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"Fallen Angels" and "Falling Knives" Special Report
Getting it Right, Requires Starting Right.
This week's Investment Advisor Ideas Newsletter focuses on Fallen Angel Stocks - quality companies that have either taken a warranted or sometimes unwarranted pounding in the market, but still possess an attractive valuation to value-hungry, long-term focused investors. If this list performs as well as our last such report, you are well advised to explore the list for names that may interest you as that report delivered 1200 bps above its benchmark. (Click here to read the last Fallen Angel report). We never take such a performance for granted, as beating the market is very difficult, but it is something we expect each research report to consistently achieve. That then begs the question - why are we so confident? The answer is simple: we believe, more so than any other research process, that AFG's Economic Margin Framework™ gets it right at the get-go of the investment research process, by correctly measuring corporate performance, which makes generating consistently right answers achievable.
There are many approaches to measuring a firm's corporate performance. The most common include flawed approaches such as - EPS Growth, ROE, and RONA. In addition, there are more exotic proprietary but equally flawed approaches such as economic value added, and cash flow internal rate of return metrics. The latter deserves particular attention, as it has achieved some popularity in the investment community and is often billed as being a very sophisticated and complete approach; yet, it is comically flawed.
There are many consultants that provide some form of cash flow internal rate of return analysis. The underlying logic behind each is that an internal rate of return (IRR) calculation is appropriate for a project, and a firm is nothing more than a collection of projects; therefore an IRR is appropriate for an entire firm. While the math underpinning such calculations is often impressive and detailed, the logic is comical at best and irresponsible at worst. When considering the IRR approach, two questions immediately spring to mind, revealing its flaws. The first question is why is it necessary to forecast out future cash flows to measure corporate performance today? That makes no sense. Secondly, why do IRR calculations assume that all cash flows are reinvested at the IRR? This is a nonsensical assumption. Take for example Coca Cola. The firm generated returns greater than 20% on its existing business throughout most of the 90's. Yet assuming reinvestments at such high rates of return on new investments would have been silly. Notice Coke has made incremental investments at much lower rates of return for the better part of the last decade - around 15%. Therefore any analysis that begins from such a flawed perspective is unlikely to systematically guide you towards correct conclusions. So if you happen to run across a colleague that proudly uses such an approach, don't laugh, but don't listen to them either.
So what makes The Applied Finance Group's approach different? Quite simply, AFG asks the right questions required to evaluate an investment or a company -
· How much cash does the firm generate
· How much capital is required to generate that cash flow
· What is the risk adjusted opportunity cost of investing in that capital
While the questions are simple, they sufficiently frame every investment decision. There are no silly assumptions about what a firm "will do" to evaluate a firm's "current" performance. The end result is a systematic research approach that we apply to 20,000 companies across 22 countries, which consistently generates buy and sell candidates that outperform appropriate benchmarks. Getting it right at the start - by properly measuring corporate performance - gives us the confidence to follow our research as it is likely to get it right at the end - picking stocks.
Thank you for taking the time to study our research this week.
"Fallen Angels" and "Falling Knives" Special Report
Value investors often look at companies that have been beaten up or that are on a downtrend to uncover the ones likely to be a diamond in the rough poised to bounce back. These "Fallen Angels" are solid businesses that have dropped in price due to some sort of temporary setback but should return to profitability or more "normal" levels in the next few months or years. However, the challenge of finding these stocks lies in the difficulty of distinguishing the fallen angels from the "falling knives," or companies that have experienced a drop in share prices for valid reasons.
Earlier in 2008, amid all the uncertainties in the economy that sent share prices tumbling, the market presented some attractive buying opportunities. During the 4th quarter of 2007, the S&P500 and Russell 2000 indices lost approximately 5% and 7% respectively. We felt that in certain cases, investors were unable to differentiate between good, neutral, and bad stocks and instead adopted an attitude that all stocks were bad unless proven otherwise. For this reason, we compiled a portfolio of stocks called the AFG's Fallen Angels portfolio to take advantage of this opportunity.
We screened for companies that had earned positive Economic Margins (a company's economic profitability or what it earns above its true economic cost of capital) and were expected to continue to generate positive EMs in the near term. In addition, we favored companies that had demonstrated ability to grow their businesses profitably, as these companies tend to boast strong management teams that can navigate through economic difficulties. More importantly, we considered the companies' valuation attractiveness, or the amount of upside it presents relative to its intrinsic value.
The portfolio of 11 stocks were published to clients from 01/16/08 to 05/16/08, and during that time period, the stocks returned an average of 20.54%, outperforming the blended R1000 and R2000 index benchmark by 12.39%. The table below highlights its performance.
With the success of the previous "Fallen Angels" portfolio, we have decided to publish a similar portfolio going into 2011. The companies that we have identified as our "fallen angels" all look attractive from a valuation standpoint and have management teams that understand how to create wealth for its shareholders.
Although these companies have suffered a short term setback, they still appear to be solid companies that look attractive for the long term. It is important to focus on the overall quality of the company and not overreact to short term price drops. We believe these companies have a good chance to turn their fortunes around in 2011. In contrast, the "Falling Knifes" companies have a history of destroying shareholders wealth, and are trading at unattractive valuations. We believe these firms are likely to stay at depressed levels or continue to fall in the upcoming year.
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When you fix the "naked-short" problems, the ability to counterfeit massive quantities of shares that don't exist and use them to suppress equity prices, then maybe it's worth a look.
Not until the thieves are exterminated.
+ 10,000
common stuff, nothing new. bigger fool theroy?
http://covert2.wordpress.com
pump pump pimp the junk
Thats your junk portfolio?? fallen Angels with projected gross revenues/sales in the <5% growth range? the financial paradigm has changed, not cyclical/business cycle, but SECULAR and permanent, and NOT DONE, either, more pain coming..
Some stocks in this list are analogous to the old Hudson Automobile Plant in Detroit...junk plant/equipment junk business plan going forward into the new normal...and STILL OVERPRICED at the 'bargain basement' prices of today...
there will be much Creative Destruction, the secular cycle is not yet midway...Ghost Towns/Ghost Factories/Zombie Financials....
During the Destruction of Old Capital, there really are Green Shoots, but not of the Frankenstein General Motors type..., but names most people never heard of...