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ValueExpectations.com emphasizes evaluating a company’s ability to earn a spread above their cost of capital using a very robust measure of corporate performance, Economic Margin. After evaluating a firm’s ability to create wealth VE.com then determines what price we are paying for the company using a modified discounted cash flow model. If we had to simplify performance, a very elementary way to evaluate performance can be Return on Invested Capital ROIC and valuation which can be simplified by using earnings yield. This is the approach Joel Grenblatt uses in his book, The Little Blue Book that Beats the Market.

In January VE.com highlighted a list of stocks based on Joel Greenblatt’s Magic Formula Investing Strategy from 1998-2004 Greenblatt’s simulated returns were 30.8% a year, relative to a 12.4% annual return for the S&P 500 and was only down in one year in that time-span.

In our article posted on January 9, 2009 we listed our best 30 “Magic Formula” companies which has earned returns comparable to the tests conducted by Mr. Greenblatt. From Jan. 9, 2009 to Dec. 14, 2009 the 30 companies we recommended from our “Magic Screen” have returned a solid 32.06% spread above the S&P 500. Since our last “Magic Formula” portfolio was successful we have decided to run the screen again for a new list of companies to see just how consistent this strategy is.

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A look at Greenblatt’s formula for successful “Magic Formula Investing”:

1. Establish a minimum market capitalization (usually greater than $50 million).

2. Exclude utility and financial stocks

3. Exclude foreign companies (American Depositary Receipts)

4. Determine company's earnings yield = EBIT / enterprise value.

5. Determine company's return on capital = EBIT / (Net fixed assets + working capital)

6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).

7. Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.

8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

9. Continue over long-term (3-5 year) period.

Mr. Greenblatt was a student of both Ben Graham and Warren Buffet and tried to include valuable insights from each investor in his “Magic Formula.” His Magic Formula was a screen that percentile ranked two variables: Return on Invested Capital (quality) and Earnings Yield (valuation). The idea is simple, buy the best companies at the best price and then hold on to them for one year. The Little Blue Book recommends selecting the top 30 firms from the “Magic Formula.” That formula ranks each company by variable and then puts a 50% weight on each.

 Click Here - If you are a professional investor and would like a review of your portfolio by an AFG representative or to discuss companies AFG find attractive that fit your investment style.

To stay updated on companies AFG believes are attractive investment opportunities register for ValueExpectations.com It's Fast and Free! 

About the AFG Screener

Professional investors have many ways to screen and narrow their list of constituents to create a focus list of companies they use to select from to develop their portfolios. In the industry, there are many screeners that are part of subscriptions to databases and investment tools, however, many of them do not provide guidance on the best screening methods to use. Created by The Applied Finance Group (AFG), the AFG Screener tool is a web-based company-screening application located on AFGView.com that is designed to save you time when narrowing your list of constituents. More importantly, AFG’s screener allows you to use proprietary variables that have been proven to outperform, helping investors make better investment decisions.

AFG’s Screener allows clients to find aggregate groups of companies that meet specific criteria from AFG’s entire global universe of over 14,000 securities. Using the Screener, one can find a list of companies that either match one of AFG’s preset screens or one based on a customized screen that you create.

The AFG Screener identifies attractive valuations, strong management teams, corporate performance, and the quality of earnings of a company as well as all traditional financial variables,

Because AFG’s Screener is web-based, clients can gain access from anywhere that has an internet connection, convenience and ease of “one-click screening” with our default screens, various forms of result presentations, and compatibility with Microsoft Excel for further analysis.

How to Use AFG’s Screener

Access AFG custom built screens that many clients regularly utilize that include AFG’s proprietary Economic Margin (EM), valuation and management quality variables along with many others.

Build your own custom screens using any variables you are familiar with such as price multiples and other accounting information by themselves or coupled with powerful AFG variables with just a few clicks of the mouse.

Once you have narrowed your list of constituents to those companies that meet your specific criteria you can easily upload your new list into AFG’s valuation model to analyze each company in greater detail or see how they rank vs. their peers on key AFG variables.

Default / Custom Screens

Whenever a new user is introduced to AFG’s Screener, they are provided with two default screens – AFG’s Default Buy screen and AFG’s Default Sell screen. Using these screens, one can filter companies based on AFG’s buy/sell criteria.

However, the AFG Screener is very intuitive allowing clients to create their own screens based on custom criteria. There are countless combinations that can be used to create a custom screens, as there are over 600 variables to choose from. AFG’s Screener tool can be used to list companies based on Indexes, Sectors, Industries, and previously created Portfolios.

Using Excel / Further Research

AFG screens can also be accessed using AFG’s Excel add-in to combine results with other spreadsheets or to create a report for your investment team. Exporting your information will give you more freedom to read, organize and document your data as well as pull in other variables within AFG’s Excel add-in to easily rank order your list of companies based on the same variables available within the screener.

Example Screen:

Below is a list of 12 companies that resulted from a quick screen that sought to identify those companies within the S&P 500 with attractive valuations, market cap above $1 billion, expected to improve EMs greater than sector peers, and that have a current stock price of under $30. Improving EMS and an attractive default AFG valuation rank is a good place to start when looking for the companies most likely to outperform. This is just one simple example of the capabilities of using AFG’s screener tool to select a focused list of stocks that are the most likely to outperform and a list that is worthy of more time spent on due diligence on the companies that meet the specified criteria.

The Applied Finance Group would also  like to invite professional investors to join AFG’s Market Forecast Project so you can better understand what your peers currently think about the market and cultivate the “wisdom of Crowds” into actionable investment ideas and themes.

Register to View Complete Market Review and Sector Analysis, it's FAST and FREE!

Healthcare reform has been a hot topic of discussion in the news and on blogsites all over the country as the Obama administration mulls over whether or not a public option for healthcare makes sense and what a plan like that would entail. Any new reform to the current healthcare plan would have a great effect on stocks within the Healthcare sector. Below is a list of stocks we find attractive and a few that we find unattractive within the S&P 500 Health sector. The chart consists of each company’s attractiveness as an investment opportunity using The Applied Finance Group’s (AFG’s) buy/sell criteria (explained below), and also grades each company based on expected Economic Margin (EM) change and valuation ranks within the sector. Companies expected to improve EMs and that have a more attractive valuation than their sector peers have proven through backtests to be more likely to outperform than stocks AFG views as overvalued and that have an expected decline in EMs.

Source (The Applied Finance Group)

*Valuation & EM Change are Ranks within their sector

AFG's Buy/Sell Criteria - factors in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the deviation between a stock's current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model.

Recently The Applied Finance Group, LTD provided rankings for CEO Magazine to identify the greatest wealth creating and wealth destroying CEOs in the S&P 500. In the spirit of the upcoming Super Bowl between the Arizona Cardinals and Pittsburgh Steelers, we would like to compare companies in the two respective states to see which state’s CEO is the best wealth creator.

AFG’s scoring methodology is based on its proprietary Economic Margin Framework that sets out to correct accounting distortions and properly understand the market expectations priced into a stock. Most investors understand the concept of Earnings Per Share (EPS) and are happy with the stocks they own that have the ability to grow earnings. AFG’s Economic Margin methodology shows us that earnings are important but are not sufficient to properly measure a company’s operations. AFG looks past earnings to evaluate the profitability and growth (wealth creation) of the entire operation of a business.

Economic Margin (EM) is defined as EM = (Cash Flow - Capital Charge)/ Productive Capital. In simple terms, EM seeks to measure the ability of a company to make money in excess of a risk-adjusted cost of capital. AFG used a multifactor ranking system that combines series of scores to determine a winner in each state. The system evaluates the ability of companies to sustain their historical Economic Margin performance, forecasts expected Economic Margins benchmarked against their peers, and systematically grades management. Based on those criteria, AFG has selected 6 good companies from each state.

However, if you consider investing in any of those companies, please note good companies are not always good investments. There are two components to look at for any investment: the ability of a company to create shareholder value and the attractiveness of its share price in the market. There are times when a well ran business that creates wealth is not a great investment. Investors must understand the embedded expectations they are paying for that performance and determine if those expectations are realistic for the company going forward.

 Arizona Super Bowl Companies with Sales Growth Expectations Implied by Current Trading Price

  Pennsylvania Super Bowl Companies with Sales Growth Expectations Implied by Current Trading Price

*Assuming a constant 5 year median EBITDA margin for each company.

*Assuming a constant 2007 EBITDA margin for FSLR.

Generally speaking, companies with pessimistic VE sales growth relative to their 5 year median sales growth are considered undervalued from AFG’s perspective, such as PETM, RRR,FCX, APOL from Arizona, and ABC, UGI, CEPH, from Pennsylvania.

And the winner is....

Cephalon Inc (CEPH) -CEPH has been a very profitable company in the last three years with very stable economic margins, much like the Pittsburgh Steelers who won the Super Bowl just three years ago. Based on AFG’s forecast, it appears that CEPH is in position to maintain its economic profitability while continuing to grow its assets.

First Solar Inc (FSLR) – FSLR is a solar module designer and manufacturer located in sunny Arizona. Helped by the growing public attention and support to alternative energy, the company has done a nice job of turning their business around from earning below their cost of capital to a high level of profitability.

 

In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

Using AFGView.com, we screened for firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet