TXT

With almost 5 months of 2010 in the books, we decided to take a look at the total returns for the S&P 500 broken down by-AFG defined sectors (excluding financials) to see which sectors have outperformed/underperformed the index so far this year. You will notice in the chart below that the Energy, Utilities and Health sector seem to be dragging down the returns of the overall index, while the Consumer Durable and Capital Goods sectors are leading the way.

Last week on www.ValueExpectations.com we provided readers a list of the most reliable companies from the Russell 1000 based on the quality of earnings (accrual levels), management’s ability to create wealth along with other criteria The Applied Finance Group uses in its stock research process to identify firms that are the most likely to outperform. After the large selloff yesterday, with many predicting another large correction around the corner and the increasing number of bearish opinions on the market we will provide our readers a list of the riskiest firms in the Russell 1000 to avoid or to trim from your portfolio when looking to eliminate positions.

When identifying potential torpedoes AFG looks for companies with the least valuation upside compared to their sector peers, below sector median expected Economic Margin change, and a management quality score that reflects a management team following a wealth destroying strategy. These 18 S&P 500 companies from every major AFG defined sector (ex. Financials) are potential torpedoes that could be lurking in your portfolio. These companies all possess characteristics that make for a bad investment opportunity. If you own one of these companies or consider adding one to your portfolio, we suggest taking a closer look as they look the most likely to underperform their sector peers according to criteria that has proven successful at identifying winners and losers in the market.

A focus list of buys and sells for our readers to use as a starting point when looking to make changes to portfolio. This list contains attractive and unattractive stocks from every major sector excluding financials. AFG's buy and sell lists have proven through time to provide a significant spread between the buys and sells helping you to identify winners and avoid potential torpedoes.

Today we will focus on the Capital Goods sector and provide readers with a few names we like as well as a couple that we don’t in terms of investment attractiveness from within this sector. We will also take a look AFG’s Management Quality Chart to help us better understand each of these companies from a corporate performance and strategic standpoint. Lastly, using snapshots from www.afgview.com (AFG’s web-based research platform), we will take an in-depth look at Fluor Corp.

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 investors 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 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 have been following a wealth destroying strategy and 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 should be looked at with caution when considering these companies as additions to your clients portfolio as they contain many of the characteristics that AFG has proven to cause a company to be more likely to underperform the market and its sector peers.

Investment   Management Ticker Name Sector  Opportunity Quality Score Unattractive S&P 500 Companies With Poor Management Quality Scores (NYSE:TXT) TEXTRON INC Capital Goods Unattractive Poor (NYSE:HOT)  STARWOOD HTLS & RSRTS WW Consumer Services Unattractive Poor (NYSE:IGT) INTERNAT GAME TECHNOLOGY Consumer Durable Unattractive Poor (NYSE:CAT)  CATERPILLAR INC Capital Goods Unattractive Poor (NYSE:TSN) TYSON FOODS INC Consumer Non Durable Unattractive Poor (NYSE:ANF)  ABERCROMBIE & FITCH CO Consumer Services Unattractive Poor (NYSE:BJS)  BJ SERVICES CO Capital Goods Unattractive Poor (NYSE:JNPR)  JUNIPER NETWORKS INC Technology Unattractive Poor

Source: EconomicMargin.com

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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.

 

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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.

AFG Investment Opportunity Rank within Sector Management Quality Signal Ticker Name Sector Valuation Signal EM Change Signal 10 S&P 500 Companies Following Poor Management Strategies (NYSE:TXT) TEXTRON INC Capital Goods Unattractive Unattractive Negative Wealth Destroyer (NYSE:HOT)  STARWOOD HTLS & RSRTS WW Consumer Services Unattractive Unattractive Negative Wealth Destroyer (NASDAQ:WYNN) WYNN RESORTS LTD Consumer Services Unattractive Unattractive Negative Wealth Destroyer (NYSE:CAT)  CATERPILLAR INC Capital Goods Unattractive Unattractive Negative Wealth Destroyer (NYSE:RRC)  RANGE RESOURCES CORP Energy and Extraction Unattractive Unattractive Fair Wealth Destroyer (NYSE:TSN)  TYSON FOODS INC Consumer Non Durable Unattractive Unattractive Fair Wealth Destroyer (NYSE:TIF) TIFFANY & CO Consumer Services Unattractive Unattractive Negative Wealth Destroyer (NASDAQ:AMAT)  APPLIED MATERIALS INC Technology Unattractive Unattractive Negative Wealth Destroyer (NYSE:JCI)  JOHNSON CONTROLS INC Consumer Durable Unattractive Unattractive Negative Wealth Destroyer (NYSE:JWN)  NORDSTROM INC Consumer Services Unattractive Unattractive Negative Wealth Destroyer

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.

 

 

 

 

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On March 9th 2009, the S&P 500 hit its low mark of the year of 666.79. Since March the market has rallied up to 1,068.78 as of the close on September 16, 2009 and we thought it timely to analyze the companies that have made the biggest gains and losses since the low and provide some insights on how we view the 10 biggest gainers and losers in the index going forward. All of the biggest movers have been ranked based on attractiveness according to The Applied Finance Group’s (AFG’s) investment criteria and valuation model. The companies with the most attractive valuations and positive Economic Margin (AFG’s measure of corporate performance) movement have proven to be more likely to outperform those companies that look unattractive according to AFG investment criteria and that look expensive within AFG’s valuation model.

The list below contains the companies that have experienced the biggest price movements in the S&P 500 since the March 9th low and how each of these companies measure up going forward, according to AFG’s investment criteria and valuation model. Companies that look attractive according to AFG’s valuation model along with improving Economic Margins have proven through vigorous back-tests to identify the company’s most likely to outperform their benchmark.

AFG Investment Opportunity Rank within Sector % Move Since March 9th Low Ticker Name Sector Valuation Signal EM Change Signal S&P 500 Biggest Gainers Since March 9th Low (ex. Financials) (NYSE:TXT)  TEXTRON INC Capital Goods Unattractive Unattractive Negative 416% (NASDAQ:WYNN)  WYNN RESORTS LTD Consumer Services Unattractive Unattractive Negative 366% (NYSE:GCI) GANNETT CO INC Consumer Services Unattractive Unattractive Negative 365% (NYSE:ODP) OFFICE DEPOT INC Consumer Services Fair Unattractive Positive 969% (NYSE:GT)  GOODYEAR TIRE & RUBBER Consumer Durable Fair Unattractive Positive 342% (NYSE:F) FORD MOTOR CO Consumer Durable Fair Unattractive Positive 314% (NYSE:THC)  TENET HEALTHCARE CORP Health Fair Unattractive Fair 538% (NYSE:IP) INTERNATIONAL PAPER CO Basic Material Fair Unattractive Fair 467% (NYSE:WYN) WYNDHAM WORLDWIDE CORP Consumer Services Fair Fair Negative 422% (NYSE:DOW) DOW CHEMICAL CO THE Basic Material Fair Attractive Positive 308% S&P 500 Biggest Losers Since March 9th Low (ex. Financials) (NYSE:FDO)  FAMILY DOLLAR STORES INC Consumer Services Attractive Attractive Positive -12% (NASDAQ:CEPH) CEPHALON INC Health Attractive Attractive Positive -6% (NYSE:ABT) ABBOTT LABORATORIES Health Attractive Attractive Positive 1% (NYSE:DF) DEAN FOODS Consumer Non Durable Fair Attractive Positive -5% (NYSE:AZO)  AUTOZONE INC Consumer Services Fair Attractive Positive -2% (NYSE:PCS) METROPCS COMMUNICATIONS Technology Fair Attractive Fair -34% (NYSE:CAH) CARDINAL HEALTH INC Health Fair Attractive Negative -8% (NYSE:SUN)  SUNOCO INC Energy and Extraction Fair Attractive Negative 1% (NYSE:HES)  HESS CORP Energy and Extraction Fair Attractive Negative 1% (NYSE:HRB)  H&R BLOCK INC Consumer Services Fair Fair Positive -2%

 

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S&P 500 Expectations and Market Analysis 

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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.

ValueExpectations.com has continued to provide investment ideas to help our readers make better informed investment decisions which leads to outperformance. In addition to finding buy opportunities, VE.com also understands the importance of avoiding potential torpedo’s given the current market volatility.

ValueExpectations.com has compiled a list of potential torpedo stocks within the S&P 500 that all contain several characteristics that AFG finds unattractive when searching for potential investment ideas. If one of these firms is a portfolio holding we recommend careful evaluation as they could all be torpedo’s.

The 15 firms listed below all meet AFG’s Strong Sell Criteria. In addition, these companies are all projected to earn less than their cost of capital which means they will earn a negative Economic Margin and all of these companies have a Z-Score (Altman Z-Score) in the at-risk range or risk of bankruptcy in the next 2 years. For a review of your current holdings using AFG’s research tools CLICK HERE FOR A FREE TRIAL.

S&P 500 - Potential Torpedoes (ex. Financials)

 

AFG Sell Criteria: 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.

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.

The Altman Z-score - 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

AFG has a solid track record of identifying winners and losers in the market, check our buy/sell spreads since 1998.

Since March 9, 2009, the S&P 500 experienced quite a recovery, going from 676 to 813, or just over a 17% rebound. To put that into perspective, the market historically delivered 8% average annual returns. In the table below we provide a list of the top and bottom 10 performers since the March 9th rebound began, to give you an idea of who the new Bulls and Bears are. In the list you will find each company’s attractiveness from a valuation standpoint, as well as an analysis of sales growth expectations imbedded in these companies’ stock prices. Compare the expectations for sales growth to what they have delivered historically to see which stocks on this list are most likely to meet or exceed those expectations, and thus be more likely to out-perform. This list contains companies from the S&P 500 excluding all financial companies.

 

Top & Bottom Returns (S&P 500 excluding financials) Since March 9, 2009

 

*Scott Goto Arts

 

*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.

With the first quarter of 2009 winding down, ValueExpectations.com has compiled a list of the best and worst performing stocks thus far in 2009 (excluding financials). It is not surprising for us to see two companies on the top performer list (S and MYL) that also appeared on our list at the end of January, or three bottom performing companies (ODP, TXT and MTW) still remaining on the bottom performer list over a month and a half later. We published an article in early February highlighting the top and bottom performers for the month of January and posed the question “Is the January Effect effective?”

 

Top 10 S&P 500 Companies (YTD 2009)

 

Bottom 10 S&P 500 Companies (YTD 2009)

 

Our conclusion: Looking at the YTD returns for the companies in our January effect article's top and bottom lists, we notice that there is a huge spread. January’s top performers have earned an average return of 4.66% YTD compared to January’s bottom performers’ average YTD return of -57.15%. This pretty compelling spread suggests that the January effect may be something investors want to pay closer attention to next year and it may even be helpful for the remainder of 2009.

 

 

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, 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 companies assuming their EBITDA margins and Asset turnover stay constant at the company's historical 5 year median.

Below is Value Expectations’ analysis of the companies in the S&P 500 with the 10 best and 10 worst returns for 2009 YTD (excluding financial companies). Comparing the sales growth expectations priced in (VE sales growth) to what the company has delivered in sales growth historically allows us to see which firms have the most reasonable sales growth expectations implied by their current trading prices and thus are more likely to outperform. Will the companies with the best returns be able to maintain their momentum for the remainder of 2009? Will the companies with the worst returns be able to turn things around? We will track the S&P500 winners and losers in the year ahead and provide you with regular updates.

10 Worst S&P 500 Companies 2009 YTD

 

10 Best S&P 500 Companies 2009 YTD

*data as of close Feb. 20, 2009

 

*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.

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