RUSSELL 1000

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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:

For information on AFG's Tools and Research for professional money managers, click here 

Whats Working Russell 1000

What's Working Russell 2000

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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.

Wondered what’s been working in this market? This data from our latest Monthly Market Review highlights a select list of variables and their performance over the past 12 months.

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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

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.

Here is a look at where the Wealth Creators and Destroyers lie. A Wealth Destroyer is classified as a company that has a negative Economic Margin and is growing its business. Wealth Creators are those firms that have positive Economic Margins and are growing their business. The difference in Management Quality between S&P 500 and the Russell 2000 are quite clear with S&P having about 23% of its firms classified as Wealth Destroyers compared to over 40% in the Russell 2000. 

Firms classified as wealth destroyers in the past include Enron & Adelphia.

Wealth Destroyers need to earn the right to invest, divest losers and identify their core competencies. Wealth Creators should grow their business to capture NPV opportunities.

 Other articles we have written discussing Management Quality include:

Special Study: Good and Bad Management Strategies

VE Blog: CEO Wealth Creators and Destroyers

VE Blog: Good Companies - Not Always Good Investments