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ValueExpectations.com has continued to provide investment ideas to help our readers make better informed investment decisions. In addition to finding Buy opportunities, VE.com also understands the importance of avoiding potential torpedoes given the current market volatility, so we have decided to provide a list of potential sell/short ideas from the S&P500 index (excluding Financials). These companies on our list look “At-Risk” of going bankrupt in the next 2 years according to the Altman Z-score (Z-Score), and look overvalued according to the AFG’s valuation framework.

Here is the list of 15 firms that you may want to avoid for your portfolio.

Overvalued S&P 500 Companies (Ex. Financials) with Poor Z-Scores (Altman Z-Score)

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.

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

In our May Market Review we released a series of graphs representing the valuation attractiveness of each sector relative to its historical norms and to the entire AFG universe. Below is a graph representing the AFG Technology sector which is attractively priced when you compare against its historical trading ranges (red line) and when comparing against the overall AFG Universe (represented by the value of 1). Listed are the 10 most attractive and 10 least attractive companies in the AFG Technology sector that are within the S&P 500. Also listed below the graph is an explanation of AFG’s Relative Valuation Chart.

Technology Sector Relative Valuation Chart

Relative Valuation Chart -This graph shows the Percent to Target Current (Valuation Attractiveness) 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. This example illustrates that the median Technology company is undervalued relative to the market currently and has been trading at a discount to its historic relative valuation, indicating a potentially attractive opportunity.

Top/Bottom 10 Companies In AFG Tech Sector Ranked by Valuation Attractiveness (within S&P 500)

Note: Telecommunications companies are included in the AFG Technology Sector

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.

On January 13th, 2009, we posted a list of companies that were, “In Shape and Looking Good.” The screen looked at the Altman Z-Score (a bankruptcy forecast model) and valuation. On January 14th, Nortel Networks (NT), filed for bankruptcy protection. As of January 13, 2009, Nortel had a Z-Score of -3.5. As we posted earlier this week, Dr. Altman’s heuristic is broken down into 3 zones:

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

As you can see from the chart below, Nortel Networks (NT) has a Z-score of -3.5 putting it in the “Likely to go Bankrupt in the Next 2 Year” category. Looking at its peers, ALU looks in jeopardy, where CSCO and JNPR are safe in the “Not Likely to go Bankrupt in the Next 2 Years” zone.

Below is a List of Firms in the R1000, that have negative Z-scores like Nortel Networks (NT) as of January 13th, 2009. Besides Z-Score this table also provides implied sales growth expectations priced-ion to justify their current price. Those with an N/A for VE Sales Growth need to fix their business model before we begin to evaluate the embedded expectations in their stock's price.

*VE Sales Growth calculated for these firms on 1-13-09

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.

Here is a list of companies, two from each sector within the S&P 500 that are expected to improve their Economic Margins (EM) the most over the next two years along with the bottom two in each sector expected to have their EM’s deteriorate the most. Companies expected to improve their EM’s more than their sector peers have proven to be more likely to out-perform. Improving EM’s coupled with low expectations priced-in for sales growth are the companies on this list that may be worth a look as a potential investment.

Also included in this table is the implied sales growth priced-in over the next five years in order to justify the stock’s current trading price compared with their achieved 5 Year Median Sales Growth. Ask the question are the expectations for sales growth realistic compared with what revenue growth the firm has delivered in the last five years.

If you would like to learn more about the Economic Margin methodology or Value Expectations feel free to contact an AFG representative to schedule a web-demo at support@afgltd.com.

S&P 500 Companies with the Biggest Forecasted Change in Economic Margins

16 Potential Torpedoes - That Could Be Lurking In Your Portfolio

AFG recommendations are ranked and have consistently identified winners and losers, therefore, this list of potential torpedoes should be given a second look if you own them or are considering adding them to your portfolio as they have characteristics that AFG has proven to be more likely to under-perform.