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ValueExpectations.com emphasizes evaluating a company’s ability to earn a spread above their cost of capital using a very robust measure of corporate performance, Economic Margin. After evaluating a firm’s ability to create wealth VE.com then determines what price we are paying for the company using a modified discounted cash flow model. If we had to simplify performance, a very elementary way to evaluate performance can be Return on Invested Capital ROIC and valuation which can be simplified by using earnings yield. This is the approach Joel Grenblatt uses in his book, The Little Blue Book that Beats the Market.

In January VE.com highlighted a list of stocks based on Joel Greenblatt’s Magic Formula Investing Strategy from 1998-2004 Greenblatt’s simulated returns were 30.8% a year, relative to a 12.4% annual return for the S&P 500 and was only down in one year in that time-span.

In our article posted on January 9, 2009 we listed our best 30 “Magic Formula” companies which has earned returns comparable to the tests conducted by Mr. Greenblatt. From Jan. 9, 2009 to Dec. 14, 2009 the 30 companies we recommended from our “Magic Screen” have returned a solid 32.06% spread above the S&P 500. Since our last “Magic Formula” portfolio was successful we have decided to run the screen again for a new list of companies to see just how consistent this strategy is.

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A look at Greenblatt’s formula for successful “Magic Formula Investing”:

1. Establish a minimum market capitalization (usually greater than $50 million).

2. Exclude utility and financial stocks

3. Exclude foreign companies (American Depositary Receipts)

4. Determine company's earnings yield = EBIT / enterprise value.

5. Determine company's return on capital = EBIT / (Net fixed assets + working capital)

6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).

7. Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.

8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

9. Continue over long-term (3-5 year) period.

Mr. Greenblatt was a student of both Ben Graham and Warren Buffet and tried to include valuable insights from each investor in his “Magic Formula.” His Magic Formula was a screen that percentile ranked two variables: Return on Invested Capital (quality) and Earnings Yield (valuation). The idea is simple, buy the best companies at the best price and then hold on to them for one year. The Little Blue Book recommends selecting the top 30 firms from the “Magic Formula.” That formula ranks each company by variable and then puts a 50% weight on each.

 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.

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Understanding the amount of accruals a company has on its books and the quality of its reported earnings is especially important during earnings season, as poor earnings quality companies are more likely to have negative earnings surprises and underperform as a result. With so many companies reporting earnings this week, we wanted to share an analysis of their earnings quality based on The Applied Finance Group’s Earnings Quality score. AFG’s Earnings Quality variable is based on the concept of accruals and is an important indicator, which helps to differentiate between companies with poor and high quality of reported earnings. Watch out for firms with poor EQ score – make sure they are not trying to pad their sales numbers through channel stuffing, for example.

*Source: www.afgview.com

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.
• Low Accrual companies outperform high accrual companies
 

 Here is a look at how well the Earnings Quality variable works when you split top half vs. bottom half in each sector/style universe.

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

Here is a look at an example of a poor Earnings Quality company that has a negative earning surprise and thus underperforms.

Eastman Kodak

• Other Liabilities declined in Q308, leading to high accruals – change in licensing agreement required immediate recognition of deferred revenue.
• Eastman Kodak (EK) subsequently missed earnings in Q408.
• EK’s stock dropped 29% on January 28th, when Q408 earnings were announced.
• EK has underperformed the S&P500 by almost 70% since January 28th.
 

source: www.economicmargin.com

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