TIF

It is very important to understand a company’s management strategy and management’s ability to create wealth for its shareholders. By using The Applied Finance Group’s (AFG’s) Management Quality score you have the ability to grade management’s ability to make wealth creating decisions and eliminate wealth destroying firms from your list of constituents. AFG’s Management Quality variable is used as an exclusionary variable to get rid of companies which continue to grow their businesses when they are not even profitable (generating negative Economic Margin or negative EM, which is AFG’s way of understanding a firm’s economic profitability). When business units are unproductive and destroying wealth, management teams should not be looking to grow that business unit and concentrate on the parts of their company that have been creating wealth. Instead, the corporation needs to fix the broken parts of its business first by divesting losers and work on improving profitability to earn the right to expand. The best strategy AFG or any investor likes to see is a very profitable business (generating positive EMs) that grows its assets to maximize its profitability.

The companies listed below (which include CAT & AMAT) have been following a wealth destroying strategy by growing their assets as their EMs have been declining which is reflected in their stock prices as none of these companies have been able to create any value for their shareholders over the last year. Along with managements inability to create shareholder wealth, these firms also look unattractive according to AFG’s valuation model and other key criteria AFG evaluates when considering the attractiveness of potential investment opportunities. These companies must stop growing their assets or divest some losers and focus on improving their EM’s before these firms will begin to see sustainable improvements in their stocks price and begin to add wealth to their shareholders. The expected change in the level of a company’s EMs has proven through back-tests to be highly correlated with the subsequent performance of its stock price. The 2 company examples below show the levels of each companies EMs through time as well as their asset growth. CAT and AMAT have continued to grow their assets as their EMs have declined and that strategy is reflected in their falling stock prices.

Management Competence Factors

• Have there been any changes in the executive management team?

• Has the company had any significant write-offs or poor earnings quality?

• Has the company recently made any significant acquisitions and, if so, what are the strategic implications and costs?

• How is the company spending any excess cash?

• What did we learn from the company’s most recent earnings call and what was the tone of analyst questions?

Management Quality Score Insights:

• Measures a company’s EM+1 and LFY Asset Growth.

• Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.

• Un-bias quantitative way to analyze a company

• Holds management teams accountable for unprofitable growth

Below are examples of AFG's Wealth Creation Reports of CAT & AMAT that show deteriorating EMs while continuing to grow their assets and the subsequent poor performance over the past 1 year.

Other Popular Articles: 

Faisal Laljee of stocksandblogs.com came out with 2 blogs earlier this year providing companies that he believed were the top stocks to own/watch for 2009 (Part 1, Part 2). Laljee was on the money with his predictions so far through 2009. 13 of the 15 companies he recommended have positive returns and the whole portfolio of 15 companies has an average return of 21.24% compared to the S&P 500 return of 0.10% over the same time period. Valueexpectations.com thought it would be useful to analyze how these firms are positioned as possible investment opportunities going forward from AFG’s valuation standpoint. Valuation Attractiveness is determined by AFG’s proprietary valuation framework, which estimates a stock’s intrinsic value through a DCF model which incorporates a corporation’s Economic Profitability, Growth of Capital Base, Decay, and Cost of Capital. In addition, we also showed sales growth expectations embedded in each company’s latest stock price and its historical 5 year median sales growth. It is interesting but not surprising that all the Attractive stocks have low implied sales growth compared to those companies’ historical performance.

Stocksandblogs.com 15 Companies To Own/Watch In 2009 : Perfomance Results

*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.

A common buzz for investors is learning that their holdings have increased earnings per share. EPS growth is thrown around Wall Street circles, analyst discussions, corporate conference calls and investment talk shows as if it is the central focus for companies. What professional investors know and many misrepresent, is that earnings are important but not a complete driver for the true cash flows a company is generating.

Most investors agree that the value of a firm is the present value of its future cash flows. For the typical industrial firm, EPS only represents approximatley 50% of cash flow. If you believe that the value of a firm is the sum of its future cash flows, using EPS alone to value a firm can cause you to miss 50% of the cash flows.

The analysis we use at ValueExpectations.com has a broader focus that emcompasses all cash flows and moves beyond EPS. While capturing the true cash flow the entire firm is generating and addressing their cost of capital making several other adjustments along the way, it provides a more economic outlook for a company. We call this analysis Economic Margin:

It is not uncommon for companies to grow EPS while having declining EM’s. This occurs when the cost for the investment required to yield the increasing EPS is more than the cash flow generated from the investment.

Unlike traditional measures, EMs consider the “profitability” of EPS growth, eliminate accounting distortions, and are comparable across time and industry. By analyzing a company’s EMs through time, investors gain a more accurate account of levels and changes in a company’s current profitability and value.

If earnings are a true proxy for performance, there should be a correlation between a company growing earnings and its price to earnings ratio. As a surprise to many investors, there is actually little to no correlation between earnings growth and price to earnings ratios (left chart below).

Because of changes in depreciation, inventory methodologies, write-offs, asset mix, growth and inflation, accounting data changes for non-economic reasons. Therefore, accounting data can give the wrong buy/hold/sell indication. This is illustrated by the poor link between traditional accounting measures and stock prices (left chart below). Economic Margins (EMs) are systematically calculated for over 8,000 U.S companies. The resulting values have a much stronger link to stock prices than traditional accounting data provides (right chart below). As a result, portfolio managers and analysts have a much more accurate starting point for their analysis.

Below are a few examples of companies that have done an exceptional job growing EPS but have fail to improve their economic profitability resulting in underperformance.  Click here to read a related article: AFG Basic Valuation Concepts

 Click here to read a related article: AFG Basic Valuation Concepts

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