Toreador Index Report

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As 2011 winds down it is important to provide our readers some insight into a few of the key metrics that we use to identify investment ideas here at The Applied Finance Group (AFG). Our goal is to provide a better understanding of how we select the companies that we supply to you on a weekly basis; companies that are more likely to outperform. The process developed by AFG is used by Toreador Advisors, who select companies that look attractive based on these metrics and track the performance of these metrics in the form of indices created from companies within the Russell 1000 universe.  The Toreador Indices serve as a starting point for Toreador Advisors in their portfolio construction process and the list of constituents from within those indices serves as a good starting point for money managers looking for new ideas as additions to their own portfolio.

 All of the indexes we will highlight in today's letter are built using AFG's Economic Margin methodology and valuation framework as their foundation. All of the stocks considered by Toreador Advisors are culled from these indexes which use key criteria used in AFG's research and stock selection process. All of the metrics used have been vigorously back-tested and have proven to consistently add value to portfolios since 1995.

In today's article we would like to briefly describe some of the metrics that are used to create the indexes, as well as highlight the performance achieved from these indices since we began tracking them in 1997. 

 The metrics we will describe below are the foundation of The Applied Finance Group's stock selection process. We have tracked the performance of each of these metrics since 1997 and will illustrate the value that each one creates.

 Valuation - Using AFG's modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's valuation metric is used as the starting point for all of our investment decisions as it is backed by AFG's Economic Margin methodology.

 AFG default valuation model builds forecasted financial statements using analyst EPS forecasts as a starting point.

 When building these forecasts, a user can simply define three value drivers to help simplify the forecasting process: Sales Growth, EBITDA Margin, and Asset Turnover. By using these metrics, we can create an income statement, balance sheet, and cash flow statement relevant to our forecasting needs. Using this financial data, we would like to answer three important questions:

 What is the cash flow generated by the company's operations?
How much capital is required?
What are the opportunity costs of this capital?

 Answering these questions gives us a fundamental understanding of the wealth creation or wealth destruction of a firm in a given fiscal year.

 This methodology can be very useful to a research process - the quantitative model that can be administered to create default valuation models for over 4000 companies in AFG's universe can be helpful for identifying which companies look attractive through this broad framework. From there, an analyst can conduct his or her own research on a stock by creating user-defined forecasts within the system to create a target price based on personal assumptions. 

 The chart below illustrates how well AFG's valuation metric has worked at identifying winners and losers in the market. A significant spread has been achieved over time by separating the most undervalued, most overvalued and the Russell 1000 universe.

 Management Quality - One key element in determining a good long-term investment is the ability for management to make good strategic decisions. AFG's Management Quality variable is used as an exclusionary variable to eliminate companies with wealth-destroying management strategies from your list of candidates.

Evaluating Management:

• Assess the companies Economic Margin.
• Evaluate the ability for a company to sustain historical levels of Economic Margin performance.
• Build out future cash flows to better evaluate expected future performance relative to their peer group.
• Look at investment prospects of firms and review how they are growing or shrinking their business.

The chart below illustrates how well AFG's Management Quality variable works to help avoid firms with wealth-destroying management teams and strategies.

  Earnings Quality - AFG's Earnings Quality variable is an important indicator of companies that may be more likely to have negative earnings surprises and underperform due to high amounts of accruals. With many firms under pressure to meet sales expectations in the current environment, it is important to watch out for those firms that may be trying to pad their sales numbers, ie. Channel stuffing (sending excess inventory to stores that cannot sell their products).

 Earnings Quality: Accruals

 ·An accrual is the difference between Cash Flow and Net Income.

·Net Income = Cash Flow + Accruals

·Low Accrual companies outperform high accrual companies

Two ways to approach accruals:

1. Cash Flow Statement

·Difference between Net Income and Cash Flow

2. Balance Sheet

 
·Change in Net Operating Assets from Period t-1 to t
·Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

The chart below shows the effectiveness of AFG's Earnings Quality variable to eliminate companies from your focus list that have a high level of accruals and are more likely to experience negative earnings surprises.  

Buy Criteria - AFG's Buy criteria takes into account all of the variables we have discussed above into one metric. The chart below illustrates the spread achieved by only including companies that met the Buy Criteria relative to the rest of the Russell 1000 universe.

If you would like to learn more about this process and you are a professional money manager, please email us at info@valueexpectations.com for complimentary trial access to a more robust platform that allows portfolio managers and analysts to build pro-forma models, screen on our proprietary variables on over 4,000 companies in the US and 30,000 companies globally, as well as assist with daily due-diligence to make your process more efficient.