CEDC

James Glassman of MSN Money provided a list of the 25 best performing stocks of the past decade and says the list is a good starting point when looking for the best stocks of the next decade because of their solid past performance. Although ValueExpectations does not share the same sentiment regarding past performance, we set out to analyze the top performing stocks of the last 10 year to determine which companies are most likely to continue their impressive run.

In a time of much volatility and uncertainty in the market many investors look for safe hiding in more defensive stocks such as tobacco, food and utilities. Other investors try to indentify companies which they believe might have a competitive advantage against their competition in order to withstand hard times. Warren Buffet has even coined the term “Economic Moat” which measures the competitive advantage a company has over other companies in the same industry.

What both of these concepts have in common is that investors have assigned a value on the expectations of future cash flows. For example, the expectation on defensive stocks is that cash flows will not suffer as much because the demand for these products will hold up better than the rest of market. Investors who seek companies with competitive advantages believe that future cash flows will not be impacted as much because of their ability to fend off competition. But what investors need to be careful of is not to make the mistake of overpaying for these sets of cashflow streams and remember that what really creates shareholder value is the spread a company earns above its cost of capital.

Since 1995, The Applied Finance Group (AFG) has combined these concepts into its Economic Margin (EM) framework. The EM measures the spread a company is generating above (or below) its cost of capital and incorporates the widely accepted economic principle that competition will compete away excess returns over time.

We have all witnessed the effects of competition in various industries. For example, back in the 70’s, IBM pioneered the creation of computers; today there are dozens of manufacturers ranging from Apple, and Dell, to Toshiba. But looking at profitable firms on a broader scale, AFG did a study looking at the median Economic Margin for the top decile of companies (about 4,500 firms) in 1997. When we look at those same companies today, we can see that the median EM for this group has fallen to 5.54%.

AFG’s research has identified four factors that determine the decay rate of EM levels

-Profitability
-Volatility
-Trend
-Size

By examining these four factors, each company in AFG’s universe has its own decay rate which is translated in to a Competitive Advantage Period (CAP). A CAP basically determines the number of years a company will be able to generate returns above its cost of capital. This allows AFG to address the issue of perpetuities associated with other VBM’s. Once a company with positive EM’s reaches an EM of zero (over its CAP) at that point those cashflows can be discounted to formulate an intrinsic value. The result of this process allows AFG to identify companies that are trading below their intrinsic value with the added transparency of comparing CAP’s and Value Expectations assigned to firms cash flows.

For those investors looking for companies in defensive sectors with a longer than average CAP, these three companies fit that criteria with the added bonus of having lower sales growth expectations imbedded into their stock price than what they have been able to deliver in the past.

Defensive Stocks with Above Average CAPs