'Guru' Report Card: Grading the Picks of the Market's Biggest Names

by: Value Expectations

Most investors involved in equities are usually interested in which stocks the major players such as famous investor Carl Icahn and prominent fund managers like John Hussman and Bruce Berkowitz are buying and selling every year or even every quarter. The picks of the “Oracle of Omaha” Warren Buffett and billionaire T. Boone Pickens are often analyzed in great detail as their impressive investment history has made them two of the richest men in America.

Today we will highlight the stocks “Gurus” have either recently been adding to their portfolios as new holdings or companies that they have recently increased their position in the last quarter and rate them using the Economic Margin Valuation model. In the coming weeks we will be taking the pros picks and give them letter grades (A,B,C,D,F) based on how we look at the company (based on value score). The first edition focuses on recent additions to portfolios that are the most attractive stocks (A’s and B’s) in the future we will provide analysis on the companies that these gurus have recently dropped/decreased positions and look unattractive (D’s and F’s) according to our valuation model.

Now let’s review our Economic Margin methodology which is the backbone of our valuation model and stock picking process.

The Economic Margin (EM) Framework was developed by The Applied Finance Group to evaluate corporate performance from an economic cash flow perspective and is an alternative to accounting-based valuation metrics. EM measures the return a company earns above or below its cost of capital and provides a more complete view of a company’s underlying economic vitality.

EM is meant to serves two purposes: Create a measure of a company’s economic profitability; that is, did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? Once we have solved for this, we can then use this EM as a function in our valuation model.

EM is calculated by dividing a company’s Operating Cash Flow minus Capital Charge by their Invested Capital. For a more detailed explanation see the chart below.

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Economic Margin Framework is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

Economic Margin captures the relevant drivers that are necessary to evaluating corporate performance and identifies wealth creating firms as well as wealth destroying firms while focusing on the key issues that drive market valuations. The EM also incorporates risk through a capital charge on all of a firm’s cash flow while also providing an annual snapshot to evaluate company track records creating and destroying wealth to evaluate current company actions.

When valuing a company, we are able to calculate a firm’s Economic Margin for the next five years by systematically building a proforma model which takes into account consensus analyst estimates. We will then calculate the percentage by which the firm could organically grow its business if it chose to reinvest all of its excess cash flows. AFG then uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

Below is a map of the inputs that go into calculating a firm’s intrinsic value.

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Below are recent additions from the top “Gurus” along with AFG’s Valuation Grade

We calculated intrinsic values for every company using AFG's Valuation methodology and ranked the companies that had the most potential upside relative to sector peers.

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Disclosure: None