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In a recent Article by John Tamny, Forbes: To Fix The Global Economy, Fix The Dollar, the effects of a weakening dollar on the U.S. Economy were nicely summarized “When money loses value, it's the equivalent of governments raising the rate at which we pay income taxes. But with taxes, we can at least see how much the government is removing from each paycheck.”

A weakling dollar will likely be followed with higher inflation.   Although there are some who believe that a weaker dollar will strengthen our exports, the reality is that companies will be spending more to produce their goods and investors will require higher nominal pre-tax rates of return. Furthermore, an increase in the overall cost of capital for equities will result in less business expansion as companies must pay more to source their funds. 

So how do investors deal with a sluggish economy and declining dollar? As the U.S. economy faces many headwinds with a declining dollar, we recommend high quality, well managed, attractively-priced businesses with high foreign exposure.   Companies with a significant overseas exposure will likely benefit from currency appreciation against the dollar making sales in those currencies especially valuable.  

 
Using AFG’s proprietary research we thought we would provide you a solid list of well managed businesses, in the S&P 500 that also have over 50% in foreign sales.

Using AFG’s proprietary research we thought we would provide you a solid list of well managed businesses, in the S&P 500 that also have over 50% in foreign sales.

 Source: The Applied Finance Group

Valuation Signal  – 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 (EM) Signal- 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.

For further guidance, we decided to contact John Tamny to ask him for his insights on what kind of stocks investors should be looking at?

John Tamny: If the dollar continues to weaken, investors will want to be in companies that are rewarded for finding physical assets of the earth (oil, gold, various commodities and businesses that serve commodity companies), while if the dollar were to strengthen or stabilize, investors would more want to be in intellectual companies such as software and other innovations

On Wednesday November 18th, Mr. Tamny, Toreador Economic Advisor and Forbes columnist will be discussing many of the reasons why a declining dollar has been hurting the growth of the US Economy along with:

• Should the dollar move to a gold standard?
• Is a trade "deficit" bad for the US Economy?
• Why a stable dollar is an essential input when it comes to economic growth.

Click here to get a replay of this talk!!

Keeping an eye on the big movers in the market does not help investors determine which stocks are poised to continue their upward or downward movement. To help our devoted readers identify the movers that still look fundamentally sound and those to walk away from, ValueExpectations.com has scored each of the top 10 Hot and Cold stocks of the month based on Valuation Attractiveness and Economic Margin Change.

If an investor should consider adding any of these stocks as a holding for a portfolio, one should look for companies with attractive valuations and expected improvements in a company’s Economic Margin (EM) which essentially is a measure of a company’s true economic profitability. As an additional level of analysis, we also recommend understanding the embedded expectations that are priced into each of these stocks.

AFG’s Valuation techniques and understanding of economic profitability have proven to identify mispriced securities in the market and help clients take advantage of mispriced securities. Accurately assessing a company’s profitability and understanding how to answer key questions such as… What is the cash flow generated by the company’s operations? How much capital is required? What are the opportunity costs of this capital? This robust process is what sets AFG’s corporate performance metric Economic Margin (EM) apart from other Value Based Metrics such as an IRR calculation, a CFIRR or a RONA Economic Profit approach.

It is not surprising to see the list of best performers dominated by Tech stocks as professional investors in our last month’s sentiment poll identified Technology as the most attractive sector to bet on in the upcoming months and companies like DOW and EK on their respective best and worst lists as they both have been discussed recently on VE.com. Dow was recently noted as one of the most attractive stocks within AFG’s Basic Materials sector (ranked 2nd most attractive sector amongst professional investors) in mid-august. Eastman Kodak (EK) is just one example of a torpedo AFG’s clients and ValueExpectations.com readers have avoided due to regularly being on AFG lists of stocks to avoid and also a model of poor Earnings Quality (high accruals) one way AFG filters out companies likely to underperform, and more likely to encounter a negative earnings surprise. EK has consistently had a poor EQ score according to AFG’s measure of accruals and continues to be ranked amongst the worst in its sector in Earnings Quality.

On March 9th 2009, the S&P 500 hit its low mark of the year of 666.79. Since March the market has rallied up to 1,068.78 as of the close on September 16, 2009 and we thought it timely to analyze the companies that have made the biggest gains and losses since the low and provide some insights on how we view the 10 biggest gainers and losers in the index going forward. All of the biggest movers have been ranked based on attractiveness according to The Applied Finance Group’s (AFG’s) investment criteria and valuation model. The companies with the most attractive valuations and positive Economic Margin (AFG’s measure of corporate performance) movement have proven to be more likely to outperform those companies that look unattractive according to AFG investment criteria and that look expensive within AFG’s valuation model.

The list below contains the companies that have experienced the biggest price movements in the S&P 500 since the March 9th low and how each of these companies measure up going forward, according to AFG’s investment criteria and valuation model. Companies that look attractive according to AFG’s valuation model along with improving Economic Margins have proven through vigorous back-tests to identify the company’s most likely to outperform their benchmark.

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The Applied Finance Group’s (AFG) Market Forecast Project is a monthly poll of professional investor’s designed to provide insights on how investor’s currently view the market and economy. This poll started out as an AFG client only poll at AFG’s annual research summit, but due to its popularity and successful predictions it has been expanded to all professional investors who register and participate and will be done monthly. The benefit of participation is being the first to receive the results before they are released on our blog or to anyone else. Earlier this month as a result of one of the poll’s questions that the Tech sector was the most attractive sector to invest in over the next 12 months, we released a list of Tech stocks that we like and a few that looked overvalued as well. In last month’s survey the Basic Material sector was the second most attractive place to invest due to the fact that many investors see an economic recovery ahead that may directly benefit many of the companies within the Materials sector when home building and new construction begin to correct and recover. Provided below is a list of Basic Material stocks that we find attractive and unattractive based on AFG’s default buy/sell criteria, valuation attractiveness and expected change in Economic Margins (AFG’s measure of corporate performance/profitability). Companies expected to improve Economic Margins greater than sector peers have proven through back-tests to be the most likely companies to outperform. Companies with attractive default valuations according to AFG have also consistently outperformed companies AFG views as overvalued.

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.

If you are a professional investor and would like to be a part of our next survey click here.

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.

 

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