When analyst and market pundits come on tv to talk about stock picks, they usually talk about the "P/E" ratio (Price to Earnings) being attractive. However if you're investing in stocks and you only look at the "P/E" ratio, you might be walking into a "Value Trap". Investors ignore half the valuation picture when investors only concentrate on P/E as investors also need to consider the growth potential of the company and what investments are needed to get the earnings. The Applied Finance Group's (AFG’s) has developed a process that incorporates these factors easily into the valuation framework. Using AFG’s Valuation Metric, we have compiled a list of 20 companies with low P/E, 10 of which we consider attractive investments, and 10 of which we consider Value Traps.

By using AFG's Economic Margin framework instead of earnings alone, investors capture the true net cash flow the entire firm is generating. It is not uncommon for companies to grow P/E while having declining EMs. This occurs when the cost for the investment required to yield the increasing P/E is more than the cash flow generated from the investment. By analyzing a company’s EMs through time, investors gain a more accurate account of levels and changes in a company’s current profitability and value.

In dedication to my recent posts on value investing vs. trading strategies, I decided to focus this week's screen to the market's favorite word: growth. Specifically, the criteria used was positive revenue growth for the next fiscal year. Of course, this does not translate to earnings growth but management teams should have figured out there's a recession and cut the cost side.

In addition to revenue growth, we are looking for companies that can thrive in this recession and take market share. These qualities are hard to quantify but I used ROE and ROA as measures of company quality, with the added kicker of a low debt-to-capital ratio so the company theoretically will have resources to pounce on opportunities.

Bullish Calls:

ON Semiconductor (ONNN), Cadence Systems (CDNS), Brocade Communications (BRCD), Broadcom (BRCM): "I prefer all of these over Taiwan Semiconductor."

By missing the earnings estimates by 8% in October 2008, GME paid dearly and fell into the multitude of stocks that got caught in the crosshairs of the massive sell-off. Jim Cramer purported on Mad Money that the GameStops of the world are destined to see significantly slipping earnings, being cast aside with the slap of a sell-sell-sell.

All companies listed below met The Applied Finance Group's (AFG's) Buy screen criteria and are in the bottom half of their sector in Market Value/Invested Capital (MV/IC), which by definition qualifies the companies as part of the AFG Value Universe. When identifying buy ideas, AFG looks for companies with the most valuation upside compared to their sector peers, above sector median expected Economic Margin change, and a management quality score that reflects a management team following a wealth creating strategy.

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Microsoft (MSFT) announced at E3 this week that the Zune Store will be offering video game downloads to the XBox 360 console thereby removing the middle-man (read GameStop (GME) ). This is bad news for the video game retailer and comes on the heels of the Wal-Mart (WMT) announcement last month, that the giant retailer would be testing video game trade-in kiosks in 77 stores across some key markets in the east.

With this Microsoft announcement, Gamestop's future looks pretty bleak, and they will now depend on trade-in's even more so than they did in the past. It will be interesting to see how Wal-Mart's plans shape up over the next few months.

Here are the 10 best and 10 worst performing stocks in the S&P 500 for the month of May excluding financials. We have provided the returns achieved by each firm during the month of May (5-1-09 to 5-28-09) along with a look at the valuation attractiveness of each of these firms going forward.

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If you are slightly bullish or think the market will move sideways in the months to come, you may find it useful to use the buy/write strategy. I have been using this with various stocks over the past month, writing them out for the nearest expiration or next expiration.

To learn more about buy/write option strategies check out my BLOG.

Purpose of Report:

Short Summary:

Sentiment

Stocks struggled at the open, but found a floor in morning trading and bounced a bit higher by midday. The Dow Jones Industrial Average made a run towards 8,250 early and is up 50 points to 8,342 heading into the final 90 minutes of trading.

The CBOE Volatility Index (.VIX) is up .04 to 31.39 and off session lows of 30.57 ahead of data on home prices and consumer confidence due out Tuesday morning. The volatility index is up 18.1 percent since hitting a low of 26.57 Wednesday morning, a sign that risk perceptions are moving higher and the options market is beginning to "price in" the possibility of increased volatility in the weeks ahead. (VIX tracks the expected volatility priced in current S&P 500 Index options.)

Bloomberg provides a score for companies within the S&P 500 based on an average of all analyst ratings from the street. Below is a table highlighting companies with the best analyst ratings, largest increase in rating, highest price targets, and worst analyst ratings and the valuation attractiveness of each of these companies based on The Applied Finance Group’s (AFG) valuation model.

Companies within each of these groups are ranked from most attractive from a valuation perspective to the least attractive. VE.com will actively track the performance of these recommendations and see how they stack up to the analyst recommendations in each group. AFGview.com, AFG’s professional investor website allows you to compare any company using their rating versus the consensus ratings of the sell side. If you are interested in an analysis on a specific company, contact afgsales@afgltd.com.

So if things were so great, why did I sell it? I started thinking about some of the factors that Warren Buffett looks for in an investment like economic moats, high ROE, profitability and consistent operating results. While GameStop performed well in many of these categories; I discovered that GameStop failed in one significant area. The company had a small competitive advantage with little to no economic moat. I felt that GameStop had no significant barrier to entry that could protect it against the likes of a Best Buy (BBY) or similar competitors.

The second most important aspect of my trading strategy (behind support and resistance) is using volume to classify stocks that are under accumulation and distribution.

Distribution is under way when, over a period of time, stocks show higher volume on down days and lower volume on up days. In a bullish trend, this predicts the trend will pullback or fail. In a bearish trend, expect the trend to continue until the distribution pattern is reversed.

We just talked about Gamestop (GME) a few days ago [May 18: Gamestop (GME) Faces Potential Challenge from Walmart (WMT) on Used Video Games], and this morning the company is out with a 2nd quarter warning. If indeed Americans are cutting back on one of the few affordable luxuries such as video games - which have been among the most recession-proof things out there - I think you can fill in the blanks about "green shoots". But I guess we can blame those Europeans - they are a convenient scapegoat. Either way, there is a subtle shift going on as less gamers can pay up for the new games, and instead are going to used. As I said in the piece earlier this week

It is quite amazing how often "the stock" knows, ahead of the news... Gamestop (GME) despite a virtual monopoly on pure play video game retail (one of the few recession proof niches) has been a massive underperformer, especially as institutional money flows into the retail niche as an "early cycle recovery" thesis. In fact it's closer to March lows than recent highs.

Gamestop (GME) reported fiscal first quarter results to the market Thursday that were in line with estimates with EPS coming in at $.42. Revenue was also reported in-line with expectations of $1.98 billion, which shows growth of 9.8% from a year ago. However, GME stock is trading down nearly 17% on Thursday afternoon after the company lowered second quarter earnings guidance and comparable store sales. At Ockham, we are always looking to find disproportionate responses to earnings releases because often value can be found in a stock that has just endured a major downtrend. We believe this could be just that sort of opportunity for investors that have a long term time frame.

“Gamestop down 15%, they lowered their outlook, second quarter outlook. They cut it based on what they’re seeing but also beat so Gamestop doing really well with a couple big video games — people are buying video games they’re staying at home, need entertainment.” Fox Business Network 5/21/2009

Q1 2009 Earnings Call

May 21, 2009 11:00 am ET