dollar invested in the business is working.

 

Link to Entire Article on ChiefExecutive.net

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