BA

A list of the 25 top performing stocks of 2010 (ex. Financials) from within the S&P 500 index. We have taken the top 25 companies from 2010 and provided our readers 3 attractive and 5 unattractive stocks from this list based on their valuation attractiveness relative to sector peers and overall investment opportunity using key criteria that The Applied Finance Group (AFG) uses in its stock selection process including corporate performance, management quality and earnings quality to see which of the top performers still look to have upside and which look like they have run out of room to run.

Understanding the amount of accruals a company has on its books and the quality of its reported earnings is especially important during earnings season, as poor earnings quality companies are more likely to have negative earnings surprises and underperform as a result. With so many companies reporting earnings this week, we wanted to share an analysis of their earnings quality based on The Applied Finance Group’s Earnings Quality score. AFG’s Earnings Quality variable is based on the concept of accruals and is an important indicator, which helps to differentiate between companies with poor and high quality of reported earnings. Watch out for firms with poor EQ score – make sure they are not trying to pad their sales numbers through channel stuffing, for example.

 

*Source: www.afgview.com

 

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.
• Low Accrual companies outperform high accrual companies
 

 Here is a look at how well the Earnings Quality variable works when you split top half vs. bottom half in each sector/style universe.

Source: AFGView client databases from 9/1998 - 5/2009   Universe size: 4,000 to 5,500 firms

 

Here is a look at an example of a poor Earnings Quality company that has a negative earning surprise and thus underperforms.

Eastman Kodak

• Other Liabilities declined in Q308, leading to high accruals – change in licensing agreement required immediate recognition of deferred revenue.
• Eastman Kodak (EK) subsequently missed earnings in Q408.
• EK’s stock dropped 29% on January 28th, when Q408 earnings were announced.
• EK has underperformed the S&P500 by almost 70% since January 28th.
 

source: www.economicmargin.com

With a major week of earnings right around the corner, we thought it would be useful to our readers to provide an analysis of the companies set to report in the first half of next week. This analysis contains a breakdown of each company's default recommendation according to AFG's Buy/Sell criteria, a look at their valuation attractiveness, and a look at the direction their Economic Margin's are expected to head in the upcoming year. The three companies that look the most attractive based on these criteria are Pfizer, Advanced Micro Devices and Boston Scientific.

A company's Economic Margin (EM) is a measurement of a their true earnings above or below their cost of capital. EM also corrects distortions caused by accounting policies to give a more accurate assessment of a company's real value. It is important to understand the direction a company's EM's are heading because, by knowing this, one can get a complete assessment of how profitable a company can be in the future. The EM Framework addresses profitability, competition, growth and cost of capital. When factoring in each of these variables, investors can fully assess a company's value. 

Below is the list of companies reporting earnings in the first half of the upcoming week along with a closer look at Boston Scientific:

 According to the chart below, BSX's intrinsic value is above its current stock price, which leads us to believe that Boston Scientific is undervalued right now. 

 According to the Wealth Creation chart below, BSX has shown a positive Economic Margin and is forecasted to improve that margin in the upcoming year.

Source: Www.EconomicMargin.com 

AFG's Buy/Sell criteria factor 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.

AFG's default valuation is a good place to start because it is a simple metric that gives a more accurate outlook on a company's value while correcting distortions.

 

- - - - - - - - - - -

 

AFG’s Intrinsic Value Chart identifies how far a stock’s intrinsic value (target price assuming immediate decay) deviates from its trading range, which helps you recognize potentially mispriced stocks and pursue long and short opportunities.

• The blue bars represent the high and low trading range for a stock for 1 year.
• The red dotted line represents AFG’s historical Intrinsic Value through time.
• When the red line (Intrinsic Value) is above the blue bars (trading range), the company looks to be undervalued.
• When the red line (Intrinsic Value) is below the blue bars (trading range), the company looks to be overvalued.

AFG’s Intrinsic Value Chart also contains a company’s Value Score (ranked valuation attractiveness), Economic Margin Change (expected increase/decrease in economic profitability), and Accuracy score (how well AFG’s default valuation has tracked the company).

Wealth Creation Report: displays a company’s Economic Margins (what a company earns above or below its cost of capital) through time as well as a projection of their expected future levels. The second graph shows how a company has grown their assets over time and also contains a projection of how they will grow their assets next year. AFG’s view on wealth creation starts by looking for profitable companies that are also growing their assets to make the most of that profitability.

Investment Insights from your peers, Professional Investors - The Applied Finance Group would 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. 
Click here to learn more

 

 

 

Fortune magazine recently put out an article listing the most admired companies in the world.  We took the top 50 firms (excluding Financials, and companies not traded in the US) on their list and put them through Applied Finance Group's quantitative recommendation framework.  Just because these firms are among the most admired companies in the world does not qualify them as the most attractive investment. Being among the most admired is an honor and means you must be doing something right, but might not necessarily mean the share price is currently attractive. 

The following articles which we have posted in the past on ValueExpectations.com will give you a better understanding of what it takes for management to create wealth, understand Management Quality, and see how EPS alone falls short in estimating a company’s value. There are two main characteristics a company must have in order to be a good investment opportunity: (1) the company needs to be a strong economic performer, (2) the company should be attractively priced.   Many people admired the DeLorean, but it was neither a good performing car nor a good priced car. Below we reveal a few "DeLoreans" after looking under the hood.

 

Top 50 Most Admired Companies According to Fortune

In Joel Greenblatt’s 2006 book, The Little Blue Book that Beats the Market, he presented his “Magic Formula” used in his hedge fund, Gotham Capital. Mr Greenblatt tested his formula between 1988 and 2004. The results were incredible, with only one down year, the magic portfolio would have returned 30.8% a year, against a 12.4% annual return for the S&P 500.

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. He also recommends one year holding periods, so we thought this would be a great time to get this list out. 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. Below is a definition of each variable.

Variable 1: Return on Invested Capital = EBIT / (Net Working Capital + Net Fixed assets)

Variable 2: Earnings Yield = EBIT/EV

The table below shows the top 30 firms with their market implied sales growth expectations. Enjoy!

 

According to Forbes.com, Cramer and a few other financial blog-sites the following qualities are usually found in stocks that do well in economic downturns of extended time periods.

• Consumer necessities
• Ability to pay a dividend
• Ability to add employees as other firms cut back
• Productivity increases as market goes down
• Healthcare stocks
• Legacy Companies – high quality company with long business history
• Involved in Military
• Oil industry
• Infrastructure
• Companies that sell used goods
• Generic products
• Overseas exposure

The following companies all have one or more of the above qualities to help them survive and perform well in an economic downturn. This table provides the implied 5 year sales growth priced-in to the stock to justify its current price along with the 5 year median achieved sales growth. Compare the revenue growth priced-in to what the company has been able to deliver in the past 5 years to see if the expectations are reasonable enough for the company to meet. Companies with reasonable expectations compared to what they have achieved are the most likely companies on the list to out-perform.

Stocks with Recession Resistant Qualities & Sales Growth Expectations

 

 

EQ is important in this current market environment because so many companies are feeling pressure to meet their sales expectations. Many companies are channel-stuffers, which is one form of accruals that often leads to negative earnings surprises. A recent poster-child for this example of sending excess inventory to stores that could not sell their products would be Crocs and the way they tried to pad their sales numbers.

Earnings Quality: Accrual

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

•Net Income = Cash Flow + Accruals

•Low Accrual companies outperform high accrual

 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.

 We screened the  S&P500 to identify those firms with the worst EQ scores. The score is given from 1-100, 1 being the best EQ company, 100 being the company with the highest amount of accruals and the worst EQ. Because high EQ companies are more likely to have negative earnings surprises, this is a group of companies you may want to avoid. The EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

After running our screen we identified 14 firms as the worst Earnings Quality firms. You can set yourself up for success and save time by narrowing your list of constituents to only those that meet our standard valuation, Economic Margin and Management Quality checks and following that up by filtering out those companies most likely to have negative earnings surprises (high EQ). The Chart Below identifies the firms that met our screen criteria, along with the EQ score and our VE analysis.

 

Worst 10% Earnings Quality Companies In the S&P 500

 

 

Universe Size: 4,000 to 5,000 Firms

Source: Applied Finance Group Database from 9/1998-5/2008

 This variable does not add any value for companies within the financial sector and those companies are automatically screened out when using this variable.

Recently we also screened the S&P 500 to identify investment opportunities and identified over 150 companies (industrials) that have negative sales growth expectations embedded into their current market valuations. These companies include high quality companies such as: COH, DOW, CAH, TGT, JNJ, UTX, SBUX, and WAG, among others. If you would like to Read our study Click Here