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The Applied Finance Group (AFG) uses several variables in its systematic approach to help identify companies that are the most likely to outperform or underperform various benchmarks. To provide insight into AFG's screening process, we will show step-by-step instructions on how to run a screen using proprietary AFG variables. We will highlight what the variables are, why they are important, and share backtest results for each of the variables. Clients of the Applied Finance Group have access to these variables on AFGView.com to screen and build charts, as well as in our Excel Add-in to download and build custom reports.

*Please note - all backtest performance is from our US backtest system from 9/1998 through 10/2009, assuming monthly turnover.

1. What variables are taken into account to be considered a Strong Buy opportunity

EM + 1 Change (Momentum)

• EM +1 Change = EM +1 (Forecasted) – EM 0 (LFY)

• EM +1 Change measures the forecasted direction of a company’s Economic Margins.

• As a predictive stock performance variable, we observe decent returns from the EM +1 Change metric, but this performance is much less robust than our Percent to Target metrics. Typically, we have seen that the information of increasing or decreasing forecasted economic profitability is already priced into a stock to some degree.

• Overlaying EM +1 Change on the Percent to Target metrics allows for a screen that seeks out cheap companies with promising economic forecasts.

Percent to Target - Current (Valuation)

• Identifies the extent of mispricing between a firm's projected cash flows and its current market value.

• to Target - Current = (Target Price Current – Current Close) / (Current Close)

• Percent to Target Current represents upside/downside based off of AFG’s Immediate Decay (Current) Intrinsic Value.

• Our research shows that Percent to Target – Current works well across size, investment style, and the entire AFG universe: ALL, Russell 2000, Russell 1000, S&P 500, Value, Growth, Large Cap, Mid Cap, and Small Cap.

• As a screening metric, this variable is recommended as the starting point for any strategy, as it has a consistent track record of benchmark outperformance.

Top Half Vs. Bottom Half - Percent to Target Current

Please note: This bar chart highlights the annualized outperformance of the top half of Percent to Target versus the overall universe in green, and the annualized underperformance of the bottom half of Percent to Target versus the overall universe in red for a variety of various benchmarks in US equity markets.

Percent to Target - Plus3 (Valuation)

• Percent to Target - Plus3 = (Target Price Plus3 – Current Close) / (Current Close)

• The Percent to Target Current metric allows for a target price using minimal analyst forecasting and limits the impact of the assumptions inherent in the AFG model’s algorithms.

• The Percent to Target Plus3 metric allows for the inclusion of three additional years of analyst forecasting, which will solve for a target price that includes expectations for growth and profitability changes in the near future.

• There are advantages to each of these strategies, so we work to find companies attractive under both scenarios.

Please note: This bar chart highlights the annualized outperformance of the top half of Percent to Target versus the overall universe in green, and the annualized underperformance of the bottom half of Percent to Target versus the overall universe in red.

Accuracy (Model Precision)

• The Accuracy Score identifies the correlation of the market price for a stock over a calendar year in relation to the Intrinsic Value calculated based on the data from the most applicable fiscal year.

• This Accuracy measure is then quantified as an average of the previous seven years to identify the extent to which the AFG model has been successful in identifying the value of a company.

Management Quality Score (Quality)

• Measures a company’s ability to create wealth.

• Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.

Please note: This bar chart highlights the annualized outperformance of screening for companies with a Management Quality Score >= 0 (non-Wealth Destroyers) versus the overall universe in green, and the annualized underperformance of screening for companies with a Management Quality Score = -1 (Wealth Destroyers) versus the overall universe in red for a variety of various benchmarks in US equity markets.

If you are a professional investor and would like to see if your current holdings meet AFG’s criteria click here.

By combining the variables mentioned above, our clients have enjoyed the following performance from our Buy/Sell List.

Buy/Sell Spreads

Screen Criteria

Screen Results

When using the AFG Screen above to narrow our list of constituents to the companies AFG considers the most likely to outperform their sector peers, the following stocks made the cut.

Now that we have narrowed our list of viable constituents to companies that look most likely to outperform, we can take our analysis to the next step that a user of AFG's research would take when digging deeper into a company to understand the embedded expectations in a stock's price, gain insight into the wealth creating abilities of the company and come to a more refined intrinsic value. Of the companies that made it through our buy screen we will provide a more in depth look at Dun & Bradstreet Corp. (NYSE:DNB) using AFG’s proprietary research tools.

Analyzing DNB’s Wealth Creation Strategy using AFG’s Wealth Creation Report

AFG’s Wealth Creation Report provides users the ability 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.

A company that generates cash flows above its cost of capital (positive Economic Margins) and is growing its asset base is considered to be following a wealth-creating strategy. Backtests have proven wealth-creating companies are more likely to outperform companies following a wealth-destroying strategy (negative Economic Margins and growing assets). Avoiding firms with management teams who attempt to grow despite negative EMs helps avoid potential torpedoes. AFG believes that if a firm is not profitable, it needs to divest losers and focus on its core competencies to get profitability levels back on track and earn the right to grow, rather than throw more money at a losing business.

Beyond having positive Economic Margins (EMs) and growing assets, investors want to see a company improve its EMs at a greater rate than its sector peers, as these companies have also proven to be more likely to outperform than companies with declining EMs. AFG’s Wealth Creation Report (WCR) allows you to visually analyze a company’s historical 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.

DNB though the eyes of AFG’s Intrinsic Value Chart

AFG's valuation techniques 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 identify 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). 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.

Disclosure: none

Source: How We Decide What Stocks to Buy