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With the biggest shopping season of the year just around the corner, we thought it would be timely to highlight some consumer sector companies that look attractive according to The Applied Finance Group’s (AFG’s) criteria for investment opportunity attractiveness, as they are in line to benefit from the upcoming seasonal spending patterns. The list of companies we have provided look the most attractive within the AFG consumer sector in terms of valuation attractiveness, economic performance, and overall investment attractiveness relative to their peers.

One of the companies that we feel particularly confident in is the retailer Kohl’s (KSS) which is currently a holding in The AFG 50, (a model portfolio of 50 large cap stocks designed to help Portfolio Managers save time, make more informed investment decisions, and outperform their benchmark). We are confident about Kohl’s competitiveness because they have a strong cash flow, strong execution, and have been outperforming their competition.

Going into this holiday season, consumers will most likely remain thrifty due to the overriding economic conditions, although their confidence levels have improved so far this year. They will search hard for values, being mindful of budget. We continue to believe Kohl’s will remain one of the most successful retailers in this country, as it strives to and succeeds in providing value to consumers with freshness and relevance of its merchandize.

The complete list of consumer stocks we have provided below, which includes the highlighted Kohl’s, are the companies AFG believes are the most likely to outperform. Companies that AFG identifies as having an attractive valuation, improving Economic Margins (AFG’s corporate performance metric) and an attractive investment opportunity signal have proven over time to outperform those companies with unattractive valuations, declining Economic Margins, and unattractive investment opportunity signal.

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.

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By David Lee Berkowitz

"No man's life, liberty, or property is safe while Congress is in session."
-frequently attributed to Mark Twain or, more occasionally, Will Rogers

The second quarter began with stocks rising. Stocks, corporate bonds and commodities all rebounded from what we think will be “generational” March lows. We probably won’t see those prices again in our lifetime.

But the run stalled in late May. The markets fell a bit from their highs in June. It’s one thing to rebound from a generational low, it’s quite another to make up all the lost ground. The asymmetry of returns guarantees that when you go down -50%, you must go up +100% to get even. We are still in the process of restoring our wealth, but we are on the right path. Had we panicked out at the bottom, I have no doubt that many of us would be sitting here wondering if it was the right time to get back in. The market is up around +50% from its bottom.

The long-term growth oriented ValueAligned® Folio account was up +14.2% gross (+13.9% net) in the separately managed accounts. For the year as of June 30, 2009, the ValueAligned® Folio accounts are up +5.2% gross (+4.7% net).

We are doing well because we have tweaked our investment process; we are taking profits sooner and adjusting position sizes to volatility – that way more volatile stocks will not hurt intermediate performance on the downside, but will still contribute to our goal of doubling our money (+100%) in five years on the upside.

Leading indicators of future economic prospects drove the stock market off its March lows. Leading indicators have continued to move higher over the past few months. Just as the rapid and sudden decline in leading indicators and economic prospects tanked stocks last year, this year's improvement is driving them higher. So far in 2009, early expansion factors have dominated returns. Technology, materials and consumer discretionary stocks far outpaced the other sectors.

We recovered most of the losses from some of our smaller consumer discretionary stocks from the first quarter of 2009, and many of the losses from 2008. As we discussed with you last quarter, we believed that our losses in our small special situation stocks like AC Moore (NASDAQ:ACMR), +161%, since March 9th low through June 30th, Borders (NYSE:BGP), +667%, and Tempur-Pedic (NYSE:TPX), +232% were unwarranted by their fundamentals. Many of these stocks traded way below fair value because of low liquidity and investors’ fear of leverage. Since we judged that these companies would survive the recession, their shares were too cheap to sell. Sure enough as financial conditions returned to pre-Lehman bankruptcy levels the stocks rebounded. BGP is up +892% year-to-date; ACMR is up +158%; TPX is up +109%; Coach (NYSE:COH) is up +42.5%; Fossil (NASDAQ:FOSL) is up +58% (as of July 31st).

The stress tests for the banks are now over, and private, as opposed to government capital, is available for some of the largest banks. As private capital went into banks, we saw a little pause in the rally through quarter end. Of course, the market continues to power ahead through the beginning of August. Until we have other reasons to doubt the rally we will remain invested – but with some dry powder to take advantage of lower prices when they come. At the end of July we were

about 85% invested in stocks of ValueAligned® companies and 15% in cash. We were overweight consumer discretionary, technology and healthcare stocks.

The “swing” chart (above) of the bear market starts at the high in October 2007. The “panic” stage of this decline started in September of last year when Lehman Brothers failed.

Notice the latest rally from the March bear market bottom of +41.1% on the chart at above - that’s the biggest rally so far in the bear market. But despite the rally, we are still down -39.0% from the top in 2007.

From Fear to Panic

The severe financial panic that came from the extreme uncertainty of outcomes from the Lehman Brothers bankruptcy and AIG rescue froze economic activity and caused one of the fastest and steepest stock market declines in history. Financial conditions are back to normal recession levels – the conditions that existed prior to the September panic.

The market downturn is now in its 19th month which makes it the longest bear market and recession since World War II. The drivers of the first part of the bear market were the downturn in residential construction, housing price declines and declines in personal and business consumption. That was reflected in the first nine months from October 2007 where the stock market declined by about -22%.

The driver of the second phase was the September 2008 Lehman Brothers bankruptcy which caused a run on the nation’s banking system and on its money market funds that provided liquidity to businesses of all sizes. Credit seized up and economic activity halted. Confidence has returned as trust at least among our financial institutions is slowly returning. The public’s trust is another story. That might take decades to repair.

True financial panic as reflected in stock market volatility has only occurred three times in the last century – 1929, 1987 and 2008. Here I am referring to a financial condition that produces intense fear where trust is driven from the system as participants - businesses, individuals and the banks themselves - don’t understand who is solvent and who is busted.

Panic Back to Fear

Keith Hays of Hays Advisory shows the difference between panic and fear. He points out that fear is a necessary condition for an extended bull market to begin. However, panic erodes trust so much that normal bear market bottoms can’t form and wholesale liquidation of stocks and every other asset starts a cascade price declines – severely and suddenly exterminating the balance sheets of shaky companies and scared consumers.

Normal fear is depicted between the two red lines in the chart above. These tops in volatility – a measure of the degree of uncertainty in stock prices – correspond to normal bear market bottoms. You can see from the chart at the left that sometime in the last three months panic has receded and normal fear is back.

We love normal fear. Many times normal fear is just a misunderstanding about the transition from a terrible economy to a recovering economy. Fear is paralyzing for those without facts and methods to make rational decisions. And fear is the essential ingredient for a new bull market to begin.

A huge market rally off an economic low point is always perceived as just another bear market bounce. The gains are dismissed because the stock market always sniffs out pending economic improvement faster than improving fundamentals appear – and the fear from the previous panic prevents rational action by most investors.

Leading Indicators Point the Way

Since stocks are a discounting mechanism for future activity there is always this lag between stock price performance and a company’s outlook. The lag is usually around six months – the time that Francois Trahan of ISI Portfolio Strategy says is the time between leading indicators and Gross Domestic Product (GDP - the economy). The ECRI Weekly Leading Indicator Annualized Growth Rate topped out in June 2007. Six months later the recession started in December 2007. Many are excited in stock market land because this indicator bottomed out in December 2008. If a six month period holds again, then the economy bottomed out in June or July 2009.

Better Second Quarter Earnings Tell Us That Better (But Not So Good) Economy is Approaching

After the financial panic, the U.S. economy reacted much faster to changes in the economic outlook than ever before. Companies stopped ordering new stuff. Manufactures shut down plants. Consumers stopped buying everything. Then they started buying only the most necessary value oriented goods.

Managements quickly reduced employment, capital expenditures, advertising, travel and unfortunately, the short-sighted ones, probably even cut growth capital investments like research and development. According to ISI, the economic and strategy advisors, management cut employment by a record -4.8% because it looked like we were sliding into depression. The magnitude of the lay-offs was about 35% greater than what the models predicted given the actual decline in GDP. We bet that the other cuts were deeper than ever before too.

During a recession, analysts beat down earnings expectations as corporations drastically cut costs. All through the winter and spring of this year, analysts slashed their estimates of earnings. But they seemed to be much slower in reacting to the shock than were the companies they follow. This dynamic set us up for this current earnings season.

After being beat up so badly at the beginning of the downturn, analysts became overly cautious at the bottom. Therefore, earnings reports typically beat stunningly low expectations this quarter, and then analysts started raising their estimates. It does not mean all is right with the world, but it does mean that investors have pushed many stocks’ prices so low that embedded expectations are way too low. Of course, that means that the market was grossly undervalued in the middle of March, at the beginning of the second quarter.

Look at the example of Texas Instruments (NYSE:TXN) below. The blue line is the stock price (right scale) and the red line is analysts’ estimates. Notice how the analysts’ estimate line is highly correlated with stock prices.

In July earnings for most companies came in much better than expected for the second quarter just ended. Companies are succeeding in cost cutting their way, if not to prosperity, then at least to much better than feared results.

According to Bloomberg, with about 90% of the S&P 500 companies reporting positive surprises lead disappointments by almost a 3.3 to 1 margin. Results are much stronger than expected with the average surprise of those reporting better by +10.0%. This has led to many upward revisions for this year but more importantly for next year.

The bottom-up estimate for the S&P 500 is increasing and is now $59.82 for 2009, and the S&P 500 is now expected to earn $74.48 in 2010. That puts the S&P 500 at 13.2x next year’s currently expected earnings. If sentiment and valuation improve, the S&P 500 should move to its historical multiple of about 16x which would mean a move to 1192 – without any increases in earnings estimates. That would mean another +20% or so for the index.

The fact that analysts and investors underestimated how quickly companies responded to the near universal drop in demand was inevitable. Analysts always miss the economic turns because they are too excited near the top and too cautious at the bottom. Stocks tend to go up as analysts increase their estimates so analysts have an incentive to low ball positive change – when their estimates are too low their stocks go up anyway – and clients are less likely to complain if their stocks are going up.

Some pundits and other assorted market wizards argue that the better-than-expected earnings are simply due to cost cutting and we all should not get too excited. They are right! We should never get too excited or too depressed for that matter. But the first improvements are always cost driven. Nominal demand has not come back yet. The government still must subsidize spending – by paying people to buy cars for instance. Company revenues are weak which shows up in nominal (not adjusted for inflation) GDP. But all the cost cutting means productivity is rapidly increasing – EVA is going up. And that is good because something has to offset the coming tax hikes and government interference. This huge increase in productivity will accomplish some of that but not nearly enough.

Back to a Stock Picker’s Market

The S&P 500 (INDEXSP:.INX) has risen +50% from the market low in March. The huge rise is in sharp contrast to the collapse of almost all asset prices in 2008. As last year's market declined correlations between stocks’ returns rose dramatically – to nearly 90% during the worst of the credit crisis.

Today, stock price movements are returning to more normal correlations, which mean there is differentiation within the market. Consequently, stock returns are being driven less by macro-economic forces, and more by stock specific factors. We are moving towards more of a stock pickers market.

As market volatility decreases, stock price correlation decreases. From a quantitative portfolio management perspective, high market correlation has been a significant problem. This approach tries to separate future outperformers from underperformers using fundamental data. When all stock returns are driven by macro considerations, traditional fundamental factors are less important.

However, with volatility back near historical ranges, the efficiency and value of quantitative screening is rapidly returning. Regardless of the direction of future market returns (barring a complete collapse) we will benefit by having a portfolio of the shares of great ValueAligned® companies.

Insider Selling – A Warning?

After buying heavily in early March as the market collapsed, company insiders (CEO, CFO, Directors and large holders) started selling throughout most of the quarter. Insiderscore.com’s Weekly Score hit its lowest level in over two years as the S&P 500 climbed to its best level since January. Overall, the insider sentiment was very negative for the quarter as insiders used the market bounce to unload boat loads of company stock. So far the market has absorbed this supply in stride and hasn’t taken the selling en masse as a negative signal.

The first two weeks of each quarter show very light insider activity due to the number of insiders constrained from selling because of closed insider windows around the time of earnings reports. We start seeing activity in the fifth and sixth week.

The last time insider sentiment was this bearish three weeks into a quarter was the second quarter of 2007. And the last time the Weekly Score was this bearish for three weeks was the third quarter of 2007. Of course, we reached the market high in that third quarter. Insiders were smart sellers right before the bear market.

But corporate insiders are people too. They are subject to the same emotions that we all are. As the market comes off the “generational low” in March, a bunch of insider selling should be expected. Many of the sellers now were the same people that were worried about their companies going bankrupt just a few months ago. This round of insider selling is likely signaling a pause in the ferocious rally of late – but just a pause to refresh we think.

POLICY UNCERTAINTY MATTERS

This country has come to feel the same when Congress is in session as we do when a baby gets hold of the hammer. It’s just a question of how much damage he can do with it before we take it away from him.

-Will Rogers

The stock market low in March marked the crescendo of panic caused by the chaos and uncertainty of fiscal policy changes going forward. The President and his Congress passed a fiscal stimulus bill that many suggested was not timely or targeted. The House passed the Cap and Trade energy bill which the President endorsed. And healthcare reform is still up in the air, hotly debated for sure, but extremely expensive nonetheless.

The Democrats and President Obama in particular have hammered home the unfairness of the "Bush Tax Cuts" because income inequality has grown so wide. “The rich are getting all the favors from the rich that were in power” goes the story that is told.

This purported fact alone is repeatedly cited without even a peep from the media, the political opposition or concerned citizens. The problem is that "income inequality" is meaningless without context and certainly by itself does not call for a more "progressive" - soak the rich - tax policy.

During the campaign the President famously suggested to Joe-the-Plumber that we need to spread the wealth around. He meant it, but only now are Independents and Republicans that voted for Obama finding out just how much he meant it.

This President does not give a hoot about economic growth, only about redistribution in the name of social justice. But how do we measure "well being" and are the income growth statistics really so flat for the Middle Class? And does economic inequality really translate automatically into social and political injustice as the President seems to believe? The question in the end is: Do the rich dominate politics and make policy to cement their hold on power?

It seems that the election of this President and a very progressive Democratic Congress with a filibuster proof majority would suggest that the rich do not always gravitate toward the party that taxes them less. In fact, there were many more wealthy Americans trying to elect this President while he made crystal clear that his objective was to tax the rich more and redistribute their property/income to the less rich and poor.

What's going on here? Perhaps we do not have an entrenched plutocracy like so many in Congress and in the Democrat party predicted; perhaps instead we have a government by idle elites who feel entitled to experiment with grand policies thought up somewhere in think tanks and academia. These policies happen to entrench their favored special interests’ power.

My point today, though, is to remind my readers that this basic mistake about how well off the Middle Class is and how it has fared under "Free Market Economics" has huge policy and budgetary implications which in turn have growth implications far into the future.

The Stock Market Measures All This

The stock market knows this - as it always does. It is not a coincidence that at the same time that the President's personal poll numbers are moving lower - below Carter's now at this time in his Presidency - that the stock market has moved +50% off its bottom. As the President’s political capital wanes the likelihood of passage of his most progressive policies diminishes. The stock market begins to discount a brighter long-term future return on private capital.

Will Rogers Was Right – Evidence the Market Fears Congress

Way back in 1973 Princeton Professor Burton Malkiel conjectured that regulatory uncertainty is a negative influence on the stock market. He treated Congressional activity as a proxy for this regulatory uncertainty. When Congress is in session uncertainty is high; when Congress is out of session uncertainty is lower. The premise though is that when regulatory change is uncertain and dramatic, the stock market suffers. As the uncertainty about radical change dissipates, the stock market stabilizes and often recoups its losses.

In his 1973 investment book, A Random Walk Down Wall Street, Malkiel contends that "[I]t is not so much the direct cost of regulation that has inhibited investment but rather the unpredictability of future regulatory changes." The financial panic coupled with huge regulatory uncertainty in the President’s first few months led to the March bottom in my view.

Here Comes the Sun, Congress Goes on Recess

In their March 2005 paper entitled Congress and the Stock Market, Michael Ferguson and Douglas Witte showed that stock market returns are lower and more volatile when Congress is in session than when it's in recess. Get this. About 90 percent of capital gains recorded on the Dow Jones Industrial Average (DJIA) index between 1897 and 2001 occurred on days when Congress was not in session, according to the study.

If a dollar was invested in the Dow Jones Industrial Average in 1897 using an “out-of-session” investment strategy, by 2001 it would have grown to $216 (excluding dividends and transaction costs for simplicity’s sake). The same investment would have yielded only $2 using the “in session” strategy! Congress destroys wealth; government is the problem. Ronald Reagan was right!

Also, their study found that stock returns are significantly lower when the Democrats hold a majority in Congress. And returns are significantly higher when a Democratic Congress is not in session than when a Republican Congress is not in session.

The authors’ three possible explanations for their findings suggest that the current bounce has been driven by the public’s relief that Congress did not yet do as much damage to business as first thought as it heads out to August recess.

1. Congressional activity depresses the market. In recent decades the average approval rating for Congress has been extremely low, while lately it has been historically low – in the 20% area. Behavioral finance suggests that investors’ moods or attitudes may affect stock prices in many diverse settings. It turns out that the evaluation of information and attitudes toward risk are greatly affected by mood. Not surprisingly, depression leads to greater risk aversion and more pessimistic forecasts than happier moods. Considering the consistently negative opinion the public has of Congress, it is possible that Congressional activity has a negative impact on stock prices.

2. Congressional activity as a proxy for regulatory uncertainty. As Malkiel predicted, regulatory uncertainty brings down economic performance.

3. Congress acts in favor of concentrated minority interests, instead of the public welfare. We know that regulatory bodies are captured by powerful, concentrated economic interests. And these Democrats are driven by the most destructive kind of special interests for business in our opinion – labor unions (not labor by the way but the guys and gals that get the benefits from running the labor unions), the environmental groups and those in academia that hold the mistaken notion that the U.S. is run by the wealthy for the wealthy systematically leaving behind the middle class.

When Mr. Obama Goes to Washington, Sell!

At the beginning of President Obama’s first term, the CXO Advisory Group set out to measure the new President’s opinion about private versus public capital and his attitudes about the stock market as a way to gauge the likely economic effect of his proposed policies. Overall, these beliefs might mean that the President regards stimulation of private investment in public companies as a relatively ineffective means of achieving his policy objectives and investors are therefore a low-priority constituency. In other words, policy shifts that favor investors are unlikely.

The President of the United States, especially when the President's party controls both houses of Congress, arguably has more power over the economy and financial markets than any other individual. This power derives from influence over legislation, including the tax code, and the latitude of the executive branch to set and implement policies not constitutionally or legislatively/judicially prohibited. What are the current President's beliefs about the stock market, as expressed directly or via proxies? Do these beliefs have implications for investors?

Comments documented on their website suggest that President Obama believes:

• Over the short term, the stock market is not a reliable indicator of whether new policies/tactics will ultimately help or hurt the economy.

• The stock market has recently reacted to a deteriorating global economy and not to new policies/tactics intended to remedy that deterioration.

• The stock market is no higher than fourth (behind the job market, credit market and housing market) as an indicator of socioeconomic conditions.

• Over the short term, the stock market is very noisy, perhaps more sentimental than rational, and people tend to err in reaction to noise.

• Over the long term, the stock market is somewhat predictable, with future returns varying inversely to current price-earnings ratios (P/E). Moreover, government policies can largely control the degree of long-term market volatility.

• P/Es are getting low enough (3/3/09) that they indicate future stock returns are "potentially" a "good deal." (Nice call by the President by the way.)

In summary, the President's statements since taking office indicate that he views the stock market as an unreliable and low-priority indicator of the socioeconomic value of his policies/tactics. Investors beware.

WHAT’S THE LESSON?

Large losses seem to destroy investment programs and retirement plans. Not only must an investment portfolio that suffers a large loss contend with the asymmetry of gains and losses (a -50% loss requires a +100% gain to get back to even), but the time to recover is totally unpredictable. And that causes great anxiety – we understand.

An investment program in stocks started in 1965 in the S&P 500 didn’t begin to make gains until 1989, adjusted for inflation. A diversified portfolio of stocks during that extended period, which contained several large market corrections, destroyed purchasing power for 17 years before the market recovery began in earnest in 1983.

We are facing the same dilemma today. Over the past decade ending at the bottom in March 2009, the stock market has destroyed capital and reduced purchasing power. The real, inflation-adjusted annualized return was a loss of -5.9%. (See chart above). To recover this loss will require about a +100% real increase (real means above inflation). That’s 5 years at an annual real rate of +15%; 10 years at a real rate of +7% and 20 years at a real +3.5% rate.

At first glance you might immediately panic. But wait, what does history tell us? For those of us that did not panic out of the market near the bottom, we are already up some +50% in just 5 months before inflation. Take away 5 months of inflation and it is still right around +50%.

So let’s say we don’t go up or down by the end of the year – how many years left until we get our wealth back in order. Well 7% seems reasonable given the chart above – it’s less than half of the very best 10 year rates of return shown on the peaks. Our +50% already bought us 6 years of 7% real returns. That means we would need much, much smaller real returns for the next 9 years to get to that +100% gain. That seems much less daunting.

But if the past decade has taught us anything, it is that the doctrine of blindly being continuously invested in the stock market has flaws. It really matters when you begin investing. And as the chart above shows investing near the top in prices gets us to negative 10 year returns sometimes.

If we panic and can’t stay on plan with complete faith in the future, it certainly cannot be a strategy for retirees who are drawing down their savings constantly.

We think that simple strategies, like the election cycle strategy recounted above or a simple model based on current market valuations, are good alternatives to the conventional buy and hope doctrine.

By accepting market risk only during the political sweet spot or by investing our savings in great companies, growing their intrinsic value at low valuations, we put the odds in our favor of beating inflation and maintaining purchasing power and dignity into retirement.

IN THE END

In March we suggested it was not the time to exit your long-term plans. In fact, we suggested that you should add to your stock accounts where possible. Even though the market has run up now it is not the time to exit. We’ll continue to actively manage the portfolios by also revaluing the shares of our great companies and then monitoring their buy and sell points. We will also keep track of market risk and Congressional follies to give us the highest probability that we earn the highest returns going forward.

Since we held on and even bought more shares of great companies when others were panicking, we're willing to hold for the next decade or more – we are confident we will be rewarded from these valuations. We think this time is a fantastic opportunity. And what we do today could make the difference between looking back on this market in regret and reaching our financial goals.

We are experienced advisors who have studied for many years the market cycles, corporate strategy and human behavior. We know that all by yourself without the guidance of an experienced advisor, you may believe that this time is very different from all the others. We understand that it temporarily relieves the psychic pain of losses, and relieves the anxiety of an uncertain future.

That’s why we consider that our best service to our clients isn’t our brilliant economic commentary or our economic/market calls, but simply the saving our clients from their own understandable but sometimes destructive behavior.

Best regards,
David Lee Berkowitz
Rapidan Capital, LLC

Other interesting article: On Value Expectations  

Rapidan Capital, LLC is an independent investment firm that manages assets for a broad spectrum of individuals and their families. We provide comprehensive, institutional level investment and family office services that may have been previously unavailable to individual investors. Our pledge to be passionate about long-term performance defines our commitment to client satisfaction. We have eliminated the middlemen and our experienced analysts and portfolio managers have worked to create the latest innovation in growing wealth - the Value-Aligned Investing® system.

On Monday we highlighted several companies from our buy/sell list that represented investment ideas for all types of investors, which included Small and Large Cap stocks as well as Growth and Value stocks. Since Value Expectations tends to provide Large Cap Value Stocks for potential Buy ideas, earlier this week we decided it would be helpful to also highlight some small cap stocks we like from the Russell 2000. Now, moving on to the Growth investor, we will focus on companies we classify as growth stocks and find attractive within the S&P 500 (excluding Financials). By definition, AFG classifies growth stocks as companies with a Market Value/Invested Capital (MV/IC) in the top half of their sector.

In the table below are 10 growth stocks that we find attractive based on AFG’s valuation model, and are ranked neutral or higher based on AFG’s default recommendation.

Attractive Growth Companies - S&P 500 (excluding Financials)

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.

AFG's Growth Universe - Companies in the AFG universe, which have MV/IC in the top 50% of the universe and have EPS estimates.

Market Value/Invested Capital (MV/IC) - The firm's average total equity, debt and other obligations divided by net invested capital.
 

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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Back in February Valueexpectations.com released a blog highlighting Fidelity’s Low Priced Stock Fund that follows a strategy of only investing in stocks with a share price of under $35. In that blog we provided a list of 30 stocks that we thought were attractively priced according to The Applied Finance Group’s (AFG's) valuation model broken up into three price brackets: under $10, $10 to $20 and $20 to $35.

From Feb 5th 2009 to June 5th 2009 the 30 stocks recommended as a group outperformed the S&P 500 by an average of 36.5%, the 10 stocks under $10 outperformed by 57.1%, the $10 to $20 stocks outperformed by 40.1% and the $20 to $35 stocks outperformed by 12.5% respectedly. 

Joel Tillinghast, the fund’s manager began this fund with a strategy of only investing in stocks under $10. Since this stragtegy began Fidelity has moved the stock price limit to $35 where it currently sits. Tillinghast believes that share price alone is not of importance but the lower priced, smaller-cap universe of stocks experiences the most frequent mispricing’s and also has the least amount of analyst coverage.

As an update to the prior blog on this strategy Valueexpectations.com provided a list of 30 stocks that we believe are attractively priced and do not fit AFG's default sell criteria. Each group is ranked based on valuation attractiveness. AFG's analysis begins and ends with valuation, however along the way there are other key factors AFG considers when looking for buy opportunities: expected Economic Margin improvement, management quality, earnings quality.

Attractively Priced Companies Under $30

The Halloween Indicator in the stock market sometimes defined as “sell in May and go away” is a strategy that is based on the difference in the performance of the market during May to October vs. November to April. The strategy is to invest in the S&P 500 during “the best 6 months” and switch to bonds during “the worst 6 months” to avoid the summer doldrums of small to negative returns. Since January of 1950 the average returns for November to April “good months” is 7.9% compared to the 2.5% average return delivered from May to October ‘bad months”.

Although there is a significant spread in returns between the good and bad months, does this mean you should convert to bonds and go on a vacation until September? There are several views for and against market timing but we feel it is too difficult to identify when to be out and when to be in the market. If you dig deeper into the market performance since 1950, you will find that 20 good and 20 bad months make up a significant part of the market performance. For more information read the following market timing strategy filled with pitfalls.

The market has been up in those worst 6 months 60% of the time since 1989, not as profitable as the best 6 months but still positive. I believe 2009 is a good lesson for many, with all of the inefficiencies and irregularities in today’s market, the mixed macro economic reports, and the belief we are headed toward a recovery, jumping out of the market could mean missing out on making up for some of the losses the market handed us in 2008

However, being invested isn’t enough, identifying quality companies and a good value will put you in an even better position to outpace the general market. Listed below are companies that should be considered as potential investment opportunities. These companies all have a valuation attractiveness near the top of their sector in addition to expected improvement of profitability (Economic Margin) above their sector, and do not follow a wealth destroying strategy defined by AFG’s management quality score.

Attractive companies to consider in each sector instead of selling in may and going away

A brief description of AFG's buy criteria variables is below:
• 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.• Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.• Management Quality – Assess management’s ability to make wealth creating decisions.

 

In March, Jim Jubak of MSN Money released a list of stocks that he believed should be stocks that you should pay attention to in the upcoming months/quarters as potentially attractive investment opportunities. ValueExpectations.com set out to answer the question, which stocks on Jim’s watch list look attractive according to AFG’s valuation model and should be on your watch list?

Provided in the table below are Jubak’s watch list companies and how they fare from a valuation perspective using The Applied Finance Group’s Value Score variable which ranks the valuation attractiveness of each company based on the discrepancy between the company’s current trading price and AFG’s target price.

Jubak's Watch List Companies (Ranked by Valuation Attractiveness)

Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.

AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

Jim Jubak (Jubak’s Journal – MSN Money) recently released an article outlining 5 major missteps a company can make on the road to recovery during a recession and provided 5 stocks he believes avoided such missteps and are primed for success when the market returns to normalcy - COH, PEP, QCOM, FLS, NUE. According to Jubak, he likes these companies because they all have good debt to equity ratios, solid balance sheets, and they have not been “beaten up so badly that they will spend the first year of the market recovery patching holes”. Jubak currently has 50% of his portfolio “Jubak’s Picks” in cash and the other 50% in stocks and does not expect the market to bottom for another 6 months or more, but believes these 5 stocks will be solid performers when the market does finally return. ValueExpectations.com has taken Jim’s 5 shipshape companies and analyzed them using The Applied Finance Group’s (AFG's) valuation model and buy criteria.

A brief description of AFG's buy criteria variables is below:

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. Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. Management Quality – Assess management’s ability to make wealth creating decisions. AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

Jubak's 5 shipshape stocks for the turnaround

Click Here for a closer look at some of The Applied Finance Group's valuation concepts.

Faisal Laljee of stocksandblogs.com came out with 2 blogs earlier this year providing companies that he believed were the top stocks to own/watch for 2009 (Part 1, Part 2). Laljee was on the money with his predictions so far through 2009. 13 of the 15 companies he recommended have positive returns and the whole portfolio of 15 companies has an average return of 21.24% compared to the S&P 500 return of 0.10% over the same time period. Valueexpectations.com thought it would be useful to analyze how these firms are positioned as possible investment opportunities going forward from AFG’s valuation standpoint. Valuation Attractiveness is determined by AFG’s proprietary valuation framework, which estimates a stock’s intrinsic value through a DCF model which incorporates a corporation’s Economic Profitability, Growth of Capital Base, Decay, and Cost of Capital. In addition, we also showed sales growth expectations embedded in each company’s latest stock price and its historical 5 year median sales growth. It is interesting but not surprising that all the Attractive stocks have low implied sales growth compared to those companies’ historical performance.

Stocksandblogs.com 15 Companies To Own/Watch In 2009 : Perfomance Results

*AFG’s Value Expectations allows us to understand the Sales Growth, EBITDA Margin, and Asset Turnover 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 the list of companies assuming their EBITDA Margins and Asset Turnovers stay at the 5 year median levels.

After reading a few articles highlighting attractive retail/apparel stocks, we have decided to analyze the companies mentioned in these two articles based on their attractiveness from a valuation standpoint using AFG’s valuation model.  We have examined the expectations for sales growth embedded in their current prices using AFG’s Value Expectation interface, as well as provided four companies that we find attractive in this retail/apparel space. The first four companies listed in the table are from an article in MSN Money by Catherine Holahan that mentions companies thriving in the recession (performed well in March), The second four are from an article from The Curious Investor (SeekingAlpha.com) that give the author's picks for companies ready to take advantage of a retail revival when consumer spending returns to a more normal level. The final four stocks are companies that we find the most attractive in the retail/apparel space.

When analyzing the sales expectations for these companies, measuring the spread between a company’s VE sales growth expectations and what it has historically delivered will give you a good idea of which companies have the best chance of meeting or exceeding those expectations, and thus are more likely to outperform.

 Retail/Apparel Companies

*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.

Economic Margin (EM) Defined - A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The Economic Margin Framework™ is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

Here is a list of companies within the S&P 500 that have earned extraordinary Economic Margins (EM) over the last 7 years and are also expected to maintain high levels of EMs over the next two years. Companies expected to improve their EMs more than their peers have proven to be more likely to out-perform. High EM companies on the list below that have low expectations priced-in for sales growth and attractive valuations, are ones that may be worth a look as a potential investment.

S&P 500 Companies That Maintain High Economic Margins

*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.

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Fidelity’s Low Priced Stock Fund, which launched in 1989 (18 Billion AUM) and is managed by Joel Tillinghast, follows a simple strategy… Only invest in stocks with a share price under $35. This strategy first started with Tillinghast only investing in stocks below $10 a share, but later he moved the limit up to $35 a share. He argues that share price alone is not important but that the small-cap universe contains the most frequently mispriced stocks and the least amount of analyst coverage.

Although his fund at best has been a market performer as of late, Tillinghast had taken advantage of such mispricing’s during the last 15 years, averaging an 11% annual return compared to the 6% return earned by the S&P 500 over the same period. The fund had been closed to investors since 2003, but was recently reopened in December. Fidelity says they reopened the fund to get more cash inflow to be able to take advantage of all of the investment opportunities they see in the market.

Below is a list of the top holdings in Fidelity’s Low Priced Stock Fund as well as stocks that AFG believes are attractively priced in three price brackets: under $10, $10 to $20, and $20 to $35. Compare the implied sales growth priced-in to justify the current trading price (VE Sales Growth) vs. what the company has delivered in sales growth the past 5 years (5 Year Median Sales Growth) to see if the expectations are realistic for the company to achieve. The more realistic the expectations are, compared to what has been delivered, the more likely the firm will be to out-perform.

With just a few trading days under our belt in 2009, these stocks have made the biggest moves so far according to Bespoke.com. Will these stocks continue the January hot/cold streak into the rest of the year or is this just a fluke. Only time will tell. We measured the implied sales growth priced-in to justify their current price (VE Sales Growth) against what these firms have delivered in sales growth for the past 5 years to see which companies have low or reasonable expectations. Companies with low expectations for sales growth priced-in relative to what they have been able to deliver are the ones that are more likely to out-perform.

VE Sales Growth calculated on 1-13-09

These lists exclude financials.

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

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!