IBM

The flowchart below outlines The Applied Finance Group’s custom screening process which takes into account several factors to screen on as well as provides step by step process to end up with the highest quality investment ideas. In Step 1 of AFG’s custom screening process we identified companies that were trading at a discount to their intrinsic value as AFG’s valuation process is a key component in the screening process. Today we will combine the criteria of looking for cheap companies with companies expected to improve their economic profitability (Economic Margins) as well. Economic Margins are highly correlated with market values and can provide investors an edge in their stock selection process if they have an understanding of a company’s true economic profitability. Our daily examples will show that an increase in margins typically leads to market out performance, where a decline in margins leads to market under performance.

Today we will take a look at the valuation attractiveness of the S&P 500 and break down the index based on market cap to see how the mega-cap stocks within the index look relative to the smaller players, using The Applied Finance Group’s (AFG’s) valuation framework. Using the AFG Value Score variable (a ranked valuation attractiveness metric, 1 = the least attractively priced stock in the AFG domestic universe of 3,500 stocks, 100 = the most attractively priced stock in the universe) we have broken down the S&P 500 in groups of 50 from largest to smallest market cap to see which quintile group looks the most attractive based on AFG’s systematic approach of valuing securities.

The Applied Finance Group’s (AFG’s) valuation techniques help investors identify and take advantage of mispriced securities in the market. One way investors can identify over or undervalued stocks is by using AFG’s Intrinsic Value Chart, which displays a company’s intrinsic value relative to its trading range and helps identify entry/exit points. This easy-to-read chart identifies how far a stock’s trading range deviates from its intrinsic value (target price assuming immediate decay), which helps you recognize potentially mispriced stocks and pursue long and short opportunities. AFG’s Intrinsic Value Chart also contains a company’s Value Score (ranked valuation attractiveness), Economic Margin Change (expected improvement of economic profitability), and Accuracy (how well AFG’s default valuation has tracked the company). AFG’s valuation framework estimates a company’s equity value by subtracting debt and other liabilities from the total enterprise value. The total enterprise value is estimated by discounting projected future cash flows, utilizing analyst consensus, Economic Margin methodology, and the Decay concept which addresses the perpetuity bias in the traditional DCF model. The example we have provided is International Business Machines Corp. (NYSE:IBM) a company that currently looks undervalued according to AFG’s default valuation model. An important fact to note is that AFG has shown it tracks IBM (NYSE:IBM) well (high accuracy score of 91). Also, IBM has a current AFG Value Score of 88, meaning the company ranks in the top 88th percentile of companies in the AFG universe in valuation attractiveness. Companies AFG identifies as undervalued have proven through back-tests to be more likely to outperform than those companies with an unattractive default AFG valuation rank.

A highlight of the overall attractiveness of the Technology sector which currently looks to be trading at a discount to its historical relative valuation and looks undervalued relative to the market. The Tech sector also has consistently been voted the best sector to invest in over the next year by participants in our monthly survey of professional investors called The Market Forecast Project.

To identify potentially attractive investment ideas, The Applied Finance Group (AFG) usually uses a combination of proprietary variables to develop a focused group of potential buy ideas that meet criteria based on valuation, economic performance, management quality, and earnings quality. Although this set of investment criteria has proven successful in generating buy ideas, AFG’s valuation on a standalone basis has consistently been able to identify mispriced securities and investment opportunities that outperform their chosen benchmark.

Several times over the last year ValueExpectations.com has released lists of companies narrowed only by the valuation properties of the company using AFG’s Value Score (defined below). Today, we will revisit these blog posts and compare the performance results of the companies previously identified to the results of their benchmarks.

Below is an update of the performance of the articles we have released where companies were identified by using AFG's valuation metric as the sole variable. Included in this table is the blog portfolio's performance, the performance of the index, and the spread relative to the index. The performance of all portfolios and their benchmarks are tracked from the date of the blog's release until last Friday's close. As you can see in the table below, companies identified by AFG as having an attractive valuation have performed quite well and have consistently outperformed their benchmarks.

If you are a professional investor and would like to better understand and access AFG's valuation metric to review your portfolio - Click Here

 

Below is an updated list of the S&P 500 companies with the most attractive valuations according to AFG’s valuation model including Freeport McMoran C&G (NYSE:FCX) and Fluor Corp. (NYSE:FLR).

To stay updated on companies AFG believes are attractive investment opportunities register for ValueExpectations.com It's Fast and Free!

AFG Investment Rank within Sector Ticker Name Sector  Opportunity Valuation Signal  Cheapest Stocks In The S&P 500 (NYSE:FCX)  FREEPORT-MCMORAN C & G Basic Material Attractive Attractive (NYSE:WAT)  WATERS CORP Capital Goods Attractive Attractive (NYSE:FLR)  FLUOR CORP Capital Goods Attractive Attractive (NYSE:TAP)  MOLSON COORS BREWING CLB Consumer Non Durable Attractive Attractive (NYSE:CL) COLGATE-PALMOLIVE CO Consumer Non Durable Attractive Attractive (NYSE:DNB) DUN & BRADSTREET CORP Consumer Services Attractive Attractive (NASDAQ:BIIB) BIOGEN IDEC INC Health Attractive Attractive (NYSE:PFE) PFIZER INC Health Attractive Attractive (NYSE:BMY)  BRISTOL-MYERS SQUIBB CO Health Attractive Attractive (NYSE:IBM) INTERNAT BUSINESS MACHNS Technology Attractive Attractive

 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.

Applied Finance Group’s (AFG’s) Value Score defined - 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.

To stay updated on companies AFG believes are attractive investment opportunities register for ValueExpectations.com It's Fast and Free!

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.

Attractive Companies In The S&P with High Foreign Sales
Ticker	Name	Foreign Sales %	EM Signal	Valuation Signal
AES	AES CORP THE	82.9185	Positive	Positive
CL	COLGATE-PALMOLIVE CO	76.7004	Positive	Positive
SE	SPECTRA ENERGY CORP	71.9551	Positive	Positive
GLW	CORNING INC	70.8978	Positive	Positive
HPQ	HEWLETT-PACKARD CO	68.7979	Positive	Positive
TAP	MOLSON COORS BREWING CLB	68.4812	Positive	Positive
DOW	DOW CHEMICAL CO THE	67.9052	Positive	Positive
CVX	CHEVRON CORP	67.6507	Positive	Positive
WU	WESTERN UNION CO THE	66.6793	Positive	Positive
DO	DIAMOND OFFSHRE DRILLING	59.2788	Positive	Positive
IBM	INTERNAT BUSINESS MACHNS	58.6122	Positive	Positive
PFE	PFIZER INC	57.688	Positive	Positive
FCX	FREEPORT-MCMORAN C & G	57.2432	Positive	Positive
EBAY	EBAY INC	53.5258	Positive	Positive
XRX	XEROX CORP	50.4819	Positive	Positive

 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!!

Below is a chart and table outlining the 2009 year to date performance of the sectors within the S&P 500. The Technology sector has lead the way thus-far while Utilities and Financials have been dragging down the overall average of the index. As previously reported in our Market Forecast Project, Technology was also voted most attractive sector according to our survery of professional investors. These sectors are based on the sector classification created by The Applied Finance Group.

Source(The Applied Finance Group)

Source(The Applied Finance Group)

 

Ticker	Name	Sector	Attractiveness	Valuation	EM Change
Attractive Technology Companies - S&P 500
HRS	HARRIS CORP	Technology	Attractive	Attractive	Positive
IBM	INTERNAT BUSINESS MACHNS	Technology	Attractive	Attractive	Positive
ORCL	ORACLE CORP	Technology	Attractive	Attractive	Positive
WDC	WESTERN DIGITAL CORP	Technology	Attractive	Attractive	Negative
HPQ	HEWLETT-PACKARD CO	Technology	Attractive	Attractive	Negative
Unattractive Technology Companies - S&P 500
AMAT	APPLIED MATERIALS INC	Technology	Unattractive	Unattractive	Negative
JDSU	JDS UNIPHASE CORP	Technology	Unattractive	Unattractive	Negative
KLAC	KLA-TENCOR CORP	Technology	Unattractive	Unattractive	Negative
MU	MICRON TECHNOLOGY INC	Technology	Unattractive	Unattractive	Negative
CIEN	CIENA CORP	Technology	Unattractive	Unattractive	Negative

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.

What is the most attractive sector? That's one of the questions we asked a group of professional investors in our Market Forecast Project. The answer varied from person to person, but there was a general consensus.  The majority was in favor of Technology, which pulled away by far with 41 of a possible 98 first place votes. Survey participants were asked to rank a list of sectors from 1-11 in order of how attractive they found that sector to be over the next 12 months. Technology ranked highest with an average ranking of 2.7, well ahead of the rest; Basic Material placed second with an average rank of 4.8. We've put together a list below of both attractive and unattractive companies within the Technology sector.  It may be worthwhile to take a closer look at the companies listed. If the insight provided by the survey’s investment professionals holds true, you could be among those who outperform the market.

Market Forecast Sector Ranking Results
15. Rank Order, which sector seems most attractive to you over the next 12 months?
(1 = Most attractive)

Results Have Been Ranked by Most Attractive

                                                                                              1 Technology
                                                                                              2 Basic material
                                                                                              3 Energy & extraction 
                                                                                              4 Health
                                                                                              5 Capital goods 
                                                                                              6 Consumer non-durable 
                                                                                              7 Financials
                                                                                              8 Consumer services 
                                                                                              9 Consumer durable
                                                                                              10 Transportation
                                                                                              11 Utilities

10 Attractive Technology Stocks


10 Unattractive Technology Stocks

 

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.

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).

In our May Market Review we released a series of graphs representing the valuation attractiveness of each sector relative to its historical norms and to the entire AFG universe. Below is a graph representing the AFG Technology sector which is attractively priced when you compare against its historical trading ranges (red line) and when comparing against the overall AFG Universe (represented by the value of 1). Listed are the 10 most attractive and 10 least attractive companies in the AFG Technology sector that are within the S&P 500. Also listed below the graph is an explanation of AFG’s Relative Valuation Chart.

Technology Sector Relative Valuation Chart

Relative Valuation Chart -This graph shows the Percent to Target Current (Valuation Attractiveness) for a universe relative to the overall market. Values greater than 1 indicate the universe is more undervalued than the market, while values less than 1 indicate the opposite. The red line identifies the historical median value to provide a basis to understand valuation levels relative to historic norms. This example illustrates that the median Technology company is undervalued relative to the market currently and has been trading at a discount to its historic relative valuation, indicating a potentially attractive opportunity.

 

Top/Bottom 10 Companies In AFG Tech Sector Ranked by Valuation Attractiveness (within S&P 500)

 

Note: Telecommunications companies are included in the AFG Technology Sector

Tickersense.com has recently published an article highlighting 15 companies that have been the leaders of the market since the low on November 20, 2008. Made up mostly of Tech stocks (8 of 15), this list of companies has been responsible for about half of the total change of the S&P500 since November 20, and the author believes it is a good place to start if you are “looking for leadership”. Below is a table highlighting the price performance of 12 of the 15 companies (Financials were excluded as well as WYE and SGP due to takeovers).

A second table provides an analysis of the valuation attractiveness of these companies as well as the market expectations for sales growth implied in the stock’s current price using AFG’s Value Expectations interface. Measuring the spread between a company’s VE sales growth expectations and what it has historically delivered should 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.

 

 Performance From November 20, 2008 to Yesterday's Close

 

Valuation Attractiveness & Implied Sales Growth Expectations

 

*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.

Below is a look at the YTD returns, valuation attractiveness and sales growth expectations of the two biggest and smallest companies in each sector within the S&P 500 (excluding financials). This link provides some insight into Applied Finance Group’s (AFG’s) valuation techniques. Also compare the expectations for sales growth to what the companies 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.

 

 Biggest/Smallest Companies (Mkt Cap) By Sector S&P 500 (excluding financials)

 

*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.

Fortune magazine recently put out an article listing the most admired companies in the world.  We took the top 50 firms (excluding Financials, and companies not traded in the US) on their list and put them through Applied Finance Group's quantitative recommendation framework.  Just because these firms are among the most admired companies in the world does not qualify them as the most attractive investment. Being among the most admired is an honor and means you must be doing something right, but might not necessarily mean the share price is currently attractive. 

The following articles which we have posted in the past on ValueExpectations.com will give you a better understanding of what it takes for management to create wealth, understand Management Quality, and see how EPS alone falls short in estimating a company’s value. There are two main characteristics a company must have in order to be a good investment opportunity: (1) the company needs to be a strong economic performer, (2) the company should be attractively priced.   Many people admired the DeLorean, but it was neither a good performing car nor a good priced car. Below we reveal a few "DeLoreans" after looking under the hood.

 

Top 50 Most Admired Companies According to Fortune

The Russell 1000 Index has lost 44% over the past year and is down 14% year to date. Similarly, the Russell 2000 Index is down 42% for the past 12 months and lost investors 18% since the beginning of this year. With both of these indexes down substantially recently by about the same amount, are large caps more attractive than small caps?

Percent to Target Charts: This graph shows the Percent to Target Current for a universe relative to the overall market. Values greater than 1 indicate the universe is more undervalued than the market, while values less than 1 indicate the opposite. The red line identifies the historical median value to provide a basis to understand valuation levels relative to historic norms.

Small Universe: Companies in the AFG universe that have a market cap less than $300 million and EPS consensus estimates are available.

This chart illustrates that the median Small Cap company is currently overvalued, relative to the market. Over the past 6 years, small Caps have been trading at a premium to their historic valuation.

 

Large Universe: Companies in the AFG universe that have a market cap greater than $2 billion and EPS consensus estimates are available.

This chart illustrates that the median Large Cap company is currently undervalued, relative to the market. Large Caps have been trading at a discount to their historic valuation, indicating a potentially attractive opportunity.

 

 

Following is a list of the biggest 10 companies (determined by market cap) in the Russell 1000 and Russell 2000. AFG’s Value Expectations interface, which solves for implied sales growth embedded in a stock price (VE Sales Growth), allows us to understand the embedded 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. An undervalued company is more likely to outperform those companies with high expectations relative to what they have delivered historically. The tables below display the implied future sales growth of these companies assuming their EBITDA margins and Asset turnovers stay at their 5-year median levels.

 

 

Conclusion:
Both the percent to target charts and VE analysis show that large caps look more attractive than small cap stocks. The large cap stocks on the list have lower expectations for implied sales growth and the overall universe is currently undervalued. 

This data is a sample of our Market Review.  Register to view Complete PDF... IT's Fast and FREE

If you are a registered user, click here to access complete PDF of our Market Review

 

The tech sector has been taking a pretty bad beating the past few months but according to Bill Luby of SeekingAlpha.com, The 4 Horsemen of Tech (RIMM, AAPL, GOOG, AMZN) will be the most likely companies in the sector to make the strongest comeback when the tech sector makes a comeback. Here is a list of many of the big names in tech and the implied sales growth expectations priced-in to justify their current price. The companies with low sales growth expectations priced-in (VE Sales Growth) compared to what they have been able to deliver in sales growth (5 Year Median Sales Growth) are the companies we believe have the best chance of making a strong comeback with the sector.

According to historical valuations the tech sector appears to be trading at a discount compared to historical valuations such as the Tech Bubble.

Big Tech Companies and Sales Growth Expectations

 

Over the years, The Applied Finance Group has made thousands of calls regarding stock valuations and whether they should be buy or sell candidates. More often than not, our calls have tended to work out and add value to our clients’ portfolios. Chart 1 below shows the cumulative performance of theoretical portfolios that consist of the most under and over valued stocks in the Russell 1000 and Russell 2000 indices. The main take away, is that over time our valuation approach has delivered superior results identifying Buy and Sell candidates for professional investment managers.

Chart 1

While our results are impressive, we have had periods of poor performance, most notably during the period of “irrational exuberance” of the late 1990’s, specifically from January 1999 to June 2000. During this period chart 2, summarizes our performance over this time period. Notice that this period, “over-valued” stocks performed much better than “under-valued” stocks.

 Chart 2

Proudly, I can say we never panicked about our under-performance during this time period. Unlike many investment research firms, we did not justify crazy company valuations. Back then, new research firms sprung to life everyday preaching how the world was fundamentally changing, and declaring that measuring corporate performance and understanding valuation were relics of the past. As irrationally optimistic about a “new world” as the market was then, today’s market suffers from excessively irrationally pessimistic beliefs about the future. As a picture is worth a thousand words, we thought it would be instructive to show our Intrinsic Value Reports for numerous high profile firms in early 2000. Understand that these charts are the exact charts our accessed in April 2000. While it is easy now to say Cisco was over-valued, our work showed how nutty that market really was back then when even dentists gave you a hot stock pick with every cleaning.

The following charts display our intrinsic value estimates for a number of high profile firms in April 2000. Looking at these charts, it is easy to understand why our research underperformed during this time period. Charts 3, 4, 5, and 6 show our January 2000 Intrinsic Value Reports for Cisco, ADBE, IBM, and Oracle. 

Chart 3

Chart 4
 

Chart 5

Chart 6

Notice that prior to 1999, our estimate of these firms’s intrinsic value (the green square) and their annual trading range (blue bars) closely followed one another. Starting in 1999, the valuations for these companies far exceeded our estimates of their intrinsic values. In almost every case by 2000 these firms traded at over three or four times our estimate of their intrinsic values. In the case of Cisco, we estimated its value in 2000 at approximately $11 a share, but during the year it traded over $80 a share. Once during a meeting with a “new age” portfolio manager, after pointing out how crazy Cisco’s valuation was he said to us: “AFG has 1 vote regarding Cisco’s valuation, the market has placed over 500 billion (he was referring to Cisco’s market cap, with each dollar being a vote) votes saying AFG is wrong”. He then promptly said, “You are wasting my time” and asked us to leave.

As mentioned earlier, It is easy to see how our research under-performed during this time period, we said Cisco was worth $11 a share, and in the course of two years it went from $11 a share to $80 a share. While we did not panic, we certainly were not very popular in the money management community, but we stuck to our guns and continued to advise clients and prospects to reduce their positions in these shares. Fortunately, by 2001, Cisco’s stock price corrected to our intrinsic value estimate of less than $10 a share. The same pattern was evident for each of the other firms charted above. The excessive valuations exhibited by these firms in 1999 and 2000, corrected towards their intrinsic value by 2002.

Let us examine the market, and revisit the above companies in today’s environment. The graph below shows the sales expectations priced into the S&P 500 over time. What is interesting is how pessimistic the market is today relative to the past ten years. Notice that in 2000, it was priced to generate sales of over 18% annually, today it’s only priced to grow at -5% annually. This implies that five years from today, the typical firm in the S&P 500 will have 25% lower sales than they do today! That seems a bit harsh.

 

On a company specific basis, Charts 7, 8, 9 and 10 show our current Intrinsic Value Reports for ADBE, IBM, and Oracle.

Chart 7
 

Chart 8

Chart 9

 Chart 10

It is interesting how the market has come full circle since 2000. Back then, the market refused to believe that the excess profits firms generated during those heady days would eventually mean revert towards their long-term average of zero. Today, the market refuses to acknowledge that the negative economic profits many firms currently generate will trend up towards their long-term average of zero. While the market’s valuation level is very different now relative to March 2000, one thing remains certain – following the market’s manic ways rather than thinking rationally on your own will consistently result in sub-par returns for your portfolio.

To help you keep your sanity, we have put together a screen of stocks trading below their intrinsic value. These are companies that have the opportunity to deliver superior longer-term returns as the economy recovers and corporate profits return to more normal levels. Take heart however, as today’s pessimism provides investors a great long-term buying opportunity to purchase great companies such as Cisco, ADBE, IBM, Oracle and others that are trading well below their intrinsic value.

Registered members that are logged in can download here:
You can download sample of such firms from a screen we created here.

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