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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 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) information. 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.

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

The example of AFG’s Intrinsic Value Chart we have provided is PACCAR Inc. (NASDAQ:PCAR) a company that currently looks overvalued according to AFG’s valuation model. An important fact to note is that AFG has shown it tracks PACCAR Inc. (NASDAQ:PCAR) well (high accuracy score of 98). Also, PACCAR Inc. has a current AFG Value Score of 25, meaning the company ranks in the bottom 25th percentile of companies in the AFG universe in valuation attractiveness. From strictly a valuation standpoint, not taking any other key AFG variables into account, PACCAR Inc. looks unattractive.

AFG’s Intrinsic Value Chart:

• Identifies entry/exit points

• Shows how well AFG has tracked the company (accuracy)

• Displays the trading range of the company each year through time (blue bars)

• Displays the end of year closing price (dash on blue bar)

• Displays AFG’s default intrinsic value (red dotted line)

How to Read this chart:

• The Blue Bars represent the high and low trading range for a stock for each calendar year.

• The red dotted line represents Applied Finance Group’s (AFG’s) historical Intrinsic Value through time.

• When the red line (Intrinsic Value) is above the blue bars (trading range) the company looks to be undervalued.

• When the red line (Intrinsic Value) is below the blue bars (trading range) the company looks to be overvalued.

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

Below is an example of AFG’s Intrinsic Value Chart and the important things  within the chart to provide a better understanding of what to look for when analyzing AFG’s Intrinsic Value Chart.

The Applied Finance Group (AFG) works with some of the most well respected investment firms in the U.S. to help them develop quantitative screening processes to identify a better pool of companies to choose from for their portfolio holdings. However, picking winning investment opportunities isn’t the only value AFG provides clients. AFG also develops quantitative strategies to quickly identify possible torpedoes lurking in your client or prospective client’s portfolio.

AFG’s quantitative process is centered on the proprietary Economic Margin (EM) Framework (what a company earns above its true cost of capital). The core of AFG’s quantitative process starts with evaluating corporate performance and the expected improvement relative to their peers, evaluating the valuation attractiveness of the company, and determining if a firm is following a wealth creating or wealth destroying strategy.

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

A brief description of those variables is available below the list of companies.

When identifying potential torpedoes AFG looks for companies with the least valuation upside compared to their sector peers, below sector median expected Economic Margin change, and a management quality score that reflects a management team following a wealth destroying strategy.

These 12 S&P 500 companies are potential torpedoes that could be lurking in your portfolio. These companies all possess characteristics that make for a bad investment opportunity. If you own one of these companies or consider adding one to your portfolio, we suggest taking a closer look as they look the most likely to underperform their sector peers according to criteria that has proven successful at identifying winners and losers in the market.

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

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.

Investment professionals are constantly looking for an edge in constructing their portfolio’s to invest in companies that will outperform a chosen benchmark and their peers in the sector. The purpose of The Applied Finance Group’s (AFG’s) Market Forecast Project (MFP), a sentiment survey of a large group of investment professionals is to provide that edge. Drawing from “the wisdom of crowds” to gain valuable insights on how policies will affect the markets and economy as a whole can help investors better communicate with clients, gain actionable buy and sell ideas as well as to help construct their portfolio’s.

Participant’s gain access to each month’s results before they are released to the public! Click Here to join the Market Forecast Project… Its Fast and Free!!

A recent MFP question on health care pointed the way back in September of this year that a health bill that would include a public option would fail to be passed. 78% of participants believed a public option would fail to become a reality and this has had a major impact on private health insurers such as Humana and Aetna. With many issues surrounding these private health insurance companies when the threat of a public option was much larger, these companies had been punished by the market. If you had a crystal ball to tell the future (like the MFP) you would have been able to predict that the public option would not be passed well in advance of its actual occurrence and therefore the private insurers would have looked much more attractive. Investor’s who paid attention to the MFP in September and loaded up on all of the private health insurers in the S&P 500 would have outperformed the S&P 500 and the Health Sector ETF (XLV) from September 1st through today. Private health insurers in the S&P 500 are up 18.24%, The S&P 500 is up 10.46% and the XLV is up 10.55% since the MFP identified that a public option bill would not be passed.

The Market Forecast Project is designed as a free service for professional investors who are interested in gaining insight into how their peers currently view the market and what the “wisdom of crowds” predicts for the effect of policies and events on the markets and overall economy.

Participant’s gain access to each month’s results before they are released to the public! Click Here to join the Market Forecast Project… Its Fast and Free!!

Professionals often talk about expectations in the market, avoid the market when expectations are too high and invest when expectations are very low. However, expectations can be very misleading especially if the investor is fixated on something such as EPS expectations. Companies sometimes beat EPS expectations but still underperform in the market. Click here to view an article discussing the shortcomings of looking at EPS alone.

The Applied Finance Group (AFG) excels at understanding embedded expectations with their robust Economic Margin methodology and valuation model. This process allows professional investors to use value drivers such as EBITDA and asset turns to solve for the embedded sales growth a company needs to deliver to be fairly valued in the market today.

Although AFG’s expectations research is used on an individual stock basis investors can gain insight by looking at the market on an aggregate basis to understand the expectations the entire market has priced in today.

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

Below is a snapshot of the world and S&P 500 expectations vs. what each market has been able to deliver historically. Much like understanding the expectations that are priced into a stock, these charts help clients to better understand whether the market has high or low expectations currently priced in.

As an example, if you look at the chart that shows the World expectations, over the last 14 years the average company in our global database has delivered 8.47% sales growth while currently there is roughly 7% sales growth priced in. This suggests that the market expectations are in line with what the market has delivered historically. Ideally, the most attractive investment opportunities are when the market is delivering well above the market expectations.

*World Index described below

In 2009, the average company in the S&P500 delivered roughly 6% sales growth while the market currently has 8.23% revenue growth priced in. If you think the market can deliver better than 8.23% the next 5 years then you believe you are paying for low expectations. If you believe the average company in the S&P delivers less than 8.23%, the S&P500 (INDEXSP:.INX) has slightly high expectations.

AFG model portfolio performance has shown that investing in companies that have low expectations relative to what they have historically delivered are more likely to outperform than those companies with high expectations. The key is for investors to identify markets and stocks that have low “value expectations” embedded into their stock prices.

If you are a professional investor, and have a list of stocks you would like to understand the embedded expectations for… CLICK HERE.

The table below provides a breakdown of what countries/indices were taken into account in this study to make up the world index.

The Applied Finance Group’s (AFG’s) research and suite of investment tools help investors to easily understand a company’s true economic profitability, as well as if the company’s asset management policy is suitable to maximize that profitability. AFG’s Wealth Creation Report (WCR) allows you to visually analyze a company’s historical Economic Margin (EM) level, current EM and expected change in EM based on projections built out by AFG’s default valuation model, which takes into account the total cash flow a company delivers. A company that earns above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Back-tests have proven these companies to be more likely to outperform those companies following a wealth-destroying strategy (negative Economic Margins and growing assets).

Avoiding firms with management teams who try to grow a negative profitability business has helped our clients since 1996 avoid potential torpedoes in the market. AFG believes that if a firm is not profitable, it needs to divest losers and focus on its core competencies to get its profitability levels back on track and earn the right to grow, rather than throw more money at a losing business. After getting an understanding of how profitable a firm is and which direction the firm’s profitability is headed, investors must then understand how much a company is growing out its assets to take advantage of its current profitability or what to divest in order to fix its profitability.

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

Beyond having positive Economic Margins (EMs) and growing assets, investors want to see a company improve its EMs at a greater rate than its sector peers, as these companies have also proven to be more likely to outperform than companies with declining EMs.

Below is an example of Micron Technology (NYSE:MU), a company AFG considers to be a consistent wealth destroyer, identified by using AFG’s Wealth Creation Report.

Just because a company has historically been a consistent wealth creator/destroyer does not necessarily mean the company will continue this pattern nor does it mean that the company currently looks unattractive from a valuation perspective. Over the past two years, Micron Technology has divested parts of its business, which may have been a good thing as its EMs are projected to improve in the upcoming year. However, the company currently looks to be overvalued according to AFG’s valuation model. To see how MU rates as far as overall investment attractiveness view the chart below.

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

AFG's Wealth Creation Report is a 3part chart:

The first chart is a summary of a company’s economic performance over time, as well as insight into how analyst EPS forecasts project AFG’s default EMs over the next two years.

• EM – Productive Capital = (Cash Flow minus Capital Charge excluding Intangibles) divided by the Inflation Adjusted Productive Capital.

• EM – Invested Capital = (Cash Flow minus Capital Charge including Intangibles) divided the by Inflation Adjusted Productive Capital.

•Val Score = Ranked Percent To Target for the current calendar yr. where 100 is the most undervalued and 0 is the most overvalued (ranked across all firms in database with forecasts for 4,000 firms).

• EM Chg = One year out forecast EM minus last reported fiscal year's EM. Invested Capital EM is used.

The second part of the chart is the Asset Growth chart allows additional insight not only the growth of a company, but how that company’s growth strategy has affected their economic performance.

• Assets – Steady Growth (1 Yr) = The real growth rate at which a firm can increase its capital base given internally generated cash, while maintaining a constant capital structure.

• Assets – Actual Growth (1 Yr) = Real year over year change in Inflation Adjusted Invested Capital achieved by the firm. Note: All actual growth is “actual”, i.e. 2007 growth represents growth from most recent quarterly balance sheet.

This data can then be used to identify how the stock has performed in relation to the market place.

• Return Net Market = The company's cumulative total return relative to the cumulative market-weighted average total return of the largest 2000 companies for the equivalent time period.

 Be on the lookout for Weekly company highlights using The Applied Finance Group's Wealth Creation Report.

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!

 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!

The Applied Finance Group’s (AFG’s) research and suite of investment tools help investors to easily understand a company’s true economic profitability, as well as if the company’s asset management policy is suitable to maximize that profitability. AFG’s Wealth Creation Report (WCR) allows you to visually analyze a company’s historical Economic Margin (EM) level, current EM and expected change in EM based on projections built out by AFG’s default valuation model, which takes into account the total cash flow a company delivers. A company that earns above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Back-tests have proven these companies to be more likely to outperform those companies following a wealth-destroying strategy (negative Economic Margins and growing assets).

Avoiding firms with management teams who try to grow a negative profitability business has helped our clients since 1996 avoid potential torpedoes in the market. AFG believes that if a firm is not profitable, it needs to divest losers and focus on its core competencies to get its profitability levels back on track and earn the right to grow, rather than throw more money at a losing business. After getting an understanding of how profitable a firm is and which direction the firm’s profitability is headed, investors must then understand how much a company is growing out its assets to take advantage of its current profitability or what to divest in order to fix its profitability.

Beyond having positive Economic Margins (EMs) and growing assets, investors want to see a company improve its EMs at a greater rate than its sector peers, as these companies have also proven to be more likely to outperform than companies with declining EMs.

Below is an example of Best Buy (NYSE:BBY), a company AFG considers to be a consistent wealth creator, identified by using AFG’s Wealth Creation Report.

Best Buy Co., Inc. (NYSE:BBY) – Consistent Wealth Creator

Click Here If you are a professional investor and would like to trial AFG’s research products or to see if you are qualified to have a portfolio reviewed by an AFG representative.

AFG's Wealth Creation Report is a 3part chart:

The first chart is a summary of a company’s economic performance over time, as well as insight into how analyst EPS forecasts project AFG’s default EMs over the next two years.

• EM – Productive Capital = (Cash Flow minus Capital Charge excluding Intangibles) divided by the Inflation Adjusted Productive Capital.

• EM – Invested Capital = (Cash Flow minus Capital Charge including Intangibles) divided the by Inflation Adjusted Productive Capital.

•Val Score = Ranked Percent To Target for the current calendar yr. where 100 is the most undervalued and 0 is the most overvalued (ranked across all firms in database with forecasts for 4,000 firms).

• EM Chg = One year out forecast EM minus last reported fiscal year's EM. Invested Capital EM is used.

The second part of the chart is the Asset Growth chart allows additional insight not only the growth of a company, but how that company’s growth strategy has affected their economic performance.

• Assets – Steady Growth (1 Yr) = The real growth rate at which a firm can increase its capital base given internally generated cash, while maintaining a constant capital structure.

• Assets – Actual Growth (1 Yr) = Real year over year change in Inflation Adjusted Invested Capital achieved by the firm. Note: All actual growth is “actual”, i.e. 2007 growth represents growth from most recent quarterly balance sheet.

This data can then be used to identify how the stock has performed in relation to the market place.

• Return Net Market = The company's cumulative total return relative to the cumulative market-weighted average total return of the largest 2000 companies for the equivalent time period.

Be on the lookout for Weekly company highlights using The Applied Finance Group's Wealth Creation Report.

The Applied Finance Group's Value Expectations interface sets out to understand the imbedded sales growth a company needs to earn over the next 5 years to justify the company's current stock price. Measuring the spread between a company’s VE sales growth expectation (Implied Sales Growth) and what it has historically delivered (5 year historical median) provides a basis to determine which stocks have relatively low expectations imbedded into their current prices and thus are more likely to outperform.

After solving for the implied sales growth (VE Sales Growth) for every company in the S&P500 (INDEXSP:.INX) (ex. Financials) we find that the average implied sales growth for the overall index is 7.64%. Relative to the 12.31% the same group of companies was able to deliver historically (5 Year Median), the implied sales growth (7.64%) seems fairly low relative to historical expectations. The chart below displays how the imbedded sales growth expectations (red bars) compare relative to the historical average (blue bars) by sector to determine which sectors might be the most undervalued.

One thing to note is, when we solve for sales growth, we use AFG’s Economic Margin Framework to correct for accounting distortions by taking into account Asset Life, Asset Mix, Asset Age, Capital Structure and Growth, Cost of Capital and Inflation.

Click here to register for Value Expectations to learn more about AFG’s understanding of sales growth expectations “priced-in” to share prices.

*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.

Click Here to register for ValueExpectations to recieve more long/short ideas, Market Forecast Project results, and our Monthly Market Reviews... Its Fast and Free!!

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.

The Applied Finance Group (AFG) has a disciplined approach for identifying companies that are expected to outperform and underperform the market by using proprietary metrics and measurements that have been tested and proven through time. Because AFG’s research is fundamentally derived, AFG’s quantitative analysis spans across growth and value stocks, all sectors, industries, and market caps with over 20,000 covered securities globally.

When searching for Large-Cap ideas, AFG’s Buy/Sell list is a good starting place as it has proven to create a significant spread in performance between companies that come up on AFG’s buy list and those on the sell list. Further focusing on companies based on AFG’s proprietary screening criteria (Economic Margin, valuation, quality of earnings, and management’s ability to create shareholder wealth) will save investors time in their research process. The result is a target group of stocks that can help you outperform as well as identify potential torpedoes to avoid in your portfolios.

Below is a list of attractive companies in the S&P 500 from each major AFG sector (excluding financials). It serves as a focus list of companies for investors to begin with as they meet AFG’s criteria to be an attractive opportunity. They are more likely to outperform their sector peers and the S&P 500, the benchmark that AFG’s clients most often compare themselves with.

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.

+View our List of Value Expectations Recommended Articles

AFG Recommendation Performance
9/1998 – 5/2009
Annualized Returns

Source: AFGView client databases from 9/1998 – 5/2009
Universe size: 4,000 to 5,500 firms

The AFG 50, developed by The Applied Finance Group (AFG) is an actively managed large-cap buy list of 50 stocks, benchmarked against the SP500. The AFG50 is sector neutral to its benchmark (SP500) and targets low annual turnover. The AFG50 is designed to consistently outperform its benchmark and serves as an outsourced research team providing our clients actionable buy ideas backed by detailed models, reports, updates and a backup list for possible replacements for each sector. Anytime there is a change made to the list i.e. new stock, reiterated/change of buy/sell recommendation or adjustments made to models our clients are immediately notified via e-mail.

AFG 50TM:

• An actively managed buy list of 50 stocks, remaining sector-neutral.

• Long-only and targeting turnover of less than 40% annually.

Our Goals:

• To consistently beat the index our clients are most often measured against, the S&P 500.

• To serve as an outsourced research team, distributing relevant content to our clients on a weekly basis.

• To provide consistent, actionable buy ideas in each major economic sector.

In depth research reports are issued on those companies held within the AFG50. These reports explain our analyst’s rationale for holding the company and highlight important insights to understand each company’s key economic drivers. When we drop a stock from the portfolio, we will justify why and provide a research report for our new addition.

Performance on the AFG50 stocks, are maintained and accessible on AFGview.com.

Leverage Your Research by taking advantage of our analyst research!

The chart below highlights the performance of The AFG 50 vs. The S&P 500 since inception.

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On Wednesday November 18th, Mr. John 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.

To participate in Mr. Tamny’s FREE upcoming webinar, click here

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!!

by David Lee Berkowitz (Guest Contributor)

As I write this letter, the third quarter has ended in what continues to be an incredible year for the stock markets, the economy and the country. Unfortunately, the “regime uncertainty” I wrote about last quarter has not clarified. We still do not know with any more visibility than 3 months ago what the business landscape and the new regulatory rules of the road will be.

This uncertainty is killing job growth and investment today. But unprecedented world-wide monetary stimulus is stirring the emerging markets’ economic engine. This means big US Businesses are getting more hopeful – but the small business person is still scared to death.

Why not? Huge budget deficits, tight credit and extended debates about mandates on healthcare and carbon reductions have created one of the worst small business environments since the 1970s.

In light of that, I believe it is important to briefly summarize where we’ve been this year, where we are today and the prospects for the period ahead – and also to highlight some lessons from last year’s financial collapse.

Where we’ve been

Six months ago, in early March, it truly did feel like the world might be coming to an end – talk of a return to a Great Depression-like economy dominated the media. Understandably, fear was rampant – and stocks responded to these nightmarish scenarios by hitting the lowest levels in years, with financials especially hard hit. Although no one knew it at the time, that turned out to be the bottom. Since then, the economy has moved back from the precipice – there is a growing consensus that we’ll return to economic growth in the second half of this year. The Economist recently ran a cover story discussing the extent to whichthe economic recovery is being led by Asia.

How’d we do?

The ValueAligned® Folio accounts were up +9.1% for the 3rd Qtr compared to +15.6% for the S&P 500 index. For the year as of September 30, 2009, the accounts were +14.2% year to date (YTD) with 25% in cash ready to go to work when opportunities come up against 19.3% for the S&P 500. The ValueAligned® Fund, L.P. was up +13.4% (net) with only 75% exposure to the market.

Fallen Angels

During the initial stages of historic trading rebounds, much of the market action is whacky. This chart below illustrates how this rally treated low class stocks on the first recoil rally - the outperformance of the trashy (below $5) stocks is why there is value in big cap stocks, especially with the US dollar falling so steadily.

So the really hot-shots of performance this year (for the first 3-4 months of the rally) owned what looked like dogs that happened to move down below $5 then back to say $9.50 when the crowd figured out they were down but not out. We had our fair share of these companies that had high debt but equally high cash flow and/or assets to make it through the credit crunch – and we hung on and in some cases bought more - companies like Tempur-Pedic (TPX, +196% ytd) or Borders (BGP, +487% ytd) and AC Moore (ACMR, +264% ytd)

But in the last two months, we are seeing the traditional disciplines once again start to be rewarded—change in economic performance and value, like Google (GOOG, +80% ytd).

What’s happening now?

We are about half way through earnings reports for the third quarter and the momentum continues – companies are doing much better than analysts predicted just a few weeks ago. They are also raising guidance at a time on the calendar when they usually are a bit more cautious going in to the next year.

We are about to put October to bed, which means the best stock market months are coming up - November and December. But September and October haven’t been bad or scary (pun intended), so maybe November/December won’t be as good as usual.

This earnings season has been stupendous. Many more companies that are surprising those scared-to-death analysts are outnumbering the disappointments by a 5.6 to 1 ratio.

Also, the median surprise of the median stock’s earnings on the upside is 7.90%. And that is the third quarter earnings comparison. As we shift 3 more months to comparing against the trough of 2008 despair - the 4th quarter, we should get higher growth and more upside to estimates going into 2010.

Tax Harvesting Time

Is there anyone anywhere that does not think capital gains rates are going up? We advise you to check with your tax expert to see if you have any carry forward losses from the last two years so you can take gains today to offset those losses.

Also, check to see whether any of your bond funds or stock funds will be distributing large capital gains, many of which you might not have earned but will still have to pay taxes on! As long as the penalties for withdrawal are not so onerous, then get out before the funds distribute the gains to the suckers left holding the bag.

Then, invest the money with us in one of our ValueAligned® Folios. That way you and your tax expert will control the timing and magnitude of your gains, stock by stock, not fund by fund, which puts you in complete control. Remember in taxable accounts you can most effectively harvest low rate gains or losses to minimize or eliminate tax in the current period.

Then what?

Much of the earnings gains are coming from trimming underutilized resources – like employees. Revenue growth is low and not beating expectations or bottom line growth – a situation that is unsustainable.

This is terrific for big US companies getting more and more competitive, but really bad for the US consumer, whose joblessness is here to stay, unless we get some business friendlier fiscal policy or at least more clarity from the crowd in Washington. Small businesses who employ and hire 2/3 of the US workforce need some visibility – right now they can’t see through the fog and only see higher taxes – not exactly the environment that incentivizes the hiring of new resources.

The brightest spot for earnings is the technology sector. Look for more mergers in this sector as the cash rich giants turn to strategic M&A to round out technology and product portfolios. As a result, we’ve had a strong recovery in markets – from their bottom in the beginning of March, stock markets are up over 50%, retracing a good portion of the losses since last fall.

Here are four lessons we should have learned from the last twelve months:

1. Trying to beat the market is the wrong goal. Why? 2008 is the perfect example. The S&P 500 lost -38%. If you lost only -30% - you won. Right? You beat the market after-all. Somehow I doubt you would be thrilled with such news. Investing is about achieving long-term goals. That’s the over-arching objective for all our clients – their personal goals. Do you know that there are some hedge fund managers that take performance fees on negative performance as long as they beat the market?

2. The stock market is risky, volatile, and unpredictable. But we need to ignore it or be ready to buy when others panic as long as we have the right long-term plan.

If you look at the chart above of monthly returns going back to 1926 you’ll notice that the stock market is very volatile from one month to the next. But we found out that it doesn’t really matter as long as at the time we invested we had a plan. Our plan was to leave the money alone for years, maybe even decades. Now let’s stretch out our view of the market from months to 15 year periods as shown in the figure below When viewed over long periods of time,

the stock market isn’t nearly as unpredictable or volatile. And that means it’s not nearly as risky as the media, the gurus and the politicians would have us believe.

Yet most investors view the market from the perch that only sees today’s market action. They watch it day by day, moment by moment. They get frightened and they panic. They sell at the bottom and buy near the tops – it is human nature and is the most destructive of investor behaviors.

We think it is much better to set up a plan that takes account of when you need cash and then stick to it. Stop looking at your account each hour, each day or each month – find something better to do!

3. Americans need to save more, spend less and stop relying solely on their assets appreciating for their retirement. Look at the picture below that was published in a Hays Advisory commentary. It shows that Americans have gone on a spending binge

as their savings rates (blue line) declined. Of course, with that, the actual dollar amount of savings (the yellow bars) fell to historically low levels – house price appreciation and stock market paper wealth made Americans feel that their savings were fine. Until the debt bomb exploded and the liquidation of real estate and stocks – the collateral for those loans – began in earnest, did Americans begin saving from their paychecks once again. This chart shows that Americans spent $1.5 trillion ($1,500,000,000,000) that should have been saved if past savings behavior of about 4% stayed constant.

4. All successful long-term investing is goal-oriented and therefore planning- driven. All unsuccessful investing is market-oriented and performance-driven. Investors were also reminded of the need to focus on what they can control – understanding their cash needs and spending thereby thinking through how much risk they can tolerate to fund those needs.

Where we are today?

Two years ago, the market was characterized by rampant optimism. The U.S. market had hit a new high in November of 2007 and any concerns were set aside as minor annoyances.

By contrast, six months ago the market was overwhelmed by absolute pessimism – there was no sign of hope anywhere. The chart below measures how the smart money – the Goldman Sachs of the world – is betting in the option market. When they

buy more calls than puts they are optimistic. And when Goldman Sachs is optimistic you can bet that the public and other investors are scared to death – like in March of this year. Back when the rest of us had no worries or cares and all things looked A-Ok, Goldman and the other insiders were happy to sell you stock because they knew before all of us that something really bad was brewing.

Today, the market is somewhere between those two extremes and many investors can be characterized as extremely nervous.

As a general rule, a certain level of healthy anxiety is positive – what gets investors in trouble is an excess of either optimism or pessimism. While today’s mood may be a bit too pessimistic, being cautious in the current market makes sense … provided that prudent caution doesn’t cross the line into panicked inertia or hasty decisions.

The good news is that there are still excellent opportunities for investors who are prepared for short term volatility. I spend a lot of time listening to the best market minds and to managers who have lived through multiple cycles. I am reassured that most say that they are still finding very good value – not to the extent that they did earlier this year, but still well ahead of what they would have seen a year ago.

The outlook going forward

In August, Business Week ran a cover story called “The Case for Optimism.”

The premise was simple: Beyond the issues facing the global economy, there are many underlying positives that give cause for optimism if we look out two or three years or beyond.

Powerful forces under the surface will drive economic growth … and that economic growth will drive stock prices. Examples include the positive impact of technology, the recovering US housing market, the revitalization of economies and the incredible energy from the developing world’s educated youth and emerging middle class.

Sure, it has been a harrowing storm. And now is no time to discount the dangers that still exist. But opening your mind to optimism can help you seize the opportunities ahead.

Volatility

Let me close by talking about market volatility.

In 1907, U.S. financier J. Pierpoint Morgan single-handedly averted a banking panic among U.S. investors.

Later in life, someone asked him his best guess as to the direction of the markets. His answer: “They will go up and they will go down.” One hundred years later, that’s still the best technical answer to someone looking for a short-term market forecast.

No one can predict market movements in the immediate period ahead – all we can do is understand clearly how much short term volatility we can live with, adjust our portfolios accordingly and stay focused on the horizon as we deal with the rough waters. No one likes volatility … but for most of us it’s the necessary price to arrive at our ultimate destination.

But his answer is misleading. It is incomplete. In any given short-term period like a day or a month stocks go up and down sure, but it is more accurate to say that prices in the overall stock market rise a lot, but fall a little. And that means over the long-term the stock market goes up.

175 years of data

The chart below is one of the most persuasive to show you that saving and investing now in the stock market is the best opportunity to meet your long-term goals. Previous troughs in the rolling 10 Yr Total Return of the stock market has led to annualized performance of 145% over the next 10 years – and that is just an average, about a double every 5 years.

The troughs in this chart coincide with very scary times where you feel like our best days are behind us – the Chinese (or Japanese 30 years ago) are taking over. At each trough you would be worried about budget deficits, trade deficits, savings rates, demographics, the US dollar, and inflation as though the current state will always persist into the future. It’s ironic that human nature is wired to believe these scary stories told by supposed experts, rather than believe the message of this simple chart. Use data not emotions to invest and stick to a solid plan.

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 here to be the anchor for our clients, an honor and a privilege, and a tremendous responsibility to provide perspective, understanding and support. Over the past while, I’ve talked to most of our clients about their portfolios. I would be happy to spend time with any of you that are not yet clients but would like a second opinion.

If I missed you for some reason or you would like to discuss your investments in more detail, I am always delighted to have that conversation too.

Best regards,

David Lee Berkowitz
Rapidan Capital, LLC

With 3 Quarters of 2009 now in the books, we thought it would be timely to provide a list of the top 20 performers in the S&P 500 so far this year to give investors an idea of which stocks have been doing well. Along with the list of top 20 performing companies, we have also provided a breakdown of the average return by sector as defined by AFG vs. the entire S&P 500 index to show which sectors have been leading the way. Also by using The Applied Finance Group’s (AFG's) research and valuation model we have provided further analysis on 4 of the top performing companies, 2 that we find attractive going forward and 2 that we find unattractive, based on valuation attractiveness, expected improvement in economic profitability and the overall investment attractiveness, which is based on various criteria AFG uses when identifying long/short opportunities.

Top 20 Performers In S&P 500 YTD (Total Return)

2009 YTD Sector performance (average return %) in S&P 500

 Here are a few companies from the list of top 2009 returns and we view these companies going forward based on valuation, Economic Margin Improvement, and other criteria AFG uses to value securities.

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