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Despite a free cash flow multiple that would normally signal a rally in the equity markets, stocks are sinking.

Why?

Even though analysts believe valuation multiples are inexpensive - and they are - the risk associated with firms’ abilities to actually meet their estimates is paper thin. Because of this risk, investors have stepped up the return they demand for their investment dollar - this is known as the cost of equity capital. We currently estimate the cost of equity at in 9.1%, based on 60+ factors in our valuation model. This compares with 8.5% at the beginning of the year.

The cost of equity is profound to the valuation of equity securities,as the following table illustrates.

Cost of Equity Capital

Fair Value

Current Free Cash flow Per Share

Growth Rate

Discount Rate (Cost of Equity Capital)

$42.00

$1.20

5%

8%

$31.50

$1.20

5%

9%

$18.00

$1.20

5%

12%

Causing fair value to change in the first column is the cost of equity capital-free cash flow and its growth rate remain identical. As evidenced, a one percentage point change, from 8% to 9% in the cost of equity, equates to a staggering 25% decline in fair value. If the entity's risk rises further, to a 12% cost of equity, the stock should be expected to fall by 57%. Such is the importance of the cost of equity, and the reason it must be precisely established to calculate fair value. If an entity's cost of capital rises, its share price must, by definition, fall, until it reaches its new lower fair value, as shown in the table. This is what is happening in the equity market since the beginning of the year.,

The problem current investors are facing lies in the fact, that at present, the average firm in the S&P is not priced to produce that 9.1% expected return. Thus, despite a 16.2x free cash flow multiple that is ordinarily cheap, compared to the average 21.5 multiple during the 1990's, we do not believe a sustained rally is not in sight, and would not be fooled by the occasional 200 point (or more) daily rally.

When the valuation multiple slides down to current levels, investors normally lengthen their time horizons, which can, in fact, bring about such a rally. But these rallies prove temporary, and are typically followed by further weakness, if not also accompanied by reductions in risk (the cost of equity capital).

As we enter the earnings season, many firms will report some impressive boosts to their free cash flow even though much of the increase will represent managed expense and catch-up spending, rather than add-on growth.

Equity markets are normally volatile when cost of capital and free cash flow multiples are moving in opposite directions, and that in fact, is the scenario we are facing at the moment.

As such, we would move portfolios back to maximum cash until cost of capital falls back to below 8.5%. Until then, the stocks we do find currently attractive are selling not only at reasonable to low valuation multiples, but have superior financial strength that will allow them to grow market share,

The firms in the table below examples of firms which, we believe, offer superior potential returns.

Company

Ticker

Total Debt/Equity (%)

Market Value

($MM)

Free Cash Flow Multiple

Return On Invested Capital (%)

Aaon Inc

AAON

.064

422.8

9.2

30.7

Garmin

GRMN

0

6,686

13.4

37.7

Lincoln Elec

LECO

11.5

2,376

11.2

20.0

Open Text

OTEX

44.1

2,411

11.6

18.5

True Religion Apparel

TRLG

0

701

8.9

32.5

Disclosure: No positions

Source: 5 Stocks With Superior Potential Returns