In your search for alpha stocks you should bear in mind that the objective function of any corporation should be to maximize its total market value. All corporations pretend that they are doing this, but that is not true. This objective is the equivalent to maximizing the long run value of the firm. As a managerial construct, shareholder value provides a standard against which to set long-term goals, evaluate investment opportunities, and assess performance. It provides a means of balancing all the inputs to achieve success. It is this behavior, as an investor, that you should be able to track down in an organization - if you do not want that your expected alpha stock be transient.
Economic value added
The one performance measure to account properly for all of the ways in which corporate value may be added or lost is economic value added. It is the only performance measure that ties directly the intrinsic value to the market value of a company. When it is projected and discounted to a present value, economic value added accounts for the market value that management adds to, or subtracts from, the capital it has employed. In other words, market value added is equal to the market value of all claims on the firm minus the capital or, if you prefer, market value added is equal to the present value of all future economic value added. Market value added is a measure of the value a company has created in excess of the resources already committed to the company.
So, first, maximizing market value added should be the primary objective for any company that is concerned about its long term survival. Second, a company's economic value added is the fuel that fires up its market value added.
Economic value added is the internal measure which leads to the external consequence of building a premium (or discount) into the market value of a company, the alpha you are looking for. Economic value added should be use as the basis for setting goals, allocating capital, evaluating performance, determining bonuses, and communicating with the capital markets. To satisfy this internal measure, a company must earn a rate of return on its capital (properly measured including tangible and intangible capital) that exceeds its cost of capital. By taking this spread and multiplying it by the capital outstanding at the beginning of the year, you obtain the economic value added.
You will find, in a recent article on Seeking Alpha, four companies that have returns on their capital that are superior to their cost of capital: Heinz (NYSE:HNZ), General Mills (NYSE:GIS), ConAgra Foods (NYSE:CAG), and Campbell Soup Co. (NYSE:CPB).
You will not be surprised to learn that the market value added of each company is also positive as shown in the following table.
Market Value Added (as of February 21, 2013) (in Millions$)
|Market Value of Total Capital||$29366.072||$39985.778||$17966.171||$16581.322|
|Market Value Added||$18512.297||$21525.817||$8361.795||$11111.203|
So, why you should pay attention to these companies? Simply, because they are creating value within the meaning just explained. Also, an informed decision would be to build a value weighted portfolio of these value creators (of the last three in fact because Heinz will be privatized). By doing this, the consumer staples part of your global portfolio will help you sleep at night.
Creating value takes more than acceptance of value maximization as the organizational objective. As said in our opening statement, all companies affirm to do this but that is not true. The choice of value maximization as the corporate objective must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena.
How does an investor determine if a company is creating value or not? The creation or destruction of value is measured by calculating the change in market value added over the past periods. Market value added will increase if value expands by more than the amount of new capital committed to the business, and vice versa.
This behavior should give you assurance that the alpha you expect to obtain in investing in a particular stock will persist.
In sum, the appropriate objective for an organization is value creation, the change in the market value of all claims on the firm. This objective is the equivalent to maximize the long run value of the firm. It is also the same as maximizing the market value added. And the continuous, manageable and tractable measure of value creation on a quarterly or yearly basis is economic value added, not earnings per share.
Actionable advice: First and foremost, make sure that the company you consider as an alpha potential investment has value creation as a dominant goal. It should be the first test to apply in your search for alpha stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.