Value Expectations's blog

Understanding the embedded expectations in stock prices, or what a company needs to deliver in revenue growth over the next 5 years in order to justify current stock prices, helps investors better understand whether a company's valuations are rich or low. By understanding a company's embedded expectations clients can develop a "hurdle rate" to quickly determine if a company's expectations are realistic. AFG's Value Expectations interface uniquely enables users to "solve" for the performance expectations a company must deliver in order to justify its current stock price. Our research indicates that companies with low embedded expectations tend to outperform the market, while those with higher expectations tend to underperform. Today we will apply this methodology to every stock within the S&P500 to assess the overall valuation of the index and also at the sector level to identify which sectors appear the most and least favorable accordingly.

As is well known now, Federal Reserve transcripts released last week confirmed that Fed Chairman Bernanke was caught unaware by the brewing mortgage storm that rocked many of the banks his Fed is charged with overseeing. As Bernanke put it in 2006, "So far we are seeing, at worst, an orderly decline in the housing market." Bernanke went on to note that a cooling of the housing boom was a "healthy thing." Fed critics from the left and right will doubtless seek to use Bernanke's utterances as weaponry meant to further discredit a Fed Chairman who is expert at always being wrong, but they'd be unwise to do so. Instead, they should use Bernanke's musings to explain in more confident terms why the Fed's presumed regulatory mission is a total contradiction.

Corporations around the globe are constantly under pressure to meet sales expectations, which makes it very important when looking for investment opportunities to watch out for those companies that may be trying to pad their sales numbers in various ways, ie. Channel-stuffing (sending excess inventory to stores that will not be able to sell their products). AFG's Earnings Quality variable helps investors identify companies that are likely to miss earnings by studying the components of their current earnings. Professor Richard Sloan pioneered this research, and concluded that companies whose earnings consists of a disproportionally high percentage of accounting accrual rather than cash flow are likely to suffer earnings reversals in the future.

Thanks to an explosion of Keynesian deficit spending around the world, an explosion that has predictably correlated with weak economic output, major ink is being spilled about the economic crack-up unfolding before our eyes. To state the obvious, wasteful, capital destroying governments can only spend what they first extract from the private sector. In the above sense government spending is always and everywhere an economic retardant. That's the case because governments by definition are not disciplined by profit, thus explaining spending that merely consumes capital. Conversely, a private sector that is burdened by profit demands must as much as possible deploy capital with an eye on creating more of it. Put simply, capital placed in the hands of politicians disappears, while capital placed in the hands of private actors frequently leads to innovations that allow the proverbial impoverished shoemaker to purchase equipment that expands his shoe output. Whether governments are in deficit or surplus mode, their spending nearly always weighs on economic output.

Often times heading into a new year, financial blogs and websites tend to provide lists of the best stocks to own in the coming year. We will take a slightly different approach and provide some companies to our readers that look overvalued and overall look like poor investment opportunities for 2012. While we spend a significant amount of time providing lists of attractive investment opportunities for our readers, we also understand that it is just as important for professional investors to be able to avoid potential torpedoes in the market as it is to discover the next investment opportunity poised to hit a home run. Today we will list 15 large cap companies from the S&P 500 that we deem to be potential torpedoes.

It has been a rocky ride for the equity markets in 2011 filled with volatility and confusion about where the market is headed on nearly a daily basis. With just a few days left in 2011 it is time to identify which stocks have been driving the markets so far this year. We are providing a list of the top 20 performing stocks in the S&P 500 index to keep up to date on which companies have led the way thus far. The returns listed are the total return (including dividends) the company has delivered as of last Friday's close and the index in comparison has delivered a return of -4.16% so far YTD.

In an economically-themed speech last week in Kansas, President Obama revealed for all to see just how divorced he is from reality, and why his departure from the White House in 2013 is essential. It's not that we can't recover from another Obama term - that's the easy part - but that as a serious nation we can't have a president who possesses such unserious views. Call it a pride thing. Though Obama acknowledged up front the certain wonders of free markets, he only threw out the initial bouquet to decry those same unfettered markets. As he put it, "the free market has never been a free license to take whatever you can from whomever you can," as though those who participate in the marketplace on the way to great fortune somehow took from others in doing so. Really?

Every week we provide dozens of stocks having characteristics that over time tend to beat their respective index benchmarks and thus warrant consideration if you are a professional money manager or active in equity markets. Most of the articles that we post tend to focus on helping our readers identify high quality companies that are attractively priced, however a large part of that process begins with eliminating companies from our focus lists that look likely to underperform index and sector peers. The ability to understand a company's management strategy and its ability to create wealth for shareholders is essential in the research process. As such, the Management Quality score developed by The Applied Finance Group (AFG) provides investors quick insights into company's ability to make wealth creating decisions and helps eliminate wealth destroying firms from your list of constituents.

By now most readers are familiar with an exciting energy innovation called hydraulic fracturing, or the shortened word used to describe it, “fracking.” The energy extraction technique has led to major natural gas discoveries stateside, not to mention petroleum finds that have many Americans confident about easy, domestic oil access as far as the eye can see. About energy exploration, it should be said up front that this column in no way objects to it occurring anywhere and everywhere. And while all energy subsidies – brown and green – should be abolished with great speed, to the extent that private investment exists to support the sourcing of energy, the federal government should get out of the way. All that said, it says here that the excitement underlying fracking is overdone. Though all technological advances are something to embrace, for individuals to be exuberant about fracking amid a world awash in oil is the equivalent of Americans dancing in the streets over new techniques discovered for the easy manufacture of t-shirts.

So far in 2011, as investors remain wary of a true economic recovery it is not a surprise that companies which pay a decent dividend have done well. Investors have sought out safety and stability through well managed dividend paying companies to provide some stable cash flow, while keeping some exposure to the equity markets. While there have been some positive signs of life relating to a potential economic recovery, such as the recent market rally as well as lower unemployment numbers, there is still plenty of uncertainty amongst money managers. While it is often the case that investors give up some of the potential for growth by focusing on stable dividend payers, dividend payers have tended to outperform non payers during bear markets and times of economic stagnation in the past. In the chart below we have broken down the S&P 500 into quintile groups based on dividend yield. This chart illustrates that the companies in the top quintile of dividend payers (highest yield) have done very well so far this year.

In business school in the late '90s, like just about everyone else in my class I attended a speech given by Morgan Stanley's then CEO. Thanks to a strong dollar and relatively low taxes at the time, Wall Street was booming and Morgan Stanley was seen by most as one of the premiere jobs for an MBA student to secure. Of note, the Morgan Stanley head stressed that as seemingly everyone desired San Francisco as a place to work, that better hiring options existed in other locales. In particular, so desperate was Morgan Stanley for India hires that he told anyone interested to approach him after his presentation. The latter anecdote is notable considering all the talk within the commentariat - including articles written for RealClearMarkets - about California's certain decline. Supposedly high taxes, claustrophobic regulations and nosebleed spending are authoring its imminent demise; one that began with great speed several years ago.

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.

For the past four years The Applied Finance Group has used our Economic Margin methodology to evaluate the best and worst wealth creating CEO's in the S&P500. The companies that hit the top of this list are considered "best of class." However, it is also important to consider the expectations that are priced into each of these companies and their overall valuation attractiveness which are not part of this analysis. Apple Inc.'s visionary CEO Steve Jobs created extraordinary value for shareholders-but four lesser-known CEOs were even more valuable over the past three years. Express Scripts CEO George Paz earned the title of Most Valuable CEO, followed by Exelon CEO John W. Rowe. Priceline.com CEO Jeffery H. Boyd was #3, Varian Medical Systems CEO Timothy E. Guertin was #4 and Apple CEO Steve Jobs ranked #5. This is the fourth year Chief Executive magazine and ChiefExecutive.net have published its Wealth Creation Index, ranking the performance of S&P 500 CEOs. Created in collaboration with Great Numbers! and the Applied Finance Group, the ranking is based on four factors: (1) How good a company was at making real money (operating cash flow in excess of its risk-adjusted cost of capital), (2) Its prospects for continuing to make real money, (3) Its wise use of capital, and (4) How highly the market values the company's assets.

Over the last few years, The Applied Finance Group (AFG) has been developing a new quantitative tool that helps clients easily navigate our various Valuation, Momentum, and Quality metrics. The AFG Investment Grade, as we have named it, uses these metrics in a multi-factor model to rank all the companies within our universe of over 20,000 companies. Companies with the best scores receive an A, whereas companies with the worst overall scores receive an F. This grading system allows subscribers of our research to easily identify attractive investment ideas and avoid potential torpedoes.

The 'lost generation' angst of Generation Zero and the Occupy Wall Street movement that somewhat animates it is merely a repeat of the slacker GenX movement of the early '90s, and surely other economically downcast periods for young adults before then. Each time we hear that today's angry generation will underperform that of the parents, and each time this is a nonsensical illusion wrought by bad economic policy.