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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.

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The Applied Finance Group (AFG) works with some of the most well respected investment firms in the U.S. to help them develop quantitative screening processes to identify a better pool of companies to choose from for their portfolio holdings. However, picking winning investment opportunities isn’t the only value AFG provides clients. AFG also develops quantitative strategies to quickly identify possible torpedoes lurking in your client or prospective client’s portfolio.

AFG’s quantitative process is centered on the proprietary Economic Margin (EM) Framework (what a company earns above its true cost of capital). The core of AFG’s quantitative process starts with evaluating corporate performance and the expected improvement relative to their peers, evaluating the valuation attractiveness of the company, and determining if a firm is following a wealth creating or wealth destroying strategy.

A brief description of those variables is available below the list of companies.

When identifying potential torpedoes AFG looks for companies with the least valuation upside compared to their sector peers, below sector median expected Economic Margin change, and a management quality score that reflects a management team following a wealth destroying strategy.

These 20 S&P 500 companies from every major AFG defined sector (ex. Financials) are potential torpedoes that could be lurking in your portfolio. These companies all possess characteristics that make for a bad investment opportunity. If you own one of these companies or consider adding one to your portfolio, we suggest taking a closer look as they look the most likely to underperform their sector peers according to criteria that has proven successful at identifying winners and losers in the market.

If you are a professional investor and would like to learn more about AFG’s EM methodology, investment criteria or stock selection process click here to register to trial the product.

     Source: EconomicMargin.com

AFG's Valuation Metric – Measures the percent to target (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 (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

+View our List of Value Expepectations Recommended Articles

AFG Recommendation Performance
9/1998 – 5/2009
Annualized Returns

Other Market Related Articles of Interest

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

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

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Since March 9, 2009, the S&P 500 experienced quite a recovery, going from 676 to 813, or just over a 17% rebound. To put that into perspective, the market historically delivered 8% average annual returns. In the table below we provide a list of the top and bottom 10 performers since the March 9th rebound began, to give you an idea of who the new Bulls and Bears are. In the list you will find each company’s attractiveness from a valuation standpoint, as well as an analysis of sales growth expectations imbedded in these companies’ stock prices. Compare the expectations for sales growth to what they have delivered historically to see which stocks on this list are most likely to meet or exceed those expectations, and thus be more likely to out-perform. This list contains companies from the S&P 500 excluding all financial companies.

Top & Bottom Returns (S&P 500 excluding financials) Since March 9, 2009

*Scott Goto Arts

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future sales growth of companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.