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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.

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

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.

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

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 Applied Finance Group (AFG) is an independent equity research provider that has partnered with CEO Magazine in recent years to give investors insight into which CEOs do the best job of creating value for its shareholders; after all, that is what they are hired for. The AFG/CEO Wealth Creation Index, which relies upon AFG’s corporate performance metric Economic Margin (EM), provides a better understanding of wealth creation than traditional accounting measures such as EPS and ROC. The link below will take you to the complete list of rankings of CEOs from S&P 500 companies that have held their current position for at least 3 years, based on their wealth creation abilities. Topping the rankings in 2009 is MasterCard’s Robert W. Selander, up from third place last year. Both Selander and runner-up Federated Investors’ J. Christopher Donahue run very high EM companies (24.5 percent and 20.6 percent three-year averages, respectively). Interestingly, both have been able to improve in a bad economy.

As a further layer of analysis, we have taken the companies of the top 10 CEOs and ranked them based on Valuation Attractiveness to give insights into which companies on the list look the most attractive as potential investment opportunities. Even good companies with strong leadership do not always make good investments, because it depends on what you pay for them. The companies on the list that look unattractive from a valuation standpoint are the companies we recommend reviewing in greater detail before you consider adding to any portfolio.

Since 1996, through back-tests and model portfolio results, AFG has proven to be successful at identifying winners and losers in the market by utilizing its Economic Margin methodology (understanding a company’s true economic profitability), and valuation techniques as seen in the Buy/Sell spread (provided below).

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

In recent weeks we have written several blogs (S&P 500 sector stock watch, Attractive stocks under $35, with potential investment opportunities, Solid S&P Value Companies, Cheapest Stocks In the S&P 500), discussing investment opportunities within the S&P 500. These stocks ideas all had favorable scores under The Applied Finance Group's (AFG’s) investment criteria, which includes economic performance, valuation, earnings quality and management’s ability to create shareholder wealth, among other criteria.

Another way that AFG identifies potentially attractive investments is through the use of its Value Expectations interface, which helps investors get a better understanding of the expectations embedded into stock prices. This interface 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 below displays the implied future Sales Growth (“Priced-in Sales Growth) of the companies we have recently recommended in our recent blogs, assuming their EBITDA Margins and Asset Turnovers stay at 5-year median levels.

The Applied Finance Group’s (AFG’s) goal is to help its clients pick the best stocks in any index, sector or market cap through the use of its Economic Margin (EM) methodology, valuation techniques, and ability to evaluate management’s capability to create shareholder wealth. The EM methodology helps investors understand the true economic profitability a company has earned by making adjustments to correct for some of the common distortions in traditional GAAP accounting practices. The valuation model AFG has built has proven through time to identify mis-priced securities which helps its clients take advantage of those mis-pricings and outperform their chosen benchmark (most commonly the S&P 500).

Below is a list of companies from the S&P 500, one from each major AFG sector (Excluding Financials), that meet AFG’s criteria to be considered as an attractive investment opportunity based on expected improvement in EMs, attractive valuation and a management team following a wealth creating strategy.

Investors are always looking for an edge, a way to improve their stock selection process in the hope that it improves their overall performance. Fundamental investors may flirt with the idea of adding a technical overlay to their process while a value investor may take more of a chance on a growth company. No matter what style of investor you are, you want to be sure the process you are implementing makes sense.

Because of the volatility of the market, investors seem to be paying more attention to the technicals of the companies they hold or are considering to buy. While there are several ways technical analysts look at the momentum in the market, ValueExpectations.com will concentrate on the simple, yet widely used 50 and 200 day moving averages relative to a companies current trading price.

We, at The Applied Finance Group (AFG), believe that technicals are relevant, but it is much more important to focus on the fundamentals of a company in determining which securities are over/under valued. We have taken the S&P 500 and focused only on the stocks trading above their 50 and 200 day moving averages (44%) for those investors who pay closer attention to technicals, and provided a list of companies in most of the major economic sectors that we find attractive and some that we find unattractive based on AFG’s investment criteria, which focuses more on valuation attractiveness and expected corporate performance.

However, if you do look at momentum, a variable we would suggest concentrating on is economic momentum. AFG’s economic momentum coupled with valuation give you a tremendous advantage in outperforming!

Sectors without adequate representation were excluded (Financials, Basic Material, Transportation)

Value Expectations teaches professional investors how to make more informed investment decision evaluating stocks on the basis of corporate performance, valuation, management quality, earnings quality, and other proprietary variables. These variables inevitably help identify companies that are potential long-term investments while avoiding potential torpedoes. However, during the financial crisis, leverage and a week balance sheet played a significant part when investors evaluated a holding.

To help our institutional clients navigate the environment The Applied Finance Group (AFG) developed the risk analysis template specifically to model the healthiness of a company’s balance sheet. In addition to the risk analysis template we also developed a template that calculated an Altman Z-Score developed to identify companies that are most likely to go bankrupt.

As professional investors we often move on and like to forget the past concentrating on how to gain alpha in the future. However, not to forget the past we decided to post an update list in the S&P500 on companies that are financially healthy and are attractively priced using The Applied Finance Groups valuation model.

Provided below is a list of healthy Z-score companies within the S&P 500 that also look attractive based on The Applied Finance Group’s (AFG’s) investment criteria. All of the companies listed have an attractive valuation and are expected to improve their Economic Margins (AFG’s measure of what a company earns above its cost of capital) more than their sector peers. Companies expected to improve their Economic Margin’s (EMs) have proven to be more likely to outperform than companies with an expected decline in EMs.

Using AFG’s valuation model on AFGView.com, we identified a few firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

About The Altman Z-score - Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.

The Altman Z-Score breaks down firms into 3 zones:

• >2.99 – Not Likely to Go Bankrupt

• 1.8 - 2.99 – Gray Area

• <1.8 – Likely to Go Bankrupt in the Next 2 Years
 

Related Tickers: "NYSE:PCP"

 

About Economic Margin

 

Created by The Applied Finance Group,  The Economic Margin (EM) Framework was developed to evaluate corporate performance from an economic cash flow perspective and is an alternative to accounting-based valuation metrics. EM measures the return a company earns above or below its cost of capital and provides a more complete view of a company’s underlying economic vitality

 

Value-based metrics (as opposed to accounting-based methods) have become popular for two reasons. First, capital markets have forced money managers and corporations to have a renewed focus on the balance sheet; these companies are expected to provide an adequate return on the money they have invested. Second, accounting information, although necessary, does not by itself adequately explain market valuations nor provide comparability between firms.

 

EM is meant to serves two purposes: Create an measure of a company’s economic profitability; that is, did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? Once we have solved for this, we can then use this EM as a function in our valuation model.

 

EM is calculated by dividing a company’s Operating Cash Flow minus Capital Charge by their Invested Capital. For a more detailed explanation see below.

 

 

Economic Margin Framework is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

 

Economic Margin captures the relevant drivers that are necessary to evaluating corporate performance and identifies wealth creating firms as well as wealth destroying firms while focusing on the key issues that drive market valuations. The EM also incorporates risk through a capital charge on all of a firm’s cash flow while also providing an annual snapshot to evaluate company track records creating and destroying wealth to evaluate current company actions.

 

Correcting Common Accounting Distortions

 

Accounting-based valuation methods provide an incomplete view of a company’s value by not accounting for investment to Generate the Earnings, Cost of Capital, Inflation or Cash Flow.  Because the EM corrects these accounting distortions by taking into account Asset Life, Asset Mix, Asset Age, Capital Structure and Growth , effectively linking the income statement and balance sheet, EM levels have a much higher correlation with market Values. 
 

 

A company’s performance measure must serve as a proxy for its market value creation.  Successful corporations consider cash flow, investment, competition & risk when setting strategy with the goal of creating shareholder value.  But not all management teams are successful at creating shareholder value.  As displayed on the graph below, AFG's Economic Margin can help invesmtent managers clearly distighigh managment teams abilty to create shareholder value.

 

Below is a comparison between Best Buy (BBY) and Circuit City (CC). Not surprisingly, soon after we took a snapshot of Circuit City’s Wealth Creation report they filed for bankruptcy.

Source (The Applied Finance Group)


Source (The Applied Finance Group)

 

 

The average company in the United States generates an Economic Margin of zero.  Below is a list of companies that have been able to generate EM's greater than 10% on average over the past three years.  Although all of the companies listed have had great success in generating a large spread above their cost of capital, some of these companies are classified as unattractive because they have started to trade at a premium to their intrinsic value and the direction of those Economic Margins is unattractive. (Receive Our Stock Reserch Alerts by email)

High EM Buys & Sells

Source (The Applied Finance Group)

 Next week we will be discussing the use of an Economic Margin as a complete valuation system.

On Monday we highlighted several companies from our buy/sell list that represented investment ideas for all types of investors, which included Small and Large Cap stocks as well as Growth and Value stocks. Since Value Expectations tends to provide Large Cap Value Stocks for potential Buy ideas, earlier this week we decided it would be helpful to also highlight some small cap stocks we like from the Russell 2000. Now, moving on to the Growth investor, we will focus on companies we classify as growth stocks and find attractive within the S&P 500 (excluding Financials). By definition, AFG classifies growth stocks as companies with a Market Value/Invested Capital (MV/IC) in the top half of their sector.

In the table below are 10 growth stocks that we find attractive based on AFG’s valuation model, and are ranked neutral or higher based on AFG’s default recommendation.

Attractive Growth Companies - S&P 500 (excluding Financials)

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.

AFG's Growth Universe - Companies in the AFG universe, which have MV/IC in the top 50% of the universe and have EPS estimates.

Market Value/Invested Capital (MV/IC) - The firm's average total equity, debt and other obligations divided by net invested capital.
 

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

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Bloomberg provides a score for companies within the S&P 500 based on an average of all analyst ratings from the street. Below is a table highlighting companies with the best analyst ratings, largest increase in rating, highest price targets, and worst analyst ratings and the valuation attractiveness of each of these companies based on The Applied Finance Group’s (AFG) valuation model.

Companies within each of these groups are ranked from most attractive from a valuation perspective to the least attractive. VE.com will actively track the performance of these recommendations and see how they stack up to the analyst recommendations in each group. AFGview.com, AFG’s professional investor website allows you to compare any company using their rating versus the consensus ratings of the sell side. If you are interested in an analysis on a specific company, contact afgsales@afgltd.com.

Best/Worst Analyst Rated Companies (Bloomberg)

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's Value Score - 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.

Economic Margin is a measure of economic profitability that identifies how much a company earns above or below its cost of capital. We analyzed all companies in the S&P500 Index based on their historical, current and forecasted Economic Margins to see which firms have the best average of past, present and future profitability. We identified the two most profitable and the two least profitable companies from each sector and have presented them in the table below. As a base of reference, the average firm in corporate America earns a 0 (zero) Economic Margin, or is a “break-even business”. Our research has shown that companies with consistently positive EMs that are also expected to increase their EMs in the future tend to outperfom firms with negative or declining EMs.
<!--[if gte mso 10]> Economic Margin is a corporate performance measure, which helps us identify well managed, wealth creating companies. Although not included in this post, we want to remind you that it is also important to understand the attractiveness of corporations' valuations to make sure we invest in great companies at great prices. (Here is an article by ValueExpectations.com explaining Applied Finance Group’s basic valuation concepts).

Note: Only companies in the S&P 500 were included.

S&P 500 Companies With The Best/Worst Average Profitability (Economic Margin)

Economic Margin (EM) Defined: A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The Economic Margin Framework™ is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital. more EM details (PDF)

Economic Margin (EM) Defined - A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The Economic Margin Framework™ is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

Here is a list of companies within the S&P 500 that have earned extraordinary Economic Margins (EM) over the last 7 years and are also expected to maintain high levels of EMs over the next two years. Companies expected to improve their EMs more than their peers have proven to be more likely to out-perform. High EM companies on the list below that have low expectations priced-in for sales growth and attractive valuations, are ones that may be worth a look as a potential investment.

S&P 500 Companies That Maintain High Economic Margins

*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.

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Below is Value Expectations’ analysis of the companies in the S&P 500 with the 10 best and 10 worst returns for 2009 YTD (excluding financial companies). Comparing the sales growth expectations priced in (VE sales growth) to what the company has delivered in sales growth historically allows us to see which firms have the most reasonable sales growth expectations implied by their current trading prices and thus are more likely to outperform. Will the companies with the best returns be able to maintain their momentum for the remainder of 2009? Will the companies with the worst returns be able to turn things around? We will track the S&P500 winners and losers in the year ahead and provide you with regular updates.

10 Worst S&P 500 Companies 2009 YTD

10 Best S&P 500 Companies 2009 YTD

*data as of close Feb. 20, 2009

*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.

According to MotleyFool.com, InvestorPlace.com, Jubak’s Journal, Cramer, and FortuneMagazine.com these are the most attractive stocks to own in 2009. Compare the sales growth priced-in to justify the current stock price (VE Sales Growth) to what the company has achieved in revenue growth over the last five years (5 Year Median Sales Growth) to see if what’s priced-in is a reasonable number for the company to meet or exceed expectations. Couple the expectation information with AFG’s ranking for a stock’s attractiveness relative to the universe (Value Score AFG) to find companies that we find attractive on a default basis that also have low expectations for growing sales compared to what they have delivered the past 5 years. Companies with High Value Score’s and low sales growth expectations will be the companies on this list that are more likely to out-perform.

Recommended Stocks for 2009

Related Article: EPS Increased.....Company Underperformed?

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