Embedded Expectations:Special Report

Issue#4 (11/26/2010) 
In This Issue...
Black Friday Bargains
Procter & Gamble An Attractive Investment
2010 Stocks to be Thankful For
Target - 2010 King of Retail
John Tamny On Bernanke
Quick Links

In Our Next Issue

 + Understanding Earnings Quality & Management Quality

Toreador Advisors
This is a sample of our free exclusive Investment Advisor Ideas Newsletter.   Be the first to receive a free weekly copy in your inbox, click here.

Dear Investment Advisor Ideas Newsletter Subscriber,

Today is commonly known as Black Friday, as it is said retailers wait all year for this day in order to finally turn a profit for the year.  More recently, the day has become famous for stores offering fantastic bargains. How nice would it be to find bargains every day?  As an investor, you have that opportunity, by evaluating the performance expectations embedded in a share price and comparing them against what a firm can deliver.  For example, if  the market has priced a stock to grow at 5% annually with 10% EBITDA Margins and you are confident the firm can grow at 10% with at least 10% EBITDA Margins, then you have found yourself a stock on sale. 

As we often mention, evaluating stocks from a P/E perspective, or growth/value orientation is silly.  At the end of the day, what counts is identifying stocks that are able to outperform the expectations embedded in their share price.  Put another way, we want to buy stocks on sale. This may sound easy enough right, so where is the rub?  The rub is human psychology works against you making those decisions consistently.  For example, this week CNBC has had analyst after analyst on the air discussing how strong this Friday will be for retailers.  So much attention, repetition, and focus on good news is likely to make investors want to go out and buy retail stocks.  Conversely, at the end of 2008 analysts were only bemoaning the demise of retail stocks and how the consumer will never again purchase enough to keep all the current stores afloat never mind about growing.  In other words, today is a very easy time emotionally to invest in retail stocks, while 2008 was very difficult. Sadly, today is likely a very bad time to purchase retailers, while 2008 presented an outstanding opportunity.

The two charts below summarizes these conclusions through by evaluating the Value Expectations ™ embedded in the Retail ETF - XRT, and showing the sector's return relative to the S&P 500.



The first chart shows that in 2008, the typical firm in the XRT was priced such that its revenues would decline by 1.6% a year through 2013.  While certainly possible, such a scenario is not likely over such a long period of time.  Not surprisingly, since the end of 2008 the XRT significantly outperformed the S&P 500 as the sector delivered performance exceeding those expectations.  Today the story is very different, as the typical firm in the group is expected to grow its topline by over 13% annually through 2015.  This appears unlikely given the group has historically grown at roughly 6% annually over the past 5 years.  Of course if you believe that 13% annual sales growth is an easy target, then BUY BUY BUY!  However do not be surprised if in 2 years the sector underperforms the S&P 500 regardless of how strong Black Friday turns out this year. 


Every week, Investment Advisor Ideas provides dozens of stocks having characteristics that over time have tended to beat their respective index benchmarks and thus warrant consideration if you make stock selections for your clients.

Thank you for taking the time to read our writings, and we wish you and your family a wonderful Thanksgiving holiday.


If friend or colleague forwarded this email to you, click here to continue receiving our free Investment Advisor Ideas newsletter.


Rafael Resendes

Co-Founder The Applied Finance Group 

Send to a Colleague

Join Our Mailing List

Black Friday Bargains - Retail Sector Expectations

As we mentioned earlier in the week in one of our blogs on ValueExpectations.com, the retail sector has been on fire so far this year outpacing the S&P500 by over 20% YTD and even delivered solid results in the previous quarter.  Given the optimism, analysts are expecting a 2% jump in sales this year over last year's dismal shopping season.  Although this is an encouraging sign for the sector, retailers are still far from achieving the sales and margins of the pre-recession levels.

To get a better understanding of the expectations built into the retail stocks, we will analyze these companies in greater detail using criteria developed by The Applied Finance Group (AFG) in their portfolio construction process.

First, we set out to understand the sales growth and EBITDA margins a company needs to achieve over the next 5 years to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, we can develop a "hurdle rate" to quickly determine if the company's expectations are rich or low. In many circumstances, if the imbedded future performance is very conservative relative to the company's historical performance, the stock is regarded as undervalued.

After solving for the sales growth and EBITDA margin expectations for every company within the retail sector ETF XRT, we come to the conclusion that the average company in this group needs to grow its revenue by around 14% over the next 5 years to justify the average current trading price. When you compare that to what these firms have delivered historically in terms of revenue growth over the past 5 years the median firm in this group has delivered around 7.1% sales growth over the past 5 years, the expectations for sales growth is awfully lofty when you take into account the economic landscape going forward relative to the previous 5 years.

The chart below shows how the expectations for this sector have migrated over the past 3 years. As you can see expectations were quite low over the past 2 years as this sector was beaten up by the recession. After the recent run up however you can see that expectations have risen quite dramatically to justify their current trading levels causing the overall sector expectations to look rather lofty and will be difficult to meet. Being that we think the overall sector is overvalued, it will be important to focus on the individual companies to identify the solid investments in this segment as potential buy ideas and also identify the potential torpedoes that have extremely high sales growth expectations.


Although the overall retail sector appears to be overvalued at present, several of the tickers listed below are well-managed companies that we believe are the 'Black Friday' bargains for this year.

The Procter & Gamble Company - Creating Wealth and Trading at a Discount

The Applied Finance Group's (AFG's) research and suite of investment tools help investors to easily understand a company's true economic profitability, as well as if the company's asset management policy is suitable to maximize that profitability. AFG's Wealth Creation Report (WCR) allows you to visually analyze a company's historical Economic Margin (EM) level, current EM and expected change in EM based on projections built out by AFG's default valuation model, which takes into account the total cash flow a company delivers. A company that earns above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Back-tests have proven these companies to be more likely to outperform those companies following a wealth-destroying strategy (negative Economic Margins and growing assets).

Below is an example of The Procter & Gamble Company (NYSE:PG), a company AFG considers to be a consistent wealth creator, identified by using AFG's Wealth Creation Report (3 parts of this chart explained in greater detail below).



AFG's valuation techniques also help investors identify and take advantage of mispriced securities in the market. One way investors can identify over or undervalued stocks is by using AFG's Intrinsic Value Chart, which displays a company's intrinsic value relative to its trading range and helps entry/exit points.

This easy to read chart identifies how far a stock's trading range deviates from its intrinsic value (target price assuming immediate decay), which helps you recognize potentially mispriced stocks and pursue long and short opportunities. AFG's Intrinsic Value Chart also contains a company's Value Score (ranked valuation attractiveness), Economic Margin Change (expected improvement of economic profitability), and Accuracy (how well AFG's default valuation has tracked the company) information. AFG's valuation framework estimates a company's equity value by subtracting debt and other liabilities from the total enterprise value. The total enterprise value is estimated by discounting projected future cash flows, utilizing analyst consensus, Economic Margin methodology, and the Decay concept which addresses the perpetuity bias in the traditional DCF model.

The Procter & Gamble Company (NYSE:PG), is a company that currently looks undervalued according to AFG's default valuation model. An important fact to note is that AFG has shown it tracks PG well (high accuracy score of 75). Also, PG has a current AFG Value Score of 74, meaning the company ranks in the top 74th percentile of companies in the AFG universe in valuation attractiveness.



25 S&P 500 Stocks To Be Thankful For In 2010 - Including AutoZone Inc. and Hasbro, Inc.

With the holiday season fast approaching and Thanksgiving ever so close, we will provide an update of the top performing stocks from within the S&P 500 to see which companies investors should be most thankful for in 2010 if you owned any of the companies on this list. Now that 2011 is quickly approaching it is time to separate the year's biggest winners and losers and identify which stocks have been driving the markets in 2010.

The returns listed are the total return (including dividends) the company has delivered as of last Friday's close and the index in comparison has delivered a return of 6.6% so far YTD. We can also see if there are any obvious trends in the companies with the best and worst performance of the year.



 Also by using AFG's EM framework and valuation techniques we have provided further analysis on 8 of the best/worst performing companies, 4 that we find attractive going forward and 4 that we find unattractive, based on valuation attractiveness, expected improvement in economic profitability and overall investment opportunity. NVDA, ORLY, AZO and HAS look to be trading at a discount to their intrinsic value, are expected to improve economic profitability in the next fiscal year and look poised to outperform the market going forward while the opposite is true for EL,DF, HOT, and AMD.




(If friend or colleague forwarded this email to you, click here to continue receiving our free Investment Advisor Ideas newsletter.)



Target - 2010's King of Retail


With Black Friday kicking off this morning we have focused our attention on retail stocks we find attractive. If you are a subscriber to our weekly newsletter, you can access our top 10 retail picks within the S&P 500, as well as get an understanding of the embedded expectations in the retail sector.

As consumer spending remains sluggish in this weak job environment, retailers have taken a more aggressive stance to compete for consumers' limited discretionary dollars. Specifically, retailers have stepped up on promotional activities, lowered product pricing, introduced new products, and implemented various incentive programs. However, only a handful of these retailers have positioned themselves strategically enough to benefit from an economic recovery, and this includes our newly crowned "King of Retail": Target Corp. Target is a big-box discount retailer that operates stores offering general merchandise and food items. In addition to its retail segment, it also operates a credit card segment, which offers credit to qualified customers through its branded credit cards.

During the recession, Target's sales were negatively impacted as shoppers traded down to lower-end stores such as Wal-Mart, which led to two straight years of comparable store sales declines: -2.9% in 2008, and -2.5% in 2009. However, the trend is reversing itself now as we emerge from the Great Recession. Target just reported its fourth consecutive quarter of positive sales comps (1.6% in Q310), driven by stronger traffic across all its stores. Target's results were in stark contrast with its archrival Wal-Mart, which posted its sixth straight quarter of negative sales comps. Although the macro environment remains weak, consumers are clearly more optimistic about their job prospects and the near-term outlook; therefore, they are willing to trade back up to higher-end stores, like Target.

Going forward, we believe Target will continue to be a threat to other big-box discount retailers and department stores for the following reasons:

Traffic driving initiatives: The Company is in the process of remodeling their stores and adding a fresh food section dubbed P-Fresh. This shift in capital spending from new unit openings to store remodelings is proving prudent thus far, as store traffic has improved for five straight quarters and sales in remodeled stores have generally exceeded expectations. Although the lower-margin grocery items will pressure profitability, the company said that improved sales leverage and improvement in other higher-margin categories such as apparels will likely offset those pressures. Under the remodel program, Target has remodeled 462 stores, including 341 stores remodeled year to date. It plans to remodel 380 stores in 2011, and we believe Target will continue to drive strong traffic as it improves its store displays and product assortments.

Closing the price gap: Target rolled out its reward program in October, offering its credit and debit card customers a 5% discount for all purchases. Since the national roll out, results have met management's expectations as issuance and usage of the credit and debit cards has increased sharply. Specifically, the 5% program is expected to add about one percentage point to same-store sales in Q4, and between 1% and 2% to same-store sales for 2011. While the general perception is that Target's products are priced higher than Wal-Mart, management believes Target has come very close to matching Wal-Mart's price and eliminating that price perception. With the 5% program, Target is a step closer to reducing the price gap, or perhaps, beating Wal-Mart's prices in certain product categories. In addition to generating incremental sales, the program helps Target identify and analyze its customer demographics, therefore enabling more effective marketing to its customer groups.

Long-term growth opportunities: Target is considering tapping international markets for growth opportunities, and might open stores in Canada, Mexico and Latin America in the next three to five years. The potential for international expansion bodes well for Target's long-term growth. In addition, in a move similar to that of its closest rival Wal-Mart, Target plans to penetrate the urban markets in the U.S. by introducing a smaller store format of 60,000 to 100,000 square feet, versus its regular format of 125,000 square feet.

From an Economic Margin perspective (what a company earns above its true cost of capital), Target is a strong wealth creator, as it has consistently grown its profitable business. Looking at the chart below, Target has generated 14 straight years of positive EMs, while at the same time growing its store count.



While TGT is one the few well-managed companies that consistently create wealth for its shareholders, not all good companies make good investments. It is very important to be aware of what embedded expectations you are paying for, which is why we will now focus on TGT's intrinsic value. The intrinsic value chart below illustrates that TGT is currently trading at a discount to its default intrinsic value, meaning the company is currently undervalued.


There are quite a few compelling reasons to own TGT right now, and it will be interesting to see how the company fares in the battle for customers this holiday shopping season. We believe TGT is a well-run, attractively priced company that has been doing all of the right things to continue improving its business, regardless of the economic outlook. It has been very successful at getting shoppers to trade up to TGT products during stretches of economic improvement and has also proven to be successful at gaining new higher-end shoppers that trade down to TGT products during economic downswings. We expect the "King of Retail" to do well during this holiday season, and will be closely monitoring the entire retail sector over the coming month. 

Modern Fed History Points to Ben Bernanke's Resignation

John Tamny

Just four days after Fed Chairman Ben Bernanke laid out his rationale for the latest round of quantitative easing in the Washington Post, Fed Governor Kevin Warsh, in a veiled slap at the Chairman, offered up his dissent, and on no less than the Wall Street Journal's editorial page. Though Warsh voted in favor of Bernanke's plan, his op-ed spoke volumes about conflict within the central bank that so far has revealed at least one public dissenter in the form of Kansas City Fed president Thomas Hoenig.

Modern history says this doesn't necessarily bode well for Ben Bernanke's future as head of the world's foremost central bank. Indeed, if broad discontent about QE among major economic eminences outside of the Fed is even remotely representative of unhappiness within, Bernanke may soon face a revolt. If so, his tenure as Fed Chairman could soon be coming to an end.

For background, all we need to do is return to the year 1987. Paul Volcker was Fed Chairman then, and while in the years leading up to '87 his interest rate decisions had mostly been met with votes in his favor, by then many of his allies on the board had retired or resigned, and had been replaced by Reagan appointees. Most notably, Manuel Johnson and Wayne Angell were two Reagan appointees who used market signals - commodities specifically - to inform their views on whether or not inflation was a problem.

At the time in question commodities were declining and market rates of interest were falling too. Though the Fed's targeting of the short-rate for cash is problematic on its face, market signals were calling for rate cuts by the central bank.

The problem then was that Volcker did not agree. More of a rate hawk than the newer Reagan appointees, Volcker held firm with his view that he wouldn't support a rate cut, particularly if central bankers in Japan and West Germany weren't ready to do the same alongside him.

Ultimately Volcker was caught unaware by how very much the four Reagan appointees (Martha Seger and Preston Martin the others) were of the mind that the discount rate needed to come down. And when it came to a vote, Volcker's two allies on the board did stand by him, but the Reagan appointees all defected on the way to the Fed Chairman being outvoted.

As William Greider noted in his book, Secrets of the Temple, Volcker was furious, and worse, the very public way in which his authority had been questioned made it apparent to the world that he'd essentially lost control of his Fed. Volcker actually motioned that he would resign right away, but Treasury Secretary James Baker convinced him to stick around.

But later on in the year Volcker not only faced opposition from his board members on the rate question, he also suffered what Greider viewed as subtle attacks on his authority from the money center banks effectively on his watch. Specifically, Citibank's John Reed and other major institutions with exposure to bad Latin American loans chose to work them out on their own, free of Volcker's guidance.

Having been undermined by his underlings on the Federal Reserve Board, along with heads of the major banks under his regulatory control, it was very apparent that Volcker was Fed Chairman in name only. With his term coming up in August of 1987, Volcker was still willing to stick around for another, but only if President Reagan publicly backed him.

Reagan withheld the kind of public endorsement Volcker sought, and while the former Fed Chairman is oddly lionized today by Reaganites possessing short memories, Reagan's stance was understandable. Indeed, not only had the President suffered Volcker's persistent stubbornness on interest rates, Volcker had also leaked against the Reagan tax cuts with regularity, not to mention that his three-year flirtation with monetarism (1979-1982), far from strengthening the dollar as modern mythology suggests (the dollar's rise and gold's fall began when Reagan won New Hampshire in 1980), nearly made him a one-term President.

In short, Volcker had been a difficult Fed Chairman for the President, plus his troubles inside and outside the Fed made it apparent that he'd once again lost control. Volcker retired, Alan Greenspan was nominated as his replacement, and the rest is history.

Returning to the present, Thomas Hoenig as previously mentioned is on record as being against the Bernanke Fed's (Richmond head Jeffrey Lacker is another) persistent and vain efforts to stimulate the economy through monetary machinations. As for Warsh's op-ed in the Wall Street Journal, for a Fed Governor to be so explicitly critical of the Chairman's policies on the Holy Grail of editorial pages suggests strongly that he planned the piece well in advance, and that he didn't go out on a limb in such a public way without the backing of others on the board.

If so, logic says that much like Volcker before him, Bernanke has not only lost control, but also some amount of credibility with the Fed board members beneath him. And if history rhymes as they say, it's a fair bet that Bernanke could soon enough face Washington-style pressure to "retire" with as much grace as possible.

This too might explain why Treasury yields have begun to rise. Simple logic tells us that markets had priced in QEII long before Bernanke announced his plan, so it's perhaps fair to assume that the decline in Treasuries in concert with weak stock markets is a signal that markets are pricing in a looming change in policy; one that would halt further quantitative easing. As for stocks, ultimately it will be a market plus for Bernanke to resign a job he's proven unequal to, but with a lack of information always a market negative, investors are selling shares until they know for certain how change at the Fed will play out.

Ultimately what's being suggested here is pure speculation. Still, the body language of certain members of the Federal Reserve Board of late speaks to unhappiness about the central bank's direction. If true, past history hints that Bernanke, increasingly a joke outside the Fed, is losing his grip on the inside on the way to him stepping down.


Send to a Colleague

Join Our Mailing List