RUSSELL 2000

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While economic figures have been improving, we believe unsustainable stimulus programs are the drivers behind most of the progress to date, and significant moves from current market levels require stronger 3 to 5 year growth than the economy is likely to deliver. We reiterate that the easy money has been made via allocation to equities, and picking stocks will be much more important for the rest of the year, as valuation of the overall market is becoming less attractive.

It has been a great summer. After pausing during the month of June, the S&P500 continued its year-long upswing with monthly gains of 7.4% and 3.4% respectively in July and August. While the July rally was largely attributable to better than expected Q2 corporate profits and the seemingly stalled passing of Cap & Trade legislation and Healthcare overhaul, the August rush resulted largely from better than expected housing data, consumer confidence, and a newly built consensus that the recession is virtually over. Fed Chairman Bernanke was reappointed, but that didn’t surprise anyone. There has indeed been good news on the housing market. New home and re-sales increased for the 4th consecutive month. Resale of U.S. single-family homes and condos grew 7.2% in July, suggesting a seasonally adjusted annual sales rate of 5.24 million, exceeding economists’ projections of 5 million. New US home sales grew 9.6% in July, and suggested a seasonally adjusted annual sales rate of 433,000. There were 271,000 new homes for sale at the end of July, representing 7.5 months of supply at the current sales pace, the lowest since April 2007. Separately, the Conference Board reported that its Consumer Confidence Index rose to 54.1 in August from an upwardly revised 47.4 in July, significantly exceeding the consensus expectation of 48. On August 14, both Germany and France announced Q2 GDP growth of 0.3% from Q1, unexpectedly becoming the first major industrialized nations to technically pull out of the global recession. Naturally, investors are convinced a recovery must be in budding in the US.

While the market seems to concur that many aspects of the economy are positive and indeed improving, we remain skeptical. The market believes: the housing market seems to have bottomed; financial markets have stabilized; the recession’s end is around the corner; and although the unemployment rate will continue to rise and reach double digits, the economy will just adjust to that reality. While those beliefs may not be wrong, there are two powerful offsets that give us pause as to how sustainable the current good news is likely to be. First, the $8,000 tax credit for first-time homebuyers that supported many house sales will expire in November and the Fed’s $300 billion long-term treasury purchase program, which has helped to keep interest rates low, will end in late October. Like our thoughts for the Cash for Clunkers program, we suspect those stimuli have expedited future house purchases to the present. In addition, despite robust sales, foreclosures and short sales reflected 31% of existing homesales in July, and mortgages either in foreclosure or with at least one payment past due hit 13.16% in the second quarter, the highest percentage ever recorded by the Mortgage Bankers Association. The inventory for existing homes still represented a 9.4-month supply at July’s sales pace, unchanged from June. Regarding financial markets, while banks are no longer on the brink of collapse, the FDIC recently announced it had 416 banks on its "problem" list at the end of June, up from 305 at the end of March. Further, the FDIC has closed 87 banks so far this year, on top of the 25 in 2008. Fortunately, the total assets of banks on the problem list was just $299.8 billion, approximately 15% of the total assets of Bank of America, the nation’s largest bank in terms of deposits. Ironically, this speaks volumes of the systematic risks of those mega banks, with one potential failure essentially eqivalent to thousands of small banks. However, such an increse in problem banks does foretell additional problems for the sector.

While Bernanke cheered the economy in advance of his re-appointment, the minutes of the Federal Reserve's Aug. 11-12 policy meeting published last week further fortified the belief that the US economic recovery will start in the 2nd half, though it is likely to be weak. At this point, it is irrelevant arguing about the technicalities of defining the inflection point between a recession and a recovery, as that is best left for politicians pitching their elixirs. We think the important question is: What normalized growth rate can the US economy deliver over the next 3 to 5 years? Given that consumer spending accounts for nearly 2/3 of GDP, we think it is only logical to believe the recent stubborness of a rising unemployment rate suggests things are not yet ok with the economy. Combined with current fiscal policies, present valuation levels indicate things will not be ok for the stock market in the intermediate term.

In last month’s letter we discussed how we believed the easy money in this market is over. Assuming the vast majority of companies would not go bankrupt, heading into Spring 2009, all investors had to do was buy stocks – almost indiscriminately to book impressive gains. For those that were particularly choosey the gains were “generational”. A poster child for such trades is Las Vegas Sands (LVS), which traded at $1.42 in March and now trades above $15, as an improved capital market helped relieve investors’ fears of it going broke and news of the company’s Macau IPO gained traction. As we pointed out during the depth of the market lows, the market irrationally priced fear, symmetrically to how it irrationally priced prosperity just years earlier. During the November and March lows, the average implied 5 year annualized sales growth to the S&P 500 was –8.6% and -6% respectively, saying corporate America would shrink by 36% and 27% respectively 5 years from now. That simply was not realistic. As we wrote in November 2008:

“Fear has dominated the investor mindset and when we look at the factors driving returns in the past month, the past quarter and the past year, we find price momentum, dividend yield, and financial leverage are the most powerful factors. Investors found comfort in stocks with high dividend yeild, low leverage, and bought into the theory that “stocks do well for a reason” by chasing stocks that have done well. In addition, investors also stayed away from companies with poor earings quality, as those stocks consistently underperformed their universes in different time horizons. Our belief is that it is almost impossible to time the bottom but fortunately the important issue is not finding the bottom but finding the point at which as investors we can earn superior returns. If you missed our recent look at this topic, please refer to Investor Psychology and Market Expectations, and Then and Now: Buyer Remorse Versus Sellers Loss, where we discuss this concept in greater detail. The bottom line is that while the emotional cost of commiting capital is very high today, the financial environment has become much more attractive and investors who are willing to take an intermediate perspective and invest now and/or over the next few months in stocks with attractive valuations are likely to be rewarded very nicely in the years ahead.”

Year to date (1/5/09-8/31/09), the AFG’s large cap buys outperformed the S&P500 by 13.4% while the AFG’s mid cap buys outperformed the R2000 by 22.42%, which speaks volumes of the outpeformance of stocks with attractive valuation.

How do we view the market today? Before we share our thoughts, let us frame a few points for perspective. When we look at the price range of the S&P500 index during the past 3 decades, we find that corresponding to the big bull market from the beginning of 1980 to late 2007, the S&P500 grew 15 times from 100 to 1500. During this same period, both US GDP growth and unemployment averaged approximately 6%. In general it was a period of strong economic growth, although marked by many economic upheavals such as four recessions, a tech boom and bust, 9/11, and a rising real estate market. In general, Wall Street and Main Street prospered and suffered together. Thus it is no surprise that as the economy started to sour at the end of Q4 ’07, so did the market. In fact the Great Recession has brought consecutive quarterly GDP declines, and averaged 5.9% in Q4 ’08 and Q1 ’09. Furthermore, unemployment has sky rocketed to 9.4% from 5%. Not surprisingly, the S&P 500 dropped more than 50% to below 700 in early March of 2009. Since then, however, the index has rebounded nearly 50% to 1000. Again, Wall Street and Main Street were more or less aligned. Ultimately, the macro economy will put the conditions in place that lead to overall market valuations as those macro conditions frame two of the long-term value drivers (sales growth and margins) that generate economic profitability and thus market valuations. Examining the growth expectation imbedded in the latest S&P500 prices, we feel valuation levels are rather troubling. Based on Aug 28’s close of 1029, the S&P 500 was priced at an implied sales growth of 5% for the next 5 years. While this is below the long term average expectation of 7%, and not unreasonable relative to the S&P’s historical average 5 year annualized sales growth of 12.5%, we do not think our economy will likely support a nearly 30% expansion of corporate America over the next 5 years, as the curent macro policies coming from Washington are not likely to support such growth.

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First, a 30-year trend of falling income and capital gains tax rates will reverse in the next year. It will be difficult to grow an economy as investors begin charging higher and higher rates to supply capital. It is interesting to note, that during Clinton’s term, capital gains taxes fell approximately 30%, making the cost of capital cheaper and growth easier to finance and not surprisingly a very accommodative period for economic growth and prosperity. While tax policy points to a negative on the growth front, fiscal policy is likely to lead to higher discount rates as well. In late August, the Obama administration raised its 10-year budget deficit projection by $2 trillion to approximately $9 trillion, reversing its earlier protests against the Congressional Budget Office’s (CBO) forecast that deficits between 2010 and 2019 would total $9.1 trillion. Based on the $9 trillion deficit projection, the national debt will likely reach $18 trillion, and account for 80% of the projected GDP in 2019, up from the current 60%. The CBO said deficits would remain high beyond 2013 in large part because of spending on Medicare, Medicaid and Social Security, simply as baby boombers age, rather than being tied to the recession. This will force increasing government borrowing, and in turn “crowd out” private investment. Further, as evidenced by strong increases in the price of gold recently, inflation fears are growing over these projected structural deficits – also likely to drive up the cost of capital. We believe these policy issues and fiscal realities will lead to a period of below average economic growth, which naturally will translate into below average corporate growth as well. Bottom line – we think at 5% required growth rates, the market does not offer superior rates of reutrn relative to the risk of falling short of such expectations. While we do not believe the market is grossly over-valued, we would like to stress the need to carefully pick stocks rather than just buying market exposure through index or ETF purchases. The AFG 50 and 100 portfolios are a great place to start your stock picking research as these are stocks that comply with our long, proven concepts of buying stocks with reasonable expectations, solid fundamentals and non-wealth destroying management teams.

We conclude with an interesting observation from our 2nd Market Forecast Project conducted in mid August. Investment professionals are very torn about where the economy is likely headed. Currently the nod goes to those predicting another dip, with 52% voting that they expect another GDP decline in the year ahead. But note that is not a very convincing majority, and explains why there is still such a feeling of uncertainty about our current economic condition. We continue to get more participants into our survey and welcome your input as well. If you have not seen the results for August, visit AFG’s Market Forecast Project 2 for the complete survey and its results. To participate next month, visit AFG MFP and join our survey roster to receive next month’s questions. For the month of August 2009 (7/31/-8/31), the returns are the following:

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Whats Working Russell 1000

What's Working Russell 2000

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ValueExpectations.com has calculated the performance of all the stocks we have recommended as buys since our inception in November of 2008. Below is a table with each blog we have posted that had specific Buy recommendations, along with the average return for each group of stocks compared to the overall market benchmark (S&P 500 or Russell 2000). On average, our Buy recommendations have outperformed the benchmark by 12.49% with a 59% Batting Average on our picks. This spread represents the value that AFG’s valuation techniques and Economic Margin (EM) methodology can add to your portfolio.

In case you are new to our blog, Value Expectations is an interface investors utilize to understand implied sales growth and profitability levels built into latest stock prices and find stock lists that we believe can be turned into actionable ideas for investor’s. Understanding those implied expectations for future operations is important as it helps investors to assess whether or not those expectations are realistic, which will in turn give investors a huge advantage in trying to identify stocks that will be the most likely to outperform or underperform, as AFG’s track record has shown since 1996.

We encourage you to stay up to date with our latest blogs to further your understanding of the EM methodology and to learn about more great investment ideas. We will continue to keep track of the performance of our stock recommendations compared to the market and will provide quarterly updates of our performance.

Total blog performance 11-26-08 to 8-28-09:

Performance Totals:

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Below is a chart outlining the 2009 year-to-date performance of the sectors within the Russell 2000 (based on the sector classification of The Applied Finance Group). The Consumer Services sector has lead the way thus far, while Utilities and Financials have dragged down the overall performance of the index.

Since Consumer Services has lead the pack in 2009, we thought it would be helpful to provide a list of 10 companies within the sector, 5 of which still look like they have room to run while the other 5 now look overvalued. The 5 attractive companies are expected to improve their Economic Margins (EM) better than their sector peers this year and look attractive based on AFG's valuation model. The 5 unattractive companies are expected to produce a change in EM worse that their sector peers and look overvalued based on AFG’s valuation model.

Attractive and Unattractive Consumer Services Companies - Russell 2000 

Last week we took a look at the top performers in the S&P 500; today we're going to highlight the top performers in the Russell 2000 year-to-date and show you which companies look the most attractive according to The Applied Finance Group (AFG). AFG’s valuation techniques have proven successful since 1996 at identifying mispriced securities and helping their clients take advantage of those market inefficiencies. Beyond valuation AFG helps clients understand the true economic profitability a company earns by using their Economic Margin methodology.

AFG's Valuation Signal incorporates a concept AFG calls Percent to Target (Percent to Target measures the percent deviation between a stock’s current trading price and AFG's calculation of a company's intrinsic value). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (this model is a robust modified discounted cash flow model that avoids pitfalls of traditional DCF models such as perpetuity and competition).

Economic Margin (EM) corrects distortions caused by traditional accounting policies to give a more accurate assessment of a company's true profitability. It is important to understand the direction a company's EM's are heading because companies expected to improve their Economic Margins have proven to be more likely to outperform than those with EM’s expected to deteriorate. The EM Framework addresses profitability, competition, growth and cost of capital. When factoring in each of these variables, investors can fully assess a company's value. 

AFG's Buy/Sell criteria factors in Economic Margin, Management Quality, and AFG's Valuation Metric. In order to determine Management Quality, AFG scores management on their growth decisions in accordance with the company’s ability to either create or destroy wealth. AFG's Valuation Metric measures a company's Percent to Target (the 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.

When searching for potential short/sell opportunities, The Applied Finance Group (AFG) screens companies using its proprietary Sell Criteria variables, starting with Economic Margin (EM). Economic Margin is a measure of corporate performance that identifies how profitable a company is by measuring how much the company earns above or below its cost of capital. In addition to corporate performance, AFG identifies companies that are unattractively priced using its valuation model. Lastly, AFG evaluates how well companies are run using the Management Quality score, which identifies companies with management teams that destroy wealth.

The 15 firms listed below all meet AFG’s Sell Criteria and all look extremely overvalued according to AFG’s valuation model. These companies all possess the characteristics of a bad investment and may be a potential torpedo lurking in your portfolio. AFG has proven successful since 1996 at identifying good companies as well as sell opportunities, providing a solid buy/sell spread.

15 Overvalued Small Cap Stocks - Russell 2000 (ex.Financials)

 
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.

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Many of the institutional clients of The Applied Finance Group, Ltd. (AFG) tend to focus on large cap stocks and benchmark themselves against the S&P 500 Index, which is why many of the buy ideas from ValueExpectations.com usually come from the large cap index. Earlier in the week we highlighted companies from our buy/sell list both from large and small cap, as well as from growth and value style universes. We thought it would be a good follow up for some of the investors we work with who focus on small and mid cap stocks, to provide a more thorough list of companies from the Russell 2000 Index.

Below is a summary of 20 companies to watch from the Russell 2000 Index. The table highlights the 2 companies from each sector (ex. Financials) that have the most attractive Value Score (above 80) and are currently rated Neutral or higher by AFG’s buy/sell criteria. Factors used to derive an AFG recommendation include: Expected change in Economic Margins, Intrinsic Value, and Management Quality. Many classify stocks with market capitalization under $250 million as micro caps, therefore only those companies within the index that met that market cap minimum were considered for the list.

Russell 2000 - Stocks to Watch (above $250 million, ex financials)

What do we use to measure corporate performance and calculate an intrinsic value:
AFG’s 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 its cost of capital. Our Economic Margin Framework encompasses a valuation system that explicitly addresses the four main value drivers of enterprise value: profitability, competition, growth, and cost of capital.
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).
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.

Normally when searching for buy ideas, AFG narrows its list of potential investment opportunities using several powerful proprietary variables including valuation, economic margin, management quality, earnings quality and others. Using AFG’s valuation variable (value score) as a stand-alone screen, ValueExpectations has shown portfolios that have gone on to earn outstanding returns. We first posted a blog “High Value Score Stocks: S&P 500” in December of 2008 using only AFG's valuation variable - Value Score. These companies (DDS, S, NOV, MTW, SII, WFR, CHK) were identified as having the highest value score within the entire index. Since release, that portfolio has outpaced the S&P 500 by over 71% as of May 26, 2009.

With the success of the first high value score stocks blog, we released a second portfolio in a blog posted on May 7, 2009.  This portfolio consists of S&P 500 High Value Score stocks (as of May 7, 2009) and so far it has been outperforming the S&P 500 (performance results will be released in our next performance update blog in a few weeks).

Due to user feedback, we decided to release a list of the top 15 value score stocks from the Russell 2000.

Top 15 AFG Value Score Companies - Russell 2000 (ex. Financials)

An attractive default AFG valuation is a great place to start when looking for potential investments as our valuation techniques have proven successful through time at identifying mispriced securities and helping our clients identify investment opportunities resulting in outperforming their chosen benchmark.

Applied Finance Group’s (AFG’s) Value Score defined - Value Score represents the percentile rank of the percent to target (deviation between AFG’s current default target price and stock’s current trading price).   A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

Stocks that have dropped significantly in price and are trading at all time lows provide investors attractive entry points, but some of those stocks could be deceptively “cheap”. Being able to discriminate between the two is a valuable skill for every portfolio manager and stock picker.

 In order to identify a good investment opportunity, AFG starts with assessing corporate performance by evaluating the ability for firms to generate Economic Margins above their sector median. Companies with expected improvement in their EMs tend to outperform companies with deteriorating EMs. In addition to corporate performance, AFG evaluates the valuation attractiveness and embedded expectations priced into the market through the Value Expectations interface.

The table below shows the 30 companies within the Russell 2000 Index with the greatest decline from their 52-week high trading price (as of April 30, 2009), and their attractiveness based on the ranked score of the expected change in economic profitability. In addition, we have pulled AFG’s Value Score, a measure of valuation attractiveness, and VE Sales Growth numbers, which show embedded market expectations. The companies within the Financial sector have moved for reasons other than valuation, and will not be evaluated from a valuation perspective here.

Russell 2000 - 30 Companies With The Biggest Drop From 52 Week High (ex. Financials)

*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.

When identifying possible sell/short opportunities (torpedoes) The Applied Finance Group (AFG) starts by running a screen using its proprietary Sell Criteria variables starting with Economic Margin. Economic Margin is a measure of corporate performance that identifies how profitable a company is by measuring how much the company earns above or below its cost of capital. In addition to corporate performance, AFG looks to identify those companies that are unattractively priced using our valuation model. Lastly AFG evaluates how well companies run their business using its Management Quality score, identifying companies that have management teams that destroy wealth.

The 20 firms listed below all meet AFG’s Strong Sell Criteria. In addition, these companies all earn less than their cost of capital which means they earn a negative Economic Margin and all of these companies have a Z-Score (Altman Z-Score) or risk of bankruptcy in the next 2 years, that fall in the at-risk range. AFG has a track record of identifying winners and losers in the market.

If any of these firms are holdings in your portfolio, pay extra attention to these companies as they contain all of the characteristics of a bad investment and may be a potential torpedo lurking in your portfolio. AFG has proven successful since 1996 at identifying good companies as well as sell opportunities, providing a solid buy/sell spread.

 20 Stocks To Avoid In The Russell 2000 (ex. Financials)

The following table contains the two cheapest companies in the Russell 2000 from each sector based on The Applied Finance Group’s Recommendation and Value Score (explained below). All of the companies listed below are the most attractive in their sector based on AFG Recommendation, which factors in each companies Economic Margin, Intrinsic Value, and Management Quality Score. All companies listed also had the highest Value Score (upside) relative to their sector peers. Also provided is a VE analysis of each company to identify implied sales growth expectations versus what the company has delivered historically in sales growth over the past 5 years. Measuring the spread between a company’s VE sales growth expectations and what it has historically delivered should give you a good idea of which companies have the best chance of meeting or exceeding those expectations, and thus are more likely to outperform.

Given that the stock market has lost a tremendous amount of value over the past year, it is important to point out the market cap for the companies in the table. The twenty-two companies shown below have returned -53% on average over the past year vs. -33% for the Russell 2000 Index as a whole. Specifically, a few companies now maintain a market cap that some investors may define as micro caps. If micro caps are within your universe of focus, then the following table can help identify some gems to invest in, especially since micro caps (as well as small caps) have outperformed large cap stocks by about 10% since the market bottomed on March 9, 2009. However, if the “bigger” small caps are more to your liking, the table provides a good snap shot for several companies with respectable size that may outperform the Russell 2000, based on Value Score and imbedded expectations.

Cheapest Companies In The Russell 2000 By Sector (excluding Financials)

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.

• Intrinsic Value/Value Score – A company's percentile ranking based on 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.

Applied Finance Group’s (AFG’s) Value Score defined - 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.

*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.

12 Year Window

2 Year Window

 The graphs are an analysis from our Monthly Market Review.
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The Russell 1000 Index has lost 44% over the past year and is down 14% year to date. Similarly, the Russell 2000 Index is down 42% for the past 12 months and lost investors 18% since the beginning of this year. With both of these indexes down substantially recently by about the same amount, are large caps more attractive than small caps?

Percent to Target Charts: This graph shows the Percent to Target Current 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.

Small Universe: Companies in the AFG universe that have a market cap less than $300 million and EPS consensus estimates are available.

This chart illustrates that the median Small Cap company is currently overvalued, relative to the market. Over the past 6 years, small Caps have been trading at a premium to their historic valuation.

Large Universe: Companies in the AFG universe that have a market cap greater than $2 billion and EPS consensus estimates are available.

This chart illustrates that the median Large Cap company is currently undervalued, relative to the market. Large Caps have been trading at a discount to their historic valuation, indicating a potentially attractive opportunity.

Following is a list of the biggest 10 companies (determined by market cap) in the Russell 1000 and Russell 2000. AFG’s Value Expectations interface, which solves for implied sales growth embedded in a stock price (VE Sales Growth), allows us to understand the embedded 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. An undervalued company is more likely to outperform those companies with high expectations relative to what they have delivered historically. The tables below display the implied future sales growth of these companies assuming their EBITDA margins and Asset turnovers stay at their 5-year median levels.

Conclusion:
Both the percent to target charts and VE analysis show that large caps look more attractive than small cap stocks. The large cap stocks on the list have lower expectations for implied sales growth and the overall universe is currently undervalued. 

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* EM: Economic Margin (EM) is AFG's proprietary corporate performance measure. EM is defined as cash Economic Profit over
inflation adjusted Invested Capital while Economic Profit is the difference between Operation Based Cash Flow and Capital Charge.

* MVIC: Market Value over Net Invested Capital (MVIC) is the firm's current total equity, debt and other obligations divided by its net
inflation adjusted invested capital.

Russell 1000

Russell 2000

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Most long-term trading strategies stumbled in 2008 Q4.  As investors panicked and hedge funds delivered, it seems that stock prices over the last three months were heavily influenced by short-term earnings, dividend yield, and price momentum as some investors looked for safe havens in the stock market, and others simply followed macro trends.  Despite poor performance during the market decline, we believe that a long-term valuation approach will perform very well as an investment strategy as the stock market stabilizes, and the following article will summarize what we have observed during the stock market decline (9/19/2008 - 11/21/2008) and the recent recovery over the last six weeks.

Over the course of the last 15 weeks (beginning on 9/19/2008, which is roughly the date of the Lehman Brothers bankruptcy), we have taken weekly snapshots of the stock market.  Each week, we have tracked the performance of many commonly used metrics to get a better sense of what variables are impacting investor decisions.  The following table highlights the performance of the overall stock universe (defined as US publicly-traded companies with analyst estimates, including ADRs) between 9/19/2008 and 11/21/2008, as well as the Russell 2000, Russell 1000, S&P 500, and the Value and Growth universes as defined by Market Value / Net Invested Capital:

We can see from here that, on an equal-weighted basis, the overall universe declined 45.2% over this period of time.  An interesting observation lies within the research of Valuation and Momentum based metrics.  To keep this simple, we will narrow our focus to Percent to Target as our valuation metric and Price Return - 3 Month as our momentum metric.  (The performance of these variables is measured as the percentage spread between the equal-weighted return of the top half of the universe vs. the equal-weighted return of the bottom half of the universe)

As the market declines, a momentum based strategy built on Price Return - 3 Month performs well, but as the market improves, a valuation based strategy based on Percent to Target - Current performs well.  Over this nine week period, we observed significant declines in market values in seven of these nine weeks, and a momentum based trading strategy would have performed very well over this period (relative to its benchmark - all trading strategies were negative over this time).  Note that for the entire universe, the top half of Price Return outperformed the bottom half of Price Return by 31.4% over this time frame, while the top half of Percent to Target underperformed the bottom half of Percent to Target by 12.4%.

Moving forward from 11/21/2008, we observe a very interesting reversal in the performance of these trading strategies:

Over the six weeks between 11/21/2008 and 1/2/2009, we see a radical improvement in market valuations - nearly 27.3% for the overall universe, and over 31% for the Russell 1000 & 2000.  Note that weekly trends still continue to hold true - as market valuations improve a Valuation-based strategy performs well, and as the market valuations decline, a Momentum-based strategy performs well.

Conclusion:

As we have observed stock market improvement over the last six weeks, we have also seen a remarkable improvement in the performance of a value-based strategy, and we expect this trend to continue into 2009 as we move into a more stable trading environment.