IAI

Growth/Value Special Report

Issue#3 (11/19/2010) 
In This Issue...
Growth and Value Investment Opportunities
CAT to Buy BUCY - Finally an Acquisition We Agree With
Torpedo Stock Watch - Do You Own Any?
Top 25 CEO's and Their Stock Valuations
Investing Down Under - Aussie Stocks
John Tamny On Bernanke
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 + Understanding Embedded Expectations in Stock Prices

Toreador Advisors
 
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Dear Value Expectations Newsletter Subscriber,

There once was a time when the "learned" believed the sun revolved around the earth, the world was flat, and government spending led to sustainable economic growth. This week's Investment Advisor Ideas focuses on another such misconceived idea, classifying stocks with growth and value designations. While the investment consultant community has firmly adopted the growth vs. value concept, at some point, hopefully in the near future, this classification will go the way of the buggy whip, leaching, and the above silly misconceptions. After all, the classification tends to imply a choice between owning a stock that can grow but doesn't offer much value, versus one that offers a compelling value but doesn't offer much growth. Such a choice is silly - every stock valuation implies a future stream of cash flows to justify its price. If today's price implies a smaller cash stream than a company is capable of generating, it is a value stock. If a stock's price implies greater cash stream than a company is capable of generating, it is a value trap, regardless of how sexy its products are or how strong its future revenue growth appears. It does not get much simpler than that.

 

Years ago, in 2005, I traded emails with a popular financial writer that had just criticized AutoZone for failing to deliver sufficient comparable store sales growth, though the company continued on its stated path of improving margins. He appeared smart as AutoZone shares were underperforming, and carried on with his typical snarky tone in his email. I more or less let him know he was clueless and silly for not understanding wealth creation and how that translates to intrinsic value. Needless to say, he did not reference my analysis in his later article on the company and AFG failed to obtain a PR win. Our analysis was vindicated, however, as over the past 5 years AZO has moved from approximately $80 at the time to $250 today, while the S&P 500 remained flat. Worth noting, for most of the years, AutoZone's comparable store sales growth was still negative to mediocre. His (and other investors) obsession on "growth" versus "value", rather than understanding that AZO was taking the right steps to create shareholder value and the cash flow expectations embedded in its price were very reasonable caused him to miss a great trade of our day. He was fixated on AZO as a growth stock that failed to deliver "growth", rather than understanding AZO's valuation. It is often said that history repeats itself, and today's lesson may apply to many technology giants. For example, CSCO was recently crushed on weak growth numbers, but justifying its stock price requires virtually no top line growth if it can maintain its existing margin levels. As today's kiddy set often whines - Just saying....

Much like Beta as a risk proxy survived long after its "use by" date, due to its simplicity so I suspect has been and is the case for the growth vs. value classification. Instead we would like to see stocks classified in duration terms, as companies will pursue different strategies which lead to different cash flow durations. This provides a much better framework to structure a portfolio for different phases of the economic cycle. Further, it better allows analysts to discuss stocks in terms of the operational expectations (sales growth, margins, and turns), and how they translate into future cash flows to evaluate how attractive a stock looks as an investment. At the same time, we are also mindful of reality - some investors still want traditionally defined growth and value stocks. Like golfers with stubborn hitches in our swing, we understand the need to "play through our slice" and thus prepared this list to help identify attractive "growth" and "value" stocks.


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Value Expectations

 

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Growth vs. Value - The New Buggy Whip

Traditionally most investors tend to identify themselves as either growth or value oriented when they approach constructing their portfolios. There are many varying approaches of how to classify stocks in either category, but growth investors typically focus on earnings and sales growth regardless of the company's ability to add value to its shareholders, whereas value investors search for stocks trading at relatively low price multiples. We believe that both approaches for picking stocks have their pitfalls if the investor fails to understand the cash flows that are driving the company's value and how they relate to its stock price. If a growth company is capable of generating larger cash stream than is implied by its current stock price, we consider it attractive. Likewise, if a low P/E company's stock price implies greater cash stream than a company is capable of generating, it is a value trap. Below we have provided a list of stocks which we consider attractive right now in both the "value" and "growth" universes, to help investors from both groups identify investment opportunities.

But first let's examine the past performance of growth vs. value stocks. We looked at many past studies comparing the performance of the two groups and although the approaches to differentiate one from the other may vary, most studies tend to show that value stocks have outperformed their growth brethren over the long haul, even when taking into account the high growth technology led stock markets of the 1990's, just prior to the tech bubble. The chart below is a study by Fama & French (via thedividendguyblog.com), comparing the value of a one-dollar investment back in 1927, based on size and growth/value characteristics. This study confirms that value stocks did earn far greater returns than the growth stocks regardless of the size classification.

 

 

As mentioned before, there are many different methods investors use to separate growth and value universes - here are some of the most common characteristics for the two groups:

Growth companies tend to have...

  • High earnings growth rate
  • High sales growth rate
  • High R.O.E
  • High profit margin
  • No or low dividend yield

Value Companies tend to have...

  • Low P/E ratio
  • Low price/sales ratio
  • Low price/cash flow
  • Low price/book ratio
  • High dividend yield

At AFG we have developed our own methodology of classifying the companies within a certain universe as value and growth - we use their relative Market Value/Net Invested Capital ratio. Companies with MV/IC greater than the median for the group are considered "growth", and those lower than the median are considered "value" stocks. The following chart provides some insight into how growth has fared relative to value stocks in the past based on AFG's classification. As you can see, in line with what we have already found out, AFG defined value stocks have outpaced growth stocks over the past 12 years.

 In addition, we wanted to shine some light on how our buy and sell recommendations have done within each group. The chart below demonstrates that there is a significant positive spread between the returns of the companies we find attractive and those we recommend to stay away from in each style category.

Now that we have viewed the past performance, let's look at our outlook of the attractiveness of each investment style going forward using our EM framework and valuation metrics. Based on current valuation attractiveness within our default valuation model, value looks more attractive as an investment opportunity than growth in any size category (small, mid, large), with the large cap value bucket looking the most attractive of the bunch.

 

 

In an ideal world our portfolios would be filled with stocks with booming earnings growth and discounted price tags, however in reality any solid growth stories will attract investors, which inflate the price. We recommend not to automatically ignore companies based on style as there are plenty of attractive opportunities in both the growth and value universes, especially when utilizing AFG's research and valuation techniques to identify attractive long and short prospects. By not overlooking companies based on style you will increase the size of your fishing pond and your portfolio will benefit from the diversification.

In the table below you will find a list of companies in both styles (based on MV/IC) that look attractive going forward. When creating our list of Attractive Growth/Value stocks we looked for companies that fit the following criteria.

Attractive valuations

Profitable from an economic standpoint

Expected to improve economic profitability

Poised to outperform

 

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Caterpillar to Purchase Mining Equipment Company Bucyrus Inc. Finally an Acquisition We Agree With

Back in April 2009, we labeled Bucyrus International, Inc. (NASDAQ:BUCY) as one of the most undervalued stocks in the Russell 1000 based on its attractive valuation, as it had low sales growth expectations "baked-in" to its stock price (trading around $20 per share). Since then, the stock has skyrocketed 360% to around $89 a share. A fair amount of those share gains can be attributed to the increase witnessed today, as BUCY shares rose significantly on talks of Caterpillar Inc.'s (NYSE:CAT) offer to purchase the mining equipment company for approximately $8.6 billion or $92 per share - a 32% premium to BUCY's closing price on Friday.

CAT's offer is not a huge surprise, as there has been a lot of M&A action lately in the mining industry with commodity prices on the rise and companies increasing mining operations.

However, we are not evaluating the strategy of this deal only what price CAT is paying to increase its position in the mining industry. Using AFG's EM valuation framework, we will assist our readers in understanding the implied sales growth expectations for BUCY based on its current trading price (assuming a reasonable 18% EBITDA margin and 0.85 asset turnover ratio) . Using these inputs, BUCY must generate 14% sales growth over the next 5 years to justify its current trading price of $90.

  

 

Based on historical sales growth and analyst consensus estimates for sales growth, the implied expectations seem in-line on an annualized basis with what the company is expected to deliver - making this deal look pretty fair. In most circumstances, AFG believes that companies usually tend to overpay when making acquisitions, jeopardizing shareholder value.

This deal on the surface, however, looks to be fair as the implied sales growth "priced-in" to justify the current trading price is reasonable compared to consensus estimates and what the company has delivered historically.

We really liked Bucyrus at $20 a share, but at $90 per share we believe shares are fairly valued. From this perspective, CAT is making a good deal to increase its position in the mining equipment industry.

Torpedo Watch List - Large & Small Cap Stocks To Avoid Including AT&T Inc., Dow Chemical

When managing a clients' money, it is just as important for professional investors to be able to avoid potential torpedoes in the market, as it is to discover the next attractive investment opportunity poised to hit a return home run.

Since ValueExpectations.com spends a sufficient amount of time providing readers with attractive investment opportunities it is now a good time to help our readers identify a few small and large cap stocks that rank poorly according to key AFG criteria, including Economic Margin, Management Quality (MQ) and Valuation Rank. These three variables have proven through back-tests to identify stocks likely to underperform sector peers and benchmarks. The MQ variable is used as an exclusionary variable that eliminates companies doing the wrong things or management teams destroying shareholder wealth. All of the companies included in our list have been flagged as companies following a wealth destroying strategy.

In the table below you will find 12 large cap companies from the S&P 500, as well as 14 small cap companies from the Russell 2000 that look unattractive according to key AFG investment criteria. If you own or are considering adding one of these companies to your client portfolios, you may want to take a closer look into these companies and reconsider whether or not they are worth adding/owning.

 

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Rating The Top 25 CEO's On Stock Valuation

 

The Applied Finance Group (AFG) has partnered with CEO Magazine in recent years to give investors insight into which CEOs do the best job of creating value for its shareholders; after all, that is what they are hired for. The AFG/CEO Wealth Creation Index, which relies upon AFG's corporate performance metric Economic Margin (EM), provides a better understanding of wealth creation than traditional accounting measures such as EPS and ROC. The link below will take you to the complete list of rankings of CEOs from S&P 500 companies that have held their current position for at least 3 years, based on their wealth creation abilities.

Click Here to view the entire CEO Wealth Creation Ranking article.

Click here to view complete list of companies and their respective rankings.

 


As a further layer of analysis, we have taken the companies of the top 25 CEOs and rated them based on Valuation Attractiveness to give insights into which companies on the list look attractive as potential investment opportunities. Even good companies with strong leadership do not always make good investments, because it depends on what you pay for them. The companies on the list that look unattractive from a valuation standpoint are the companies we recommend reviewing in greater detail before you consider adding to any portfolio. 

 

 

Investing Down Under - Hot Aussie Stocks

Investors looking to add some global exposure to their client portfolios have numerous reasons to consider the "Land Down Under" Australia as it has been recently recognized as the best performing and safest market in the world to invest in over the past 110 years. On a shorter term perspective, compare the performance of Australian securities (represented by the Australian Index ETF EWA) vs. the S&P 500 over the past 2 years and the Aussie stocks have outpaced the S&P by over 40%.

 

Along with its strong performance track record in its markets, Australia also enjoys the following benefits...

Advantageous location bridging the gap from Asia to the West

Vast natural resources (Mining, Agriculture)

Business friendly regulatory & tax environment

Political stability

Low unemployment

Strong currency

Lowest levels of debt among developed markets.

Along with its investment friendly policies and natural advantages the Aussies have also avoided the fray of the Global Financial Crisis and have moved through this period relatively unscathed. During this time as U.S. unemployment rates soared and interest rates sunk, Australia was able to lower its unemployment rate and was the first G20 country to tighten its monetary policy by raising the key interest rate last October.

Now that we have stated the case for considering added investment in the Australian stock market let's look at some attractive and unattractive companies based on key criteria used in The Applied Finance Group's stock selection process as potential long and short investment ideas.

No matter if you are investing at home or overseas it is always important to focus on companies that are expected to improve their economic profitability and are trading at a discount to their intrinsic value.

Lately, ValueExpectations.com has focused on providing stock ideas that would add global exposure to client portfolios, by selecting the best companies within each index, rather than recommending the purchase of a generic ETF or Mutual Fund.

The companies listed below have many of the characteristics that we look for when identifying stocks that are more likely to outperform. These companies are expected to improve their Economic Margins (what a company earns above or below its true cost of capital) in the next fiscal year and are currently trading at a discount to their intrinsic value. The backtest results shown below our list of companies will explain in detail the improved performance of portfolios when using these two criteria in concert within different countries and time periods.

 

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Bernanke Ignores Basic Laws of Economics - John Tamny
Much ink is presently being spilled by the economic commentariat concerning soft demand in the economy, and ways to increase it. Lost on the deep thinkers that presume to know what makes us prosperous is the greater truth that demand is the last thing governments would ever need to stimulate.

As humans, our demand for what we lack is unceasing, by definition. That's why we work. If this is doubted, one need only camp out an Apple store the next time our leading technology innovator releases its next must-have product.

But what the average consumer knows that the fine tuners in Washington apparently don't is that in order to buy an iPad, consumers must produce something of similar value first, exchange it for dollars, then purchase the Apple product. And if they've not created value that is exchangeable for the iPad, they must find someone who has produced the iPad's cost in dollars, and who is willing to delay near-term consumption on the way to transferring their consumptive abilities to the eager buyer.

To make what's simple even simpler, all demand is the result of production first, and this has been the case for as long as man has roamed the earth. We produce so that we can consume.

Of course economists will continue to try to put the cart of demand before the production horse, and unsurprisingly the never disappointing Ben Bernanke - the walking definition of an economic fallacy - will carry the load for them from the Fed. Bernanke did just that in an opinion piece last week for the Washington Post.

Eager to justify his latest dose of "quantitative easing" (QE) amid increasing skepticism even in Washington where the false concept of getting something for nothing is religion, Bernanke proclaimed that lower interest rates wrought by QE will increase stock prices on the way to more consumer wealth and confidence. According to our Fed Chairman, this might boost spending, and "Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion." One can't make this up.

But if the sentient among us could climb inside Bernanke's dopey dreams for a moment a la the film Inception, we might insert the part about production preceding demand so as to make his Utopian visions in the middle of the night whole. In Bernanke's case, it's apparent that he always wakes up before the production aspect enters his incomplete picture.

Absent it, the increased demand that Bernanke presumes is no such thing. That's the case because the wealth effect that he naively believes to exist is non-existent.

If shareholders exchange shares of increasing value for dollars in order to consume, the seller's dollar bonanza is naturally matched by the buyer's reduced cash position. These things even out, with no increase in consumption. And the same applies to housing. If Bernanke's rate machinations enable mortgage refinancing for certain individuals, suddenly flush mortgage holders will be matched by savers whose savings will enable the financial transaction.

Of course underlying Bernanke's vision is lower interest rates across the board driven by the Fed's interventions. But here too he gets things backwards.

Indeed, tight credit during uncertain economic periods is usually a positive signal that failed economic concepts are being starved of capital so that they're no longer able to destroy it. High rates of interest aren't scary as much they're a symptom of previous mistakes, and they're essential for drawing savers back into the marketplace to fund productive ideas quite unlike the ones that caused the financial panic to begin with.

More important, high prices of anything by definition beget lower prices in the future. No economist - including even Mr. Bernanke - would suggest that if actual demand drove gasoline to $5/gallon that price controls should be put in place. They wouldn't because the $5/gallon would signal to producers what the market desires, and that they will be compensated handsomely for delivering what consumers want.

What's never been explained is why central bank attempts to control the cost of credit are any different. In the gasoline example government intervention would distort precious price signals on the way to shortages, but just as Bernanke ignores Say's Law, his vain efforts to make credit plentiful reveal that he ignores too the crippling effects of price controls as they apply to him.

Bernanke continues to promote the view that we don't have an inflation problem, and to support his claim he points to a "considerable" amount of "spare capacity" in the U.S. The problem there, if we first ignore that U.S. producers operate in a global economy with lots of spare capacity, is that Zimbabwe, Mexico and Argentina have long had a great deal of spare capacity, and this has never spared them from the cruel monetary phenomenon that is inflation.

Indeed, outside of central banks and academic circles inflation remains what it's always been, and that's a decline in the value of money. And with the dollar continuing to test new lows against gold and every major foreign currency, it's apparent that Bernanke is additionally ignoring the price signals that are presently screaming inflation.

Perhaps to give us a laugh, Bernanke notes that the Fed labors under a dual mandate imposed by Congress "to promote a high level of employment and low, stable inflation." Funnily enough, on Bernanke's watch the rate of unemployment has doubled, and while he would correctly point out that the dollar's exchange value is a Treasury thing, gold has nearly tripled versus the dollar during his tenure. It's as though he's begging to be relieved of his duties by noting his failures, but his peers and overseers in Washington are as clueless as he is.

As a result, Americans and the world will continue to suffer a Fed head that, with every utterance shows how very unequal he is to his job. A self-proclaimed expert on the 1930s, Bernanke continues to intervene in the economy despite clear lessons from that decade showing that government intervention then turned what should have been a brief downturn into a Great Depression.
 

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