Stock Insights

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.

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.

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.

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.

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.

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 Applied Finance Group's (AFG's) framework and approach for measuring corporate performance and valuation is what sets us apart from other research providers. The AFG valuation framework has proven through vigorous back-testing to be successful at identifying companies likely to outperform index and sector peers. In the last 12 years, the spreads between companies we have labeled Strong Buys and companies we label as Strong Sells is approximately 20%. As such, by focusing on companies that rate highly according to our valuation model and other key AFG metrics, investors can set themselves up for outperformance and avoid potential torpedo stocks.

While we outperformed the market by almost 300bps in the third quarter, September was a far more brutal month than we would have expected given the concentration of high quality businesses that make up the bulk of our portfolio and the large cash position we have held. Correlation and volatility remain extraordinarily high. Cryptic statements from Ben Bernanke (and the even more obtuse European leadership consortium) carry far more weight than underlying company fundamentals in today’s “risk on, risk off” trading environment. When the noise becomes loudest, we find it most useful to get back to basics. We’ll spend a portion of this effort discussing the current market environment, but the bulk is dedicated to a fundamental discussion of our four largest equity positions which make up approximately 23% of our equity separate accounts.

The S&P500 has experienced a rough patch in the past 6 months falling 7% over that time period amid worries that the U.S. may fall into a double-dip recession and the debt crisis in Europe. That said, the negative returns of late may have created some buying opportunities for some quality companies that have been beaten up along with the market. These companies are termed "fallen angels" because they have suffered a short term setback but still appear to be well ran businesses that look attractive for the long term, and are poised to reverse that trend of negative returns. As banking opportunist Baron Rothschild recommended, often times "the best time to buy is when there is blood on the street". Today we will identify some companies which have delivered returns that have lagged the returns of the S&P 500 over the past 6 months and 1 year horizons that look attractive going forward.

ValueExpectations.com sets out to understand and identify the growth that a company needs to generate (implied sales growth) over the next 5 years in order to justify the company's current stock price. Measuring the spread between a company's expectations for sales growth and what it has historically delivered will give you a good idea of which one has the best chance of beating those expectations, and thus is more likely to outperform. AFG's Value Expectations provides a convenient way for money managers to easily unlock the expectations currently "priced-in" to an individual company or on an aggregate basis for an entire industry, sector or index. Applying this technique for an entire index is a good way to tell if the index, as a whole, is overvalued or undervalued. In today's letter we will analyze the embedded expectations in the S&P 500 Index to see if "expectations" are high or low, relative to the growth the index has achieved historically.

It almost goes without saying that whenever a merger or corporate buyout is announced subsequent reporting will center on the anti-trust implications of such a combination. Though corporations are in theory acting in the best interests of their shareholders, the existence of anti-trust lawyers means that does not always pass muster with the Justice Department. This sad reality reared its ugly head yet again yesterday with the Department of Justice's decision to block the AT&T/T-Mobile merger. Much like Microsoft over a decade ago, and A&P nearly 70 years ago, AT&T was damned no matter its future plans for the merged entity by an utterly confused DOJ. Assuming the blocked merger would have led to greatly reduced wireless prices for consumers or, in the reverse, higher prices due to allegedly enhanced pricing power, a schizophrenic Justice Department would have blocked the deal either way. For the broader economy, just another body blow among many restraining its natural evolution.

Over the past year, large-cap dividend paying stocks have done well as investors have flocked to blue-chip companies for safety and stability. This strategy is put into place as uncertainty accumulates in the market and money managers attempt to hedge against risk and offset losses. With the economy showing no signs of a surging recovery any time soon, one way investors try to offset losses is by implementing a strategy of buying safe and well managed dividend paying companies to provide some stable cash flow, while keeping some exposure to the equity markets. Why is this strategy effective? 1. Since 2000, dividend-paying stocks have done better than their non-dividend paying brethren. More specifically, in the last 25 years, dividend payers have outperformed Non-Payers by around 30% over the long-term.