NE

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
Visit His Site

Tozzi Finance Center Manager
Ross School of Business

As some investors may believe the market is starting to show "signs of recovery", many of the over 200 institutional firms The Applied Finance Group (AFG) works with can always take advantage of identifying mispriced securities. While some of AFG’s clients might have a specific focus on growth or value, most subscribe to the practice of buying growth at a discount (growth at a reasonable price GARP) and avoiding  “value traps.”

In October 2008 AFG released the study, Then and Now, discussing the low expectations priced into the market "Today many world-class franchises are available at expectations reflecting a very bearish future. Over 150 companies in the S&P 500 (industrials) have negative sales growth expectations embedded into their current market valuations". Following that study AFG issued another study, Analyzing Market Troughs and Rebounds, which pointed out that historical market recoveries have been typically dominated by value stocks.

Whether you are looking for value or more growth oriented securities, we have provided a list of  companies in various asset classes, Large Cap Growth, Large Cap Value, Small Cap Growth, Small Cap Value that are currently on AFG’s Buy and Sell list. If you are a professional investor and would like to view a complete buy and sell list or take a trial of AFG's valuation tools CLICK HERE.

Monthly Buy/Sell list Across the Market
The Applied Finance Group 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 4,500 covered securities. By 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 all investments. This focus List of stocks has outperformed the market on an annual basis by greater than 10% with our buy portfolio and underperformed the market by 10% with our sell portfolio. AFG clients then use Value Expectations to further analyze the expectations embedded in a security’s price (example of expectations embedded in the entire S&P500 over the next 5 years below) and to build out their own model to refine an intrinsic value of a company based on their own expectations.

Select Companies From AFG's Current Monthly Buy-Sell List

(Source: The Applied Finance Group)

Again, If you are a professional investor and would like to view a complete buy and sell list or take a trial of AFG's valuation tools CLICK HERE.

Model Portfolio Buy/Sell Results

To view how AFG defines the Large/Small and Growth/Value universe Click Here.

A brief description of some other of AFG's insights:

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 Value Universe - Companies in the AFG universe, which have MV/IC at the bottom 50% of the universe and have EPS estimates.

Every year Fortune releases a list of the 40 best companies to invest in now to retire on. This long-term portfolio is designed to protect your hard-earned nest-egg as you approach retirement.

Last year Fortune’s portfolio of 40 best stocks to retire on returned -23.07% from 6-20-08 to 6-16-09, relative to the -30.8% returned by the S&P500 during the same time period. This year they are replacing 23 stocks to form the new portfolio.

Provided below are the 40 stocks recommended by Fortune as the best stocks to retire on in 2009 and our outlook of these companies from a valuation perspective based on The Applied Finance Group’s valuation model.

 Fortune's 40 Best Stocks to Retire On - 2009

Related Stock Article:
Is Apple a Buy Hold or Sell?, Click Here to View

Below is a list of the 12 most undervalued stocks in the Russell 1000. All companies listed met The Applied Finance Group's (AFG's) Buy screen (criteria explained below) and are in the bottom half of their sector in Market Value/Invested Capital (MV/IC) which by definition qualifies the companies as part of the AFG Value Universe. When identifying buy ideas AFG looks for companies with the most valuation upside compared to their sector peers, above sector median expected Economic Margin change, and a management quality score that reflects a management team following a wealth creating strategy. Also shown in the table is each companies implied sales growth expectations along with their historical sales growth. All 12 of these companies have very reasonable expectations for growing their sales relative to what they have been able to deliver historically. Companies with reasonable expectations embedded in their current price have proven to be more likely to out-perform than companies with high expectations.

12 Most Undervalued - Russell 1000 (excludes financials)

A brief description of AFG'sbuy 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.

Value Universe - Companies in the AFG universe, which have MVIC at the bottom 50% of the
universe and have EPS estimates.

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

*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.

In our March Monthly Market Review we released a series of graphs representing the valuation attractiveness of each sector relative to its historical norms and to the entire AFG universe. Below is a graph representing the Capital Goods sector which is attractively priced when you compare against its historical trading ranges (red line) and when comparing against the overall AFG Universe (represented by the value of 1). Only in 1998 has the sector looked more attractive since our valuation tracking started in 1996. Listed are 10 companies in the Capital Goods sector that meet AFG’s Buy Criteria and look attractive from a valuation standpoint. Also listed below the graphs are an explanation of AFG’s Buy Criteria and AFG’s Percent to Target Charts.

Capital Goods Relative Valuation Chart

10 Capital Goods Companies (S&P 500) With Attractive Valuations

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

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 its peers.

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

Visitors Register with Value Expectations to
Access Exclusive Market Reviews and Special Studies:


 

Fidelity’s Low Priced Stock Fund, which launched in 1989 (18 Billion AUM) and is managed by Joel Tillinghast, follows a simple strategy… Only invest in stocks with a share price under $35. This strategy first started with Tillinghast only investing in stocks below $10 a share, but later he moved the limit up to $35 a share. He argues that share price alone is not important but that the small-cap universe contains the most frequently mispriced stocks and the least amount of analyst coverage.

Although his fund at best has been a market performer as of late, Tillinghast had taken advantage of such mispricing’s during the last 15 years, averaging an 11% annual return compared to the 6% return earned by the S&P 500 over the same period. The fund had been closed to investors since 2003, but was recently reopened in December. Fidelity says they reopened the fund to get more cash inflow to be able to take advantage of all of the investment opportunities they see in the market.

Below is a list of the top holdings in Fidelity’s Low Priced Stock Fund as well as stocks that AFG believes are attractively priced in three price brackets: under $10, $10 to $20, and $20 to $35. Compare the implied sales growth priced-in to justify the current trading price (VE Sales Growth) vs. what the company has delivered in sales growth the past 5 years (5 Year Median Sales Growth) to see if the expectations are realistic for the company to achieve. The more realistic the expectations are, compared to what has been delivered, the more likely the firm will be to out-perform.

Here are the best and worst performing stocks in the S&P 500 for the month of January excluding financials. Compare the implied sales growth priced-in to justify the current trading price (VE Sales Growth) vs. what the company has delivered in sales growth the past 5 years (5 Year Median Sales Growth) to see if the expectations are realistic for the company to achieve. The more realistic the expectations are compared to what has been delivered the more likely the firm will be to out-perform.

Top 10 stocks in January (excluding financials) and Sales Growth Expectations

Worst 10 stocks in January (excluding financials) and Sales Growth Expectations

In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman 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.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

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

Using AFGView.com, we screened for 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.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet

Nearly all of the biggest return earning companies in the S&P 500 are firms that have been beaten up over the past few months but have bounced back to provide the biggest return in the entire index for the month of December. These firms have ended 2008 on a high note and move into 2009 with what they hope to be sustainable momentum.

The list of companies in the S&P 500 with the worst returns in December had also been trending downward for the past few months but were unable to muster a year-end turnaround as those on the other list had been able accomplish. Many of the firms on this list have something to do with oil, as their stock prices have been highly correlated with the falling price of oil.

Compare the sales growth priced-in to justify the current stock price (VE Sales Growth), to what the company has been able to deliver the past 5 years in revenue growth (5 Year Median Sales Growth), to see which companies have reasonable expectations of achieving the Sales Growth priced-in. Companies with low expectations relative to what they have been able to achieve are more likely to out-perform.

Sales Growth Expectations for the Highest Return Companies (S&P 500) - December

**denotes only 2 years historical sales growth available (2 year median used)

Sales Growth Expectations for the Lowest Return Companies (S&P 500) - December

VE Sales Growth Calculated for these firms on 12/26/08.