NUE

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

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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In March, Jim Jubak of MSN Money released a list of stocks that he believed should be stocks that you should pay attention to in the upcoming months/quarters as potentially attractive investment opportunities. ValueExpectations.com set out to answer the question, which stocks on Jim’s watch list look attractive according to AFG’s valuation model and should be on your watch list?

Provided in the table below are Jubak’s watch list companies and how they fare from a valuation perspective using The Applied Finance Group’s Value Score variable which ranks the valuation attractiveness of each company based on the discrepancy between the company’s current trading price and AFG’s target price.

Jubak's Watch List Companies (Ranked by Valuation Attractiveness)

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.

Jim Jubak (Jubak’s Journal – MSN Money) recently released an article outlining 5 major missteps a company can make on the road to recovery during a recession and provided 5 stocks he believes avoided such missteps and are primed for success when the market returns to normalcy - COH, PEP, QCOM, FLS, NUE. According to Jubak, he likes these companies because they all have good debt to equity ratios, solid balance sheets, and they have not been “beaten up so badly that they will spend the first year of the market recovery patching holes”. Jubak currently has 50% of his portfolio “Jubak’s Picks” in cash and the other 50% in stocks and does not expect the market to bottom for another 6 months or more, but believes these 5 stocks will be solid performers when the market does finally return. ValueExpectations.com has taken Jim’s 5 shipshape companies and analyzed them using The Applied Finance Group’s (AFG's) valuation model and buy criteria.

A brief description of AFG'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. 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.

Jubak's 5 shipshape stocks for the turnaround

Click Here for a closer look at some of The Applied Finance Group's valuation concepts.

According to Bespoke Investment Group, the companies on this list have incurred the biggest changes in their EPS estimates over the past month. We took the top/bottom 10 companies (excluding financials) on the list and provided our outlook on these firms based on their attractiveness from a valuation standpoint and the sales growth expectations embedded in their current stock price. The companies on this list with an attractive valuation and reasonable expectations for growing sales are the companies we believe are the most likely to outperform.

It is important to note that earnings are important but not sufficient for evaluating a firm’s ability to create wealth and the shortcomings of EPS alone, take a look at a recent article titled EPS Incresed…Company Underperformed? For a more comprehensive approach to valuation, we suggest you look at the following strategy of how The Applied Finance Group finds value.

Companies With The Biggest Changes To EPS Estimates (last 4 weeks)

*Companies are listed in order from the biggest increase/decline in EPS estimates to the smallest increase/decline.

*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.

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)

If you have a bullish outlook on the recovery of the global economy over the next 2-5 years, it is important to know which industries will likely perform the best coming out of a global recession. Daniel Moser of Seeking Alpha believes that the US is likely to begin experiencing economic recovery starting in 2010, and believes that mining companies may be the most attractive industry for long-term investment opportunities.

With China and the US implementing huge economic stimulus plans - $585 billion in China and $787 billion in the US – the amount of money designated toward advancing and expanding these countries’ infrastructure greatly impacts the attractiveness of investing in mining companies. Infrastructure improvement is heavily dependent on utilizing copper and other base metals, a major part of these companies’ business. During the recent global slowdown these companies have sold off to extremely distressed levels making their current trading prices very attractive, if you believe like we do that they will bounce back and provide long term rewards to shareholders.

Another reason to be bullish on mining companies at this time is the opportunity for financially strong companies to consolidate at attractive discounts. According to Moser, most industries make the mistake of acquiring assets during a booming period, but some of these firms will realize discounted prices when they purchase competitors now that valuations have improved. Yet another positive signal the author notes is that hedge funds tend to have a macroeconomic bias and frequently invest in firms that show signs of benefiting from a global economic recovery.

Moser also makes the claim that there is evidence that the U.S. will be running into inflationary problems which in theory would hurt these firms. However their involvement in the production of gold and silver along with the fact that these companies have considerable amount of foreign exposure and that a few are based outside of the U.S. will give them the ability to survive an inflationary environment in the US.

Of the companies on Moser’s list, we find a couple of attractive investments. Freeport-McMoran Copper & Gold (FCX) and steel mini-mills Nucor Corp (NUE) and Schnitzer Steel (SCHN) stand out the most. The mini-mills are more nimble and can adjust their production more quickly to meet demand, whereas US Steel (X) is bogged down with less-efficient operations. Additionally, Cliffs Natural Resources (CLF) is exposed heavily to legacy steel producer US Steel. 

Mining Companies and Their Implied Sales Growth Expectations

*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 above table displays the implied future sales growth of these mining companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

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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.