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Fallen Angels Report | Issue#6 (12/10/2010) |
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In Our Next Issues
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+ Large and Small Cap Stocks to Buy in 2011 and Investor Survey Results |
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Dear Investment Advisor Ideas Newsletter Subscriber,
Getting it Right, Requires Starting Right.
This week's Investment Advisor Ideas Newsletter focuses on Fallen Angel Stocks - quality companies that have either taken a warranted or sometimes unwarranted pounding in the market, but still possess an attractive valuation to value-hungry, long-term focused investors. If this list performs as well as our last such report, you are well advised to explore the list for names that may interest you as that report delivered 1200 bps above its benchmark. (Click here to read the last Fallen Angel report). We never take such a performance for granted, as beating the market is very difficult, but it is something we expect each research report to consistently achieve. That then begs the question - why are we so confident? The answer is simple: we believe, more so than any other research process, that AFG's Economic Margin Framework™ gets it right at the get-go of the investment research process, by correctly measuring corporate performance, which makes generating consistently right answers achievable.
There are many approaches to measuring a firm's corporate performance. The most common include flawed approaches such as - EPS Growth, ROE, and RONA. In addition, there are more exotic proprietary but equally flawed approaches such as economic value added, and cash flow internal rate of return metrics. The latter deserves particular attention, as it has achieved some popularity in the investment community and is often billed as being a very sophisticated and complete approach; yet, it is comically flawed.
There are many consultants that provide some form of cash flow internal rate of return analysis. The underlying logic behind each is that an internal rate of return (IRR) calculation is appropriate for a project, and a firm is nothing more than a collection of projects; therefore an IRR is appropriate for an entire firm. While the math underpinning such calculations is often impressive and detailed, the logic is comical at best and irresponsible at worst. When considering the IRR approach, two questions immediately spring to mind, revealing its flaws. The first question is why is it necessary to forecast out future cash flows to measure corporate performance today? That makes no sense. Secondly, why do IRR calculations assume that all cash flows are reinvested at the IRR? This is a nonsensical assumption. Take for example Coca Cola. The firm generated returns greater than 20% on its existing business throughout most of the 90's. Yet assuming reinvestments at such high rates of return on new investments would have been silly. Notice Coke has made incremental investments at much lower rates of return for the better part of the last decade - around 15%. Therefore any analysis that begins from such a flawed perspective is unlikely to systematically guide you towards correct conclusions. So if you happen to run across a colleague that proudly uses such an approach, don't laugh, but don't listen to them either.
So what makes The Applied Finance Group's approach different? Quite simply, AFG asks the right questions required to evaluate an investment or a company -
· How much cash does the firm generate
· How much capital is required to generate that cash flow
· What is the risk adjusted opportunity cost of investing in that capital
While the questions are simple, they sufficiently frame every investment decision. There are no silly assumptions about what a firm "will do" to evaluate a firm's "current" performance. The end result is a systematic research approach that we apply to 20,000 companies across 22 countries, which consistently generates buy and sell candidates that outperform appropriate benchmarks. Getting it right at the start - by properly measuring corporate performance - gives us the confidence to follow our research as it is likely to get it right at the end - picking stocks.
Thank you for taking the time to study our research this week.
If friend or colleague forwarded this email to you, click here to continue receiving our free Investment Advisor Ideas newsletter.
Sincerely,
Rafael Resendes
Co-Founder The Applied Finance Group
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Identifying "Fallen Angels" and "Falling Knives" |
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Value investors often look at companies that have been beaten up or that are on a downtrend to uncover the ones likely to be a diamond in the rough poised to bounce back. These "Fallen Angels" are solid businesses that have dropped in price due to some sort of temporary setback but should return to profitability or more "normal" levels in the next few months or years. However, the challenge of finding these stocks lies in the difficulty of distinguishing the fallen angels from the "falling knives," or companies that have experienced a drop in share prices for valid reasons.
Earlier in 2008, amid all the uncertainties in the economy that sent share prices tumbling, the market presented some attractive buying opportunities. During the 4th quarter of 2007, the S&P500 and Russell 2000 indices lost approximately 5% and 7% respectively. We felt that in certain cases, investors were unable to differentiate between good, neutral, and bad stocks and instead adopted an attitude that all stocks were bad unless proven otherwise. For this reason, we compiled a portfolio of stocks called the AFG's Fallen Angels portfolio to take advantage of this opportunity.
We screened for companies that had earned positive Economic Margins (a company's economic profitability or what it earns above its true economic cost of capital) and were expected to continue to generate positive EMs in the near term. In addition, we favored companies that had demonstrated ability to grow their businesses profitably, as these companies tend to boast strong management teams that can navigate through economic difficulties. More importantly, we considered the companies' valuation attractiveness, or the amount of upside it presents relative to its intrinsic value.
The portfolio of 11 stocks were published to clients from 01/16/08 to 05/16/08, and during that time period, the stocks returned an average of 20.54%, outperforming the blended R1000 and R2000 index benchmark by 12.39%. The table below highlights its performance.
With the success of the previous "Fallen Angels" portfolio, we have decided to publish a similar portfolio going into 2011. The companies that we have identified as our "fallen angels" all look attractive from a valuation standpoint and have management teams that understand how to create wealth for its shareholders.
Although these companies have suffered a short term setback, they still appear to be solid companies that look attractive for the long term. It is important to focus on the overall quality of the company and not overreact to short term price drops. We believe these companies have a good chance to turn their fortunes around in 2011. In contrast, the "Falling Knifes" companies have a history of destroying shareholders wealth, and are trading at unattractive valuations. We believe these firms are likely to stay at depressed levels or continue to fall in the upcoming year.
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| Revenue Growth Expectations Look Rich for S&P500 |
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The Applied Finance Group's (AFG's) ability to understand the embedded expectations in stock prices and what a company needs to deliver in revenue growth over the next 5 years in order to justify its current stock price helps investors to better understand whether a company's expectations are rich or low. When expectations are low companies tend to be more likely to outperform those expectations and outperform their benchmarks. Applying this technique for an entire index is also a good way to tell if the index is over or undervalued as a whole.
By understanding the embedded expectations for growth that companies must deliver to justify their current trading price, clients can develop a "hurdle rate" to quickly determine if the company's expectations are rich or low.
Below is a chart displaying the implied sales growth (black dotted line) of the entire S&P 500 (INDEXSP:.INX) over the last 12 years as well as the 10 year median sales growth (red line) the index has achieved. This chart also illustrates the forecasted expectations (blue shaded area) for sales growth that the S&P 500 would need to generate in order to justify its current trading level according to the current embedded expectations.
Conclusion: When using the Value Expectations framework to solve for the implied sales growth for every company within the S&P 500 (assuming EBITDA and Asset Turns remain constant), we found that the average implied sales growth for the overall index is right around 13%. This is much greater than what the S&P 500 has been able to deliver over the last 10 years (10 year median sales growth for every S&P 500 company is 9.1%) which would suggest the index currently has high expectations. The following chart displays the relationship between expectations (blue line) and the actual movements of the level of the S&P 500 (red line) over the last 12 years. The theory behind our analysis of embedded expectations and the trend that you can see in the chart below is that when expectations are high (red dots) the subsequent market performance tends to be negative and when expectations are low (blue dot) or reasonable it is much easier for the firm to meet or exceed those expectations and the market tends to follow with positive returns. 
Conclusion: The current implied sales growth "priced-in" to the S&P 500 look rich relative to historic levels. Markets tend to experience declines in periods following when expectations are high.
In the final chart we wanted to help readers visualize how the markets have reacted in the past relative to their "priced-in" expectations. We measured the implied sales growth expectations in the beginning of each year (dark blue bar) and then measured the sales growth at the end of the year to see whether or not the index was able to meet or exceed those expectations. The final 3 bars (right side) show what the expectations for sales growth were in the beginning of 2010 (dark blue bar 9.45%) as well as what the street expected for sales growth in 2010 (grey bar 6.45%). The green bar indicates what the current expectations are for sales growth for the S&P 500 over the next 5 years to justify its current level which we mentioned in the first chart. What this illustrates is that in the beginning of 2010 expectations for sales growth were 9.45 percent which was somewhat high relative to historical levels and what the street expectations (6.45%) were to begin the year. Expectations have continued to rise this year with current expectations even loftier than they were to begin 2010.
Conclusion: As the market has rallied over the past few months, the expectations for sales growth have risen and currently look lofty relative to what the S&P 500 has delivered in sales growth historically. Now with such high expectations for the index and the difficulty of timing the unpredictability of the current market, it is increasingly important to focus on finding the best companies within the index using a consistent methodology and reliable framework in your stock selection process. |
| S&P 500 Companies with High and Low Expectations |
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Earlier this week we published an article on ValueExpectations.com that provided our insights into the expectations embedded in the S&P 500 index. We concluded that the current expectations for the index are grand relative to what it has delivered historically. Knowing that expectations are high for the entire index makes it increasingly important to be able to identify the best companies to include in your portfolio. Today, we will focus on the sales growth expectations embedded in stock prices for individual companies within the S&P 500 to identify those that have low expectations as well as a few with lofty expectations.
Using AFG's Value Expectations framework in this process is vital as it allows users to...
· understand the performance expectations embedded into today's stock prices
· build out pro-forma financials
· determine a target price based on user's assumptions
· stress test user's own valuation assumptions
By understanding the sales growth "priced-in" relative to what the company has delivered historically you can set a "hurdle rate" to determine whether or not expectations can realistically be met. When expectations are low companies tend to be more likely to outperform those expectations and outperform their benchmarks.
The companies from the S&P 500 listed below have been identified as having either very lofty or very low expectations for sales growth relative to what they have delivered historically, and relative to the expectations of their sector and index peers. The companies with low expectations for sales growth also look fairly attractive according to other key investment criteria. The opposite is true for the companies we have identified as having high expectations for sales growth.
Companies with low expectations embedded into their stock prices are not guaranteed to outperform. Even with low expectations "priced-in", a company's outlook may be even worse. Deciding whether or not a company is a buy or sell takes into account many variables. Discovering the embedded expectations is just one of the important steps.
One company with low sales growth expectations that also looks attractive relative to its sector peers according to The Applied Finance Group's (AFG's) Valuation and Economic Margin metrics is Freeport-McMoran (NYSE:FCX). The chart below illustrates the sales growth expectations that are currently "priced-in" to its $109 trading price. As you can see in the chart, assuming that EBITDA Margins and Asset Turns remain near 5 year historical levels, FCX is priced to grow its sales by -2% over the next 5 years. These expectations seem very low relative to what FCX has delivered in the past as well as what The Street expects for in 2011. Even when the assumptions for EBITDA and Asset Turns are altered to reflect a very conservative outlook, FCX still has low expectations for growth relative to The Street's expectations.
 (If friend or colleague forwarded this email to you, click here to continue receiving our free Investment Advisor Ideas newsletter.) |
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Price Stability is an Economically Dangerous Fad
John Tamny |
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Amid the very reasonable handwringing about the Fed's charitably naïve attempts to stimulate the economy through "quantitative easing", there's an understandable drive among some Fed critics to severely reduce its mandate. Specifically, the Fed can't create jobs as its defenders inside and outside the central bank presume, so better it would be limit its role to that of inflation watchdog.
All that is fine on its face, but in seeking to redefine the Fed's doings, naysayers have happened upon the false notion of "price stability." A recent editorial argued in favor of repealing the Fed's dual mandate so that it can concentrate "on the single task of stable prices", and then politicians such as Reps. Paul Ryan and Mike Pence have similarly called for price stability in working to redefine the activities of the world's foremost central bank.
Sadly, handing the alleged wise men at the Fed control over prices is every bit as mistaken as allowing the central bank to manage unemployment.
Indeed, it is through prices that the market economy is organized. In that certain sense, prices rise and fall with great regularity as consumers tell producers what they want less and more of. Assuming the Fed could do what it cannot; as in fine tune economic activity on the way to stable prices, we would be much worse off if Bernanke et al were to actually succeed.
To see why, it has to be remembered that the cure for high prices is in fact high prices. Or better yet, high prices foretell low prices.
If producers create a consumer product that fulfills unmet needs on the way to high prices, the latter is the signal to other producers to enter the market for the same good on the way to lowering its cost. Gyrating prices are the necessary market signal telling businesses what we need.
Taking this further, if price stability were policy, it would still be the case that a phone call from Houston to Dallas would cost $15 for a half hour of conversation. It would similarly mean that we'd be paying thousands of dollars for flat-screen televisions, not to mention even more for computers that perform very few functions.
In truth, and this is what Chairman Bernanke doesn't understand as evidenced by his scary presumption that falling prices are an economy killer, prices by definition fall all the time. A world of stable prices would not only be one of greatly reduced living standards, but also one marked by very little innovation.
As Karl Marx of all people long ago observed, a demand once satisfied engenders new demands that producers will logically attempt to fulfill. Falling prices not only enhance our standard of living, but they also expand the range of goods we can access alongside the expansion of our ability to save. The latter ensures that entrepreneurs will have access to greater amounts of capital that will enable them to remove even more unease from our lives.
Importantly, none of this is deflationary. Once again, if the price of one product falls, we can then concentrate our demand elsewhere for what was formerly out of reach, thus driving up the cost of those goods. Inflation and deflation are solely monetary concepts of dollar strength/weakness, and if the value of the unit of account is stable, there can be no inflation or deflation.
In that case, rather than price stability, the sole goal of monetary policy should be dollar-price stability. Fed officials would credibly argue that the latter is the preserve of the U.S. Treasury, and they would have a point. Be it Treasury, or Treasury working with the Fed, the mandate should be in favor of stabilizing the dollar's value.
Oddly enough, Marx once again had the answer there. Marx, much like the classical economic thinkers of his era, knew that for money values to be stable, they would have to be defined in terms of gold. Marx referred to gold as "money, par excellence."
Looked at through the prism of today, the dollar lacks a golden anchor, and the result is a money illusion that distorts the real price of everything. Worse, with consumer prices sticky in concert with commodity prices that are most sensitive to dollar-price movements, the beneficiaries of the money illusion tend to be the hard, unproductive assets of yesterday (think housing, art, rare stamps, and oil) that are least vulnerable to currency weakness, and which in fact do best when the unit of account is devalued.
Considered from an investment standpoint, commodities such as oil and gold continue to rise in nominal terms while the dollar falls, but sticky consumer prices remain relatively stable. The signal to investors is to redirect limited capital away from the entrepreneurs creating business and consumer innovations whose earnings will be eviscerated by the dollar's weakness, and into commoditized assets such as oil that realistically only have value thanks to past innovations of the mind.
Simply put, the economy suffers not so much a lack of price stability (it's once again the last thing an economy would need), but a lack of dollar-price stability that is driving always scarce capital into defensive assets least likely to be devalued in real terms by monetary mischief in Washington. As is always the case, there are no innovative companies and jobs without investment, but the dollar's weakness and instability understandably has investors unwilling to commit capital for dollarized returns that will likely be cheaper down the road.
The answer to all of this is very basic. Price stability is a utopian concept on its best day that would hamper innovation on the way to reduced living standards.
The greater, more obvious answer is dollar price stability of the gold kind that would allow investors to rate ideas on their actual merits, as opposed to how they'll perform amid dollar policy since 2001 that has erred in an economically crippling way in favor of weakness. Fix the dollar, and you fix the U.S. economy. Simple as that. |
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