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On September 22, we used AFG's equity research and investment tools to Identify Large Cap investment opportunities. Today, we will address Small Cap stocks for those investors who benchmark themselves against the Russell 2000.

Using its proprietary valuation metric, The Applied Finance Group has a measured approach for identifying companies that will under or over perform their chosen benchmarks. AFG’s analysis spans across growth and value universes, as well as all sectors, industries, and market caps; in all, nearly 4,500 domestic companies are covered and over 17,000 companies globally. 

AFG’s Buy/Sell List is the ideal place to start looking for investment opportunities, and it has proven to create a significant spread in performance between companies that come up as either buys or sells. The result is a target group of stocks that can help you outperform as well as identify potential torpedoes to avoid in your portfolios. Focusing on these companies gives investors an opportunity to build a quicker and more efficient process based on AFG’s screening criteria.

Below is a list of attractive and unattractive companies in the Russell 2000 from each major sector (as defined by AFG).

 
                                                                         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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Now that the nearly $800 billion Stimulus Package is signed into a law, the question is how its provisions would affect the different industries, which companies would present attractive investment opportunities and which ones we should avoid. After discussing the possible effects on the Solar Industry, we now turn our look to the Defense Industry.

Defense companies have enjoyed an abundance of government funding over the last several years. The estimated Defense Military outlays for 2009 are approximately 650 Billion, more than double the amount of the last budget before 9/11. As a result companies involved with defense, homeland security and aerospace have outperformed the broader markets, with the SPADE® Defense Index (AMEX: DXS) beating the S&P500 Index by 80.3% cumulatively for the 9/10/01 – 2/23/09 period.

However, this process may be coming to an end. Although historically defense spending has not been much correlated with trends in the overall economy, increase in government deficits related to recent federal bailouts and reduced tax revenue may lead to downward pressure on defense budgets. Tom Shanker of The New York Times expects U.S. Defense department to scale back on spending, as President Obama will need to identify at least some budget cuts after signing the new stimulus bill. Weapons programs that have suffered significant cost overruns are amongst the most likely to be affected, according to Mr.Shanker.

Although supplemental funding for weapons procurement and R&D is expected to decrease going forward, there is normally a lag between defense funding and the actual delivery of the purchased equipment. The Aerospace Industries Association estimates that since new procurement spending is basically committed for fiscal year 2009, and the new administration will have limited impact on fiscal year 2010, aerospace companies should see defense sales growth continue on-pace through calendar year 2012.

Whether the expected negative impact for the overall industry would come sooner or later, the key would be to identify which companies within it are relatively overvalued and most likely to suffer a severe price correction, and which have low market expectations embedded in their current stock price, thus being under lower pressure for meeting and beating analysts performance benchmarks.

Listed below are the companies from the Defense Industry according to AFG sector industry classification. Accompanying each stock, are its respective market cap, P/B, forward P/E, and sales growth expectations priced into the stock utilizing AFG’s Value Expectation application (assuming their 5-yr median EBITDA margins and asset turnover levels remain constant in the next 5 years).

 

Defense Companies and Their Implied Sales Growth Expectations:

*data date 2/18/09