MAR

By Kai Petainen (Guest Contributor)

Using academically inspired quantitative analysis, here are 10 longs and 10 shorts for 2010.

Pick some stocks, go to an island and come back in a year and see how they did. That's the premise behind an annual stock competition that T.J. White holds each year on Marketocracy's Web site. Dividends are paid, some companies go bankrupt, others are acquired, and basically everyone stays away from the Internet, as they catch fish, drink rum, mingle with the locals and hope that their stocks outperform the others. It's a fun hypothetical game, and in the spirit of that game, I thought it would be fun to pick 20 stocks for 2010: 10 long and 10 short picks.

How have I performed in the competition in the past? Well, in 2005 I chose Tesco Technologies (TESS), Shiloh Industries (SHLO), NewMarket Corp (NEU) and Meridian Resource Corp (TMR) and delivered a poor return of 0.5% vs. 3.0% for the S&P 500. I turned it around in 2006 when I chose Adams Resources & Energy ( AE - news - people ), Ameriprise Financial (AMP), Saia , Stepan Company (SCL) and Books-A-Million (BAMM) and had a superb fourth-place return of 45.2% vs. the S&P 500 of 13.6%.

In 2007, I chose Aegon N.V. (AEG), Encana (ECA), Pioneer Companies (acquired by Olin Corp) (OLN), KT Corp. (KTC) and AstraZeneca (AZN) and had a respectable return of 9.2% vs 3.6% for the S&P 500. The unfriendly year of 2008 wasn't kind to me, and my picks of Brasil Telecom (BTM), Miranda Gold (MAD), China Petroleum (SNP), Validus Holdings (VR) and Venteco PLC (VTO) had a dismal return of -40.4% vs. the S&P 500 at -38.8%.

In 2009, I chose BCE ( BCE) Chinacast Education (CAST), Nova Chemicals (NCX), Koninklijke Philips Electronics ( PHG) and Allianz SE (AZSEY). They had a return of 67% vs. the S&P 500 at 23.5%. Overall, I'm quite happy with my returns, but how will I do this upcoming year? I'm not sure, but it's fun to try.

How Did I Pick the Stocks?

I started my search for stocks via FactSet's incredibly versatile quant screening tool. Through FactSet, I was able to make a simple, quick quant screen and in the spirit of 2010, I chose these 10 factors.

For the long picks, I was ranking stocks based on: Low price-to-earnings (P/E) ratio, low price/book, high Piotroski score, low F-Score, low accruals, insider buying, low short interest, earnings momentum, sales growth and institutional buying. Basically, stocks looked good to me, would generally have a "value", "quality," "smart money" and "growth" story associated with them. I would not look at news, technical charting analysis, bid/ask spread, transaction costs, product quality, analyst research reports, taxes, risk, beta, political factors or economic macro variables. The analysis would follow a quant/value based approach, and to which I do acknowledge there are certainly some pros/cons associated with that approach. Short picks on the other hand, generally (not always) had a: high P/E, high price/book, low Piotroski score, high F-score, high accruals, insider selling, high short interest, negative earnings momentum, low (or very high) sales growth and institutional selling. That first cut, produced a series of stocks and from there it was onto some valuation analysis and creating some target prices.

Valuation analysis was performed using The Applied Finance Group's quantitative (AFG)-valuation model. Each stock was placed through their default assumptions. If the stock passed, I ran another valuation using a discount rate of 8% and a CAP (competitive advantage period) of 10 years. For the long picks, I chose (what I considered to be) conservative valuations, and for the short picks, I chose the optimistic valuations.

What about the Market?

I'm not an economist, I have no idea what will happen in the upcoming year. I won't even pretend to know, but for fun I attempted a valuation of the market. Each component of the Dow Jones was valued, target prices were created and that in turn created a valuation for me. How accurate is this? I have no idea, but I figured if people could make valuation targets for the Dow of 5,000, 20,000, and other seemingly random numbers then it wouldn't hurt to try. So, hypothetically, just for fun, an optimistic target for the end of 2010 for the Dow is (and I have virtually no confidence in this) 10,082. Are you a pessimist? Dow 8,140.

My 2010 Picks

So, here they are, my 10 Long and 10 Short picks for 2010 and some target prices. Feel free to disagree, and at the end of next year, I'll come back and see which ones I got right, and which ones I got wrong. Now to escape to an island, mingle with the locals and create some sand castles.

To view Mr. Petainen's 10 long and 10 short ideas for 2010 on Forbes.com and how they score according to his criteria Click Here!

Kai Petainen
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Tozzi Finance Center Manager
Ross School of Business

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.

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. Using AFG’s proprietary criteria, AFG publishes a monthly buy/sell list to provide clients with a refined focused list as a starting point for potential investments. AFG clients can then use Value Expectations to further analyze the expectations embedded in a security’s price and to build out their own model to refine an intrinsic value of a company based on their own expectations.

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 and unattractive companies in the S&P 500 from each major sector (as defined by AFG).  It serves as a focus list of companies for investors to begin with as they meet AFG’s criteria.  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.

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To stay updated on how other professional investor's currently view the market join our Market Forecast Project survey and be among the first to receive the results.

Understanding the true intrinsic value of a company is very important when attempting to identify and take advantage of mispriced securities. The Applied Finance Group (AFG) has proven to be successful at helping their clients find attractive investment opportunities and also help avoid potential torpedo stocks by utilizing their Economic Margin Framework. AFG’s Economic Margin (EM) is the measure of the true economic profitability a company is earning after several adjustments to eliminate distortions caused by traditional accounting practices. Understanding a company’s EM levels and expected changes in EMs is important as it has been proven through vigorous back-tests that a company’s expected change in EMs is highly correlated with the company’s future market performance. Companies expected to improve their EM’s have proven to be more likely to outperform than those companies with declining EMs.

Source (The Applied Finance Group)

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.

As 2009 approached, USA Today’s market experts gave us their insights/predictions on what they thought would happen in the upcoming year. Even as the world has changed dramatically since this list was released in December 2008, these “guru’s” picks are worthy of some attention to see how their predictions did against the overall Russell 1000 index so far this year. We ran their list through Applied Finance Group’s (AFG’s) set of screens that identify potential investment opportunities to see which companies they recommended met AFG’s criteria. Below is each expert’s picks and performance along with the performance of the Russell 1000 to benchmark against. The 6 companies highlighted (TAP, CSCO, WMT, PG, ABT, JPM) were the companies that met AFG's Buy Criteria (described below) for a potential investment opportunity and the rest failed to make the grade.

USA Today's Investment Pros - Picks For 2009

USA Today's Investment Pros Picks Vs. Russell 1000 - December 12, 2008 to March 17, 2009

A brief description of The Applied Finance Group's Buy Criteria variables is below:

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.

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

Management Quality – Assess management’s ability to make wealth creating decisions.

Related: Read our Economic Margin white paper which was published in the book: Value-Based Metrics: Foundations and Practice Edited by: Frank J. Fabozzi and James L. Grant Pages 157 – 178: Click Here

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