Understanding the embedded expectations in stock prices, or what a company needs to deliver in revenue growth over the next 5 years in order to justify current stock prices, helps investors better understand whether a company's valuations are rich or low. By understanding a company's embedded expectations clients can develop a "hurdle rate" to quickly determine if a company's expectations are realistic.

AFG's Value Expectations interface uniquely enables users to "solve" for the performance expectations a company must deliver in order to justify its current stock price. Our research indicates that companies with low embedded expectations tend to outperform the market, while those with higher expectations tend to underperform.

Today we will apply this methodology to every stock within the S&P500 to assess the overall valuation of the index and also at the sector level to identify which sectors appear the most and least favorable accordingly.

The below graph illustrates the implied sales growth for each sector and the index as a whole, along with the median level of performance actually delivered over the last 5 years. With this data, we can clearly identify that energy, health and financials have low expectations for revenue growth relative to what each sector has delivered in the past, while utilities and consumer services on the other hand have relatively high expectations.

The snapshot below illustrates the S&P 500 expectations vs. what the market has been able to deliver historically. Much like understanding the expectations that are priced into a stock, this chart can help clients better understand whether the market (S&P 500) has high or low expectations currently priced in. This chart can also provide some insight into how the market reacts when expectations are at extreme levels.

Over the past 5 years the companies in the S&P 500 delivered roughly 7% sales growth, on average, while the market currently has 5% revenue growth priced in. If you think the market can deliver better than 5% over the next 5 years then you would be paying for low expectations. If you believe the S&P 500 will deliver less than 5%, the S&P 500 (INDEXSP:.INX) has high expectations.

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By: John Tamny, Toreador Research & Trading (Guest Contributor)

On the trading floor, "If you are good, 49 percent of your decisions will be wrong. Even if you are great, something just short of a majority will be losers." Nick Kokonas, Life, On the Line, p. 172

As is well known now, Federal Reserve transcripts released last week confirmed that Fed Chairman Bernanke was caught unaware by the brewing mortgage storm that rocked many of the banks his Fed is charged with overseeing. As Bernanke put it in 2006, "So far we are seeing, at worst, an orderly decline in the housing market." Bernanke went on to note that a cooling of the housing boom was a "healthy thing."

Fed critics from the left and right will doubtless seek to use Bernanke's utterances as weaponry meant to further discredit a Fed Chairman who is expert at always being wrong, but they'd be unwise to do so. Instead, they should use Bernanke's musings to explain in more confident terms why the Fed's presumed regulatory mission is a total contradiction.

First off, Bernanke was right in saying that a slowing mortgage market would be healthy. Far from negative, sector-specific downturns are extraordinarily stimulative because they ensure that no more capital will be destroyed in parts of the economy that no longer need investment. Market signals are precious in this regard in that through rising and falling prices, investors have a better idea of where and where not capital allocation will be rewarded.

What was then unhealthy, and which remains unhealthy, and this helps to explain why the U.S. economy continues to sag, is that the political class would not allow the market correction to run its course. Instead, bailouts of the banks and counterparties impacted by the correction softened the blow of the latter, plus delayed the stimulating migration of capital to business concepts desired by the infinite inputs that comprise what we know as the "market."

Where Bernanke was and continues to be scarily wrong is in his assertion that the Fed, for having failed to foresee just how bad the correction would be, should be given more oversight of the banks whose exposure to faulty mortgage securities imperiled their very existence not long ago. Here Bernanke can perhaps be excused. A Washington pro as evidenced by his ascendance to a job at which he's failed completely, he seemingly believes as all political animals do - with good reason - that to fail in Washington is to fail upward.

Instead, what Bernanke's presumptions about the health of the mortgage market prove yet again is that regulations are a tragic lie. They don't work, and the reason they don't is that no one - and this is even more true for the individuals so lacking in ambition as to want to become regulators - has any kind of consistent knowledge of the future. Regulations, if they are to work, are of course predicated on future knowledge, and as Bernanke once again revealed in the Fed transcripts, he hadn't a clue about what was ahead.

To understand why Bernanke was caught unaware, and why regulators nearly always are, it's necessary to consider how frequently even the best investors are wrong. This is notable too in the certain sense that regulators and government bureaucrats are frequently the individuals who could not get Wall Street jobs, or who lacked the ambition to compete with the brightest minds in finance.

As former expert trader Nick Kokonas notes in the quote that begins this piece, even the great traders are wrong nearly as often as they're right. Kokonas also pointed out in Life, On the Line, that the "saying on the Chicago floors was that only two out of every hundred guys break even their first year; and out of those only one out of a hundred becomes a millionaire."

Looking back at mortgage securities in 2006, as evidenced by the billions hedge fund trader John Paulson made betting against them, a good number of very sharp market minds felt as Bernanke did; that everything was fine. If this is doubted, we need only reference Paulson's now-famous Abacus deal. His counterparties in the trade set up by Goldman Sachs needed Paulson to bet against not because they wanted to, or because they'd even heard of him, but because so great was the demand for mortgage securities at the time that purchasing same wasn't very simple. Paulson's willingness to offer them synthetic exposure allowed them exposure that they couldn't otherwise achieve in the actual markets.

Considering regulations in this light, Fed hubris post-crisis has it seeking more oversight of banks, and then Dodd-Frank is predicated on giving regulators more broadly the power to take control of banks "before" balance-sheet difficulties cause "contagion" in the financial markets altogether. Of course as the years leading up to 2008 reveal in living color, no one, least of all regulators, was aware that something was amiss. Those that did made millions, and in Paulson's case made billions.

To state the obvious, regulators, and this includes the allegedly brilliant academic minds at the Fed, will always be late to problems, thus rendering regulation worthless at best, and tragic at worst for regulations creating a false sense of security that inevitably magnifies in harmful ways the similarly inevitable errors that occur in a marketplace comprised by fallible individuals. Better is it always to limit regulation to something that doesn't even require effort by lawmakers; as in if you fail, you will be allowed to go bankrupt.

What commentators should not do is use Bernanke's now-naïve utterances against him. He was wrong about looming problems in the mortgage markets, but so were many market participants - by definition. And then what commentators should do is use the information gleaned from the Fed transcripts to rail against any and all banking regulations which, by their hubristic presumption not to mention simple logic, are doomed to fail.

About John Tamny:

Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.

To gain access to our best stock picks and most extensive buy/sell lists, click here to sign up for our free weekly newsletter Investment Advisor Ideas.

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Corporations around the globe are constantly under pressure to meet sales expectations, which makes it very important when looking for investment opportunities to watch out for those companies that may be trying to pad their sales numbers in various ways, ie. Channel-stuffing (sending excess inventory to stores that will not be able to sell their products).

AFG's Earnings Quality variable helps investors identify companies that are likely to miss earnings by studying the components of their current earnings. Professor Richard Sloan pioneered this research, and concluded that companies whose earnings consists of a disproportionally high percentage of accounting accrual rather than cash flow are likely to suffer earnings reversals in the future.

Because companies with poor Earnings Quality are more likely to have negative earnings surprises, you may want to avoid firms with this characteristic. Our back-tests indicate that the EQ variable developed by The Applied Finance Group works well at eliminating firms likely to suffer earnings reversals in the future. The chart below depicts the annualized returns of companies based on their Earnings Quality Score. The returns shown are of Russell 1000 companies sorted into quintile buckets based on EQ Score relative to the Russell 1000 universe (blue bar). Companies that fall into the bottom quintile (poorest EQ rank) have underperformed the Russell 1000 universe by over 6% on an annualized basis since 1998.

Today we have put this variable to work for you, screening the Russell 1000 to identify the firms with the worst Earnings Quality (EQ) score that also rank poorly according to AFG's overall Investment Grade rankings which also take into account factors such as valuation attractiveness and momentum. (Note: Financial companies are not included in any EQ analysis as a good portion of their business is accrual based). In the section below you will find 15 companies from the Russell 1000 that have a high level of accruals (poor Earnings Quality) and also rank poorly according to AFG's overall Investment Grade, therefore these firms appear to be unattractive investment opportunities that should be avoided.

The 15 companies listed below have poor Earnings Quality based on AFG's Earnings Quality metric and also rank poorly according to AFG's overall Investment Grade. These companies contain many characteristics of a potential torpedo stock that could blow up a portfolio. We recommend reviewing these firms closely when considering adding or owning them in a client's portfolio.

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 By: John Tamny, Toreador Research & Trading (Guest Contributor)

Thanks to an explosion of Keynesian deficit spending around the world, an explosion that has predictably correlated with weak economic output, major ink is being spilled about the economic crack-up unfolding before our eyes. To state the obvious, wasteful, capital destroying governments can only spend what they first extract from the private sector.

In the above sense government spending is always and everywhere an economic retardant. That's the case because governments by definition are not disciplined by profit, thus explaining spending that merely consumes capital. Conversely, a private sector that is burdened by profit demands must as much as possible deploy capital with an eye on creating more of it.

Put simply, capital placed in the hands of politicians disappears, while capital placed in the hands of private actors frequently leads to innovations that allow the proverbial impoverished shoemaker to purchase equipment that expands his shoe output. Whether governments are in deficit or surplus mode, their spending nearly always weighs on economic output.

All of which brings us to the first lie we're regularly told about budget deficits. Supposedly the latter are bad, but looked at through a basic economic prism, would we prefer a balanced budget in the U.S. that coincides with $3 trillion in annual spending, or an annual budget deficit of $500 billion occurring in concert with spending of $1 trillion? Economic logic says we'd much prefer deficit spending that coincides with much lower spending in total. Once again, governments destroy capital, while private actors seek to expand it. Governments that spend less necessarily leave more capital in the hands of the productive, so for commentators to bemoan deficits while ignoring the bigger problem of spending is for them to engage in an act of willful blindness.

Another lie we're told by the well-meaning in our midst is that "we can't afford it." We can't afford troops around the world and the various military adventures that heavily deployed troops lead to, we can't afford more entitlement spending, and we can't afford government subsidization of home ownership.

While the above is partially true, the reason it's not is rarely articulated. We can't afford a global troop presence because it's a waste of human and financial capital that could otherwise be deployed in more productive areas. War is tautologically a wealth destroyer, and worst of all it's a human capital destroyer, so that's why we can't afford it. Entitlement spending works against the very saving that authors our economic advancement, plus it's a work disincentive that similarly retards our advancement. Home ownership subsidies cruelly lock individuals into a location at a time when financial capital moves at the speed of a mouse click. We can't afford housing subsidies because they make us immobile at a time when the capital that funds the creation of companies and jobs is highly mobile.

As for the lie, governments that spend - and in particular deficit spend - must enter the capital markets to attract the capital necessary to fund their waste. In that case, when commentators say we can't afford the very deficits that investors are willing to fund, they're ignoring market signals that say we can afford to do much that we shouldn't. This isn't meant to defend deficit spending as much as it's to say that there are two sides to every transaction. Wrongheaded as most U.S. deficit spending is, it's allowed to take place because investors once again think we can afford it.

Commentators who should know better frequently feel they can outthink the markets, and when it comes to deficits financed in arguably the deepest market (U.S. Treasuries) in the world, they nearly always attempt to do just that. This should be remembered the next time readers see a pundit blathering on cable television about coming budget Armageddon. Right or wrong, pundits have been saying this for as long as this writer has been sentient. I'm still waiting for Armageddon, and in fact would welcome it. See below.

All of which brings us to the most popular lie about budget deficits at the moment, which says that the deficit troubles of governments mostly in Europe threaten the global economy. What a laugh, and to understand why it is, we must ask ourselves why it's a problem when governments can no longer attract investors to fund their ongoing capital destruction.

If so, we'll then see that far from an economic problem, something quite beautiful is occurring before our eyes. Investors are presently telling various European nations "you can't afford it," and if left alone, this market-driven reality will ensure smaller governments forced to get by on less. Looked at in terms of the proverbial shoemaker bereft of funds to purchase equipment necessary for more output, governments being put on smaller allowances signals a greater amount of capital to be accessed by those eager to be productive.

No doubt there exist private sector actors that will suffer and perhaps go bankrupt thanks to government default, but that too, if allowed, would be a market positive for ensuring that the banks and other financing vehicles that supported government waste through investment in same will perhaps cast a more skeptical eye on government debt in the future. Entrepreneurs can't innovate without capital, governments destroy it, so far from something we should fear, government defaults are to be embraced as a way of limiting future government evisceration of our capital stock.

Government spending on its own is always and everywhere the economic ball-and-chain; whether the spending occurs in deficit or surplus mode merely something that detracts from the real problem. In that case it's well past the time to ignore the various budget deficit lies, with an eye on fixing the true tragedy which is government spending itself.

About John Tamny:

Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.

To gain access to our best stock picks and most extensive buy/sell lists, click here to sign up for our free weekly newsletter Investment Advisor Ideas.

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Often times heading into a new year, financial blogs and websites tend to provide lists of the best stocks to own in the coming year. We will take a slightly different approach and provide some companies to our readers that look overvalued and overall look like poor investment opportunities for 2012.

While we spend a significant amount of time providing lists of attractive investment opportunities for our readers, we also understand that it is just as important for professional investors to be able to avoid potential torpedoes in the market as it is to discover the next investment opportunity poised to hit a home run.

Today we will list 15 large cap companies from the S&P 500 that we deem to be potential torpedoes. These are companies that rank poorly according to important criteria developed by The Applied Finance Group (AFG), including Economic Margin, Management Quality (MQ) and Valuation Rank. These three criteria have proven through back-tests to identify stocks likely to underperform sector peers and benchmarks. If you own or are considering adding one of these companies to your client portfolios, you may want to take a closer look into these companies and reconsider whether or not they are worth adding/owning.

Three key metrics that are utilized to identify Sell ideas that have proven to underperform sector and index peers are Management Quality, Valuation and Economic Margin improvement. Three key questions listed below help us to identify potential torpedo stocks.

1. Management Quality - Is management able to create wealth for its shareholders?
2. Valuation - Is the company currently trading at a discount to its intrinsic value?
3. Economic Margin (true economic profitability) - Is the company improving its economic profitability (what it earns above its true cost of capital) at a greater rate than its sector peers?

If the answer for a specific company is no to all three of these important questions then you may want to think twice before adding that company to your portfolio as it possesses characteristics that have proven to produce poor returns. In the table below you will find 15 companies from the S&P 500 that look unattractive according to the criteria listed above.

If you are a professional investor and would like to receive our weekly newlsetter filled with investment ideas, click here to become a subscriber!

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It has been a rocky ride for the equity markets in 2011 filled with volatility and confusion about where the market is headed on nearly a daily basis. With just a few days left in 2011 it is time to identify which stocks have been driving the markets so far this year. We are providing a list of the top 20 performing stocks in the S&P 500 index to keep up to date on which companies have led the way thus far. The returns listed are the total return (including dividends) the company has delivered as of last Friday's close and the index in comparison has delivered a return of -4.16% so far YTD.

The chart below illustrates the performance achieved by the S&P 500 YTD. It is clear that 2011 was an abnormally volatile market environment.

The 20 companies listed below have driven the returns of the overall index in 2011 and have greatly outpaced their index peers.

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By: John Tamny, Toreador Research & Trading (Guest Contributor)

In an economically-themed speech last week in Kansas, President Obama revealed for all to see just how divorced he is from reality, and why his departure from the White House in 2013 is essential. It's not that we can't recover from another Obama term - that's the easy part - but that as a serious nation we can't have a president who possesses such unserious views.  Call it a pride thing. 

Though Obama acknowledged up front the certain wonders of free markets, he only threw out the initial bouquet to decry those same unfettered markets. As he put it, "the free market has never been a free license to take whatever you can from whomever you can," as though those who participate in the marketplace on the way to great fortune somehow took from others in doing so. Really?

When I read about the members of the Forbes 400, I'm made aware of extraordinarily driven individuals who not only worked very hard to achieve their fortunes, but who also worked very smart. In doing so, and as evidenced by their grand wealth, they've made the lives of millions much better.

To list but a few members of this most exclusive group, I find Michael Dell whose eponymous computer company has made the once elusive and expensive personal computer cheap and ubiquitous, and then Amazon's Jeff Bezos, whose online retail innovations have animated the PC. I see Patrick Soon-Shiong, whose pharmaceutical genius has made the scourge that is cancer more survivable, and then I see people like Michael Milken whose financial wizardry opened democratized access to capital for the kind of entrepreneurs just mentioned.

The skeptical may well argue that Obama was targeting the rich Americans whose fortunes were somewhat maintained by the bank and auto bailouts of three years ago, not to mention the profligate individuals who purchased homes they couldn't afford only to be saved on the backs of prudent Americans who didn't commit such egregious errors. As Obama put it himself back in 2008, "Part of why our debt crisis is so bad is that some folks are making reckless decisions - racking up big credit card bills by purchasing flat-screen TVs and other luxury goods that they know they can't afford."

There Obama would have a point, but then it was the political class of which he's a prominent member that made the ghastly decision not long ago to excuse the mistakes of rich and poor alike, all of this paid for by the taxpayers.  As Obama put it in explaining his support for TARP in 2008, "Today I fully support the efforts of Secretary Paulson and Federal Reserve chairman Bernanke.  What we're looking at right now is to provide the Treasury and the Fed with as broad authority as necessary to stabilize markets and maintain credit." 

Translated, it was when politicians like Obama led our retreat away from free markets that politicians (and presidential candidates in Obama's case) gave themselves "license" to take from others. As the word "free" in free markets makes plain, the very unregulated markets that our president mocks ensure that no one is coerced; instead consenting individuals choose to transact with those offering them the best deal. The greater the profit the greater the unmet need fulfilled, and the Forbes 400 is full of bright business types who removed a great deal of unease from the lives of their customers and clients.

But rather than embrace the certain achievements of the rich in our midst whose wealth mirrors our betterment and constantly rising standards of living, Obama last week resumed his call for increasing the tax penalty levied on those whose innovations serve us. Supposedly raising the price of work for the rich will strengthen the middle class, but apparently not understood by Obama is that most of the members of the Forbes 400 were once firmly part of the middle class; their path out of the middle a function of their past ability to access capital from the very 1 percenters whose income the president would like to take more of.

Missed by Obama is that to penalize the success of the rich with taxes is to reduce the amount of investable capital for tomorrow's entrepreneurs who aspire to join the 1 percent. After that, and considering the tautological reality that the U.S.'s economic success is the certain result of the individuals who comprise the top 1 percent, is it a good idea when the economy is struggling to put more weights on the men and women with the greatest economic skills? If the previous question is hard to understand, readers might ask if the NFL would be better off economically if tomorrow Roger Goodell decreed that Aaron Rodgers, Tom Brady and Ben Roethlisberger had to throw with their left hands.

Further on Obama argued that rebuilding the economy "will require American business leaders to understand that their obligations don't just end with their shareholders." Nice rhetoric if you're a community organizer, but very much beneath a president whose stated objective is to improve the economic outlook. To put it very simply, the only obligation business leaders have is to please shareholders precisely because without shareholders there are no companies and there are no jobs.

Apparently Obama missed the above memo as evidenced by easily the most frightening part of his speech in which he noted that, "Over the last few decades, huge advances in technology have allowed businesses to do more with less, and made it easier for them to set up shop and hire workers anywhere in the world....Steel mills that needed 1,000 employees are now able to do the same work with 100, so that layoffs were too often permanent, not just a temporary part of the business cycle....If you were a bank teller or a phone operator or a travel agent, you saw many in your profession replaced by ATMs or the Internet." Missed by our most economically illiterate of presidents is that the very definition of the productivity that attracts the investment necessary for company formation and job creation is the process whereby companies figure out how to produce more with less in the way of labor inputs.

After that, would President Obama prefer that U.S. business remain static, and free of innovation? Can he name one economically successful country in the history of the world that grew to be that way by virtue of shielding itself from technological advancement? The personal computer has arguably destroyed more jobs than any technology in the history of mankind, thus begging the question of whether Obama would prefer that it not exist.

At present Obama rightly decries the lack of opportunity within our limping economy, but rather than look in the very mirror that would reveal his policies to be the problem, he continues to blame his admittedly hopeless predecessor, and then when that doesn't work, he fingers the rich and their allegedly low rates of taxation as the source of our economic ills. As Nietzsche once said, "No one is such a liar as the indignant man."

What's funny and sad at the same time is that Obama doesn't realize how easy he has it. To understand true difficulty, it's worthwhile to consider Germany in the aftermath of World War II when, after losing a generation of human capital along with nearly its entire infrastructure, many Germans were reduced to living in caves. Having inherited this spectacular disaster that made the hand that Obama was dealt look positively grand, Ludwig von Erhard slashed spending and taxes, then pegged the country's currency to a gold-defined dollar. Within three years a once destroyed country could claim one of the most powerful economies in the world.

In Obama's case he too has had three years, yet the economy that he inherited is in many ways much worse today. Looked at through the von Erhard prism, Obama did the opposite on the policy front with predictably negative results.  In short, the economic ill health that Obama properly bemoans can be directly correlated with the policies he's foisted on all of us. Obama's policy failures are our unemployment lines, and because they are, it's essential that voters relieve him of his presidential duties.

About John Tamny:
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.

To gain access to our best stock picks and most extensive buy/sell lists, click here to sign up for our free weekly newsletter Investment Advisor Ideas.

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Every week we provide dozens of stocks having characteristics that over time tend to beat their respective index benchmarks and thus warrant consideration if you are a professional money manager or active in equity markets.

The ability to understand a company's management strategy and its ability to create wealth for shareholders is essential in the research process. As such, the Management Quality score developed by The Applied Finance Group (AFG) provides investors quick insights into company's ability to make wealth creating decisions and helps eliminate wealth destroying firms from your list of constituents.

AFG's Management Quality variable is used as an exclusionary variable to get rid of companies which continue to grow their businesses when they are not profitable (generating negative Economic Margin or negative EM, which is AFG's way of understanding a firm's economic profitability). When business units are unproductive and destroy wealth, management teams should not be looking to grow that business unit but rather concentrate on the parts of their company that have been creating wealth. If a company is unable to earn back its true cost of capital then the corporation needs to fix the broken parts of its business first by divesting losers and work on improving profitability to earn the right to expand. The best strategy AFG or any investor likes to see is a profitable business (generating positive EMs) that grows its assets to maximize its profitability.

The chart below highlights how well AFG's Management Quality metric has done by eliminating companies that are more likely to underperform sector peers as well as index benchmarks. Since 2007 companies that rank in the bottom half of their sector in MQ score have underperformed the overall Russell 1000 Index by 12%. The performance achieved by the MQ variable over the last five years illustrates the value that this metric adds to a money manager's stock selection process by avoiding potential torpedo stocks which we believe is just as important as identifying the next big outperformer.

The list of companies that we will provide in today's post have been flagged as following a poor management strategy of not earning back its true economic cost of capital and still growing its asset base despite not being profitable. These firms also are all currently trading at a premium to their default intrinsic value (bottom half of valuation rank) making these companies look like poor investment opportunities that should be closely reviewed when performing your due diligence on these companies.

To view an article in which we take a more in-depth and qualitative look at all of the CEO's in the S&P 500 and their ability to create wealth for shareholders, click here to view an article in which we partnered with CEO Magazine to rank CEO's based on wealth creation.

The companies listed below have been following a wealth destroying strategy and also look unattractive according to AFG's valuation model and other key criteria AFG evaluates when considering the attractiveness of potential investment opportunities. These companies should be looked at with caution when considering these companies as additions to your portfolio as they contain many of the characteristics that AFG has proven to cause a company to be more likely to underperform the market and its sector peers.

Management Quality Score Insights:

• Measures a company's Economic Margin (EM+1) and LFY Asset Growth.
• Companies that have positive EMs should grow their business while firms with negative EMs should focus on profitability and earn the right to grow.
• Un-biased quantitative way to analyze a company
• Holds management teams accountable for unprofitable growth

Management Quality - Evaluating Management:

• Assess companies' Economic Margins.
• Evaluate the ability of companies to sustain Economic Margins based on historical performance.
• Build out companies' future cash flows to better evaluate expected future performance relative to their peer group.
• Look at companies' investment prospects, and review how they are growing or shrinking their business.

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By: John Tamny, Toreador Research & Trading (Guest Contributor)

By now most readers are familiar with an exciting energy innovation called hydraulic fracturing, or the shortened word used to describe it, “fracking.” The energy extraction technique has led to major natural gas discoveries stateside, not to mention petroleum finds that have many Americans confident about easy, domestic oil access as far as the eye can see.

About energy exploration, it should be said up front that this column in no way objects to it occurring anywhere and everywhere. And while all energy subsidies – brown and green – should be abolished with great speed, to the extent that private investment exists to support the sourcing of energy, the federal government should get out of the way.

All that said, it says here that the excitement underlying fracking is overdone. Though all technological advances are something to embrace, for individuals to be exuberant about fracking amid a world awash in oil is the equivalent of Americans dancing in the streets over new techniques discovered for the easy manufacture of t-shirts.

That’s the case because contrary to the widely held belief that oil is scarce at the moment, the greater truth is that oil isn’t expensive as much as the dollar is cheap. Measured in the constant that is gold, an ounce of the yellow metal buys roughly the same amount of oil today as it did in 1971 when a barrel of oil traded for around $2.50. Far from an energy crisis rooted in a short supply of oil, we have at present a dollar crisis that is creating the false illusion of energy scarcity.

And with a weak dollar the driver of nominally high oil costs, much as occurred in the 1970s, there’s presently a rush of investment toward the oil patch. Evidence supporting the latter abounds, and includes $100,000 jobs in previously unknown locales such as Williston, ND, the opening of Mercedes car dealerships in long forgotten Pennsylvania towns, and myriad columns from commentators on the right celebrating “America’s energy economy.”

Though I find the word “bubble” a lazy one used by writers unwilling to take the time to understand the markets about which they write, suffice it to say that the energy exploration symptoms of our weak dollar point to some very stupid money chasing an oil illusion that will surely end in tears. Much as an overly strong dollar made oil nominally cheap in the late ‘90s on the way to dumb money funding long dead Internet concepts such as Webvan, theglobe.com and eToys, it’s apparent that the reverse is occurring today as dumb money – late to a dollar driven energy boom that began in 2001 – once again searches for simple profits in the energy sector.

For this alone we can expect some staggering investment errors lured into energy by the money illusion that will lead to substantial capital destruction over time. If it’s too good to be true it usually is, and right now success in the oil patch is too easy. Investors beware.

After that, while it should be said once again that investors should be free to place their capital wherever they desire, the modern rush to energy brings with it other negatives that should have an exuberant right wing very concerned. Indeed, the flight of capital toward the energy sector cheered on loudly by the right violates the basic economic views that have historically animated the more growth oriented side of the political divide.

First up is comparative advantage. Though David Ricardo would be on the Mr. Rushmore of most right-wing economic thinkers, his brilliance is ignored here. Economist Mark Perry has noted that the profit margins in energy are rather pedestrian, ranking 112th in the U.S. among industries. That the margins are so unimpressive speaks to the value of the U.S. becoming largely energy dependent. Rather than commit limited human, financial and physical capital to an economic discipline that profit margins deem prosaic, we should allow others to source the world’s abundant oil so that we can devote always limited resources to more profitable business concepts; our production elsewhere used to exchange for petroleum that we most definitely need.

Many on the right will say comparative advantage doesn’t apply to oil, that the U.S. has many oil-rich enemies who might cease selling it to us. The problem for those who take this position is that embargoes are a certain mirage. There’s no accounting for the final destination of any commodity, so assuming a wildly unrealistic scenario whereby some or all of the world’s energy producers choose to embargo us, the simple truth is that we’ll still consume their oil as though it bubbled up in North Dakota. Once any good reaches the markets its final destination can’t be controlled, and so long as we’re productive stateside, we’ll have the resources to exchange for oil.

Of course the false presumption of the use of oil as a “weapon” speaks to yet another problem with the U.S. becoming an energy economy: much of the world’s oil is controlled by governments. That is so because oil is immovable. North Dakota oil is North Dakota oil, and because it is, the fingerprints of greedy politicians will always be apparent.

Conversely, if politicians in California ever become too overbearing in terms of taxation and regulation, Google, Intel and eBay can simply move the human capital that drives the success of all three elsewhere. That’s not the case with oil. It bears repeating that it cannot be moved.

That it can’t helps to explain all the intrusive regulation of the energy sector that the right correctly decries. The problem here is that it’s not soon going to be lightened given oil’s static qualities in terms of location, thus begging the question why the right seeks more investment in that which politicians can so easily regulate, and as the excessive governmental responses to the BP/ExxonMobil spills of the past reveal in living color, punish.

The right also correctly loathe taxation, as does this column. If so, oil is yet again not the place to commit resources. Returning to oil’s immovable nature, because it is, politicians have an easy time taxing its profits. While Facebook is a concept of the mind that can migrate its human capital to the tax climate it deems best, Continental Resources cannot change the location of the Bakken oil field. And because it can’t, politicians will always have the upper hand when it comes to taxation.

Over the last ten years the price of oil has spiked thanks to a weak dollar, thus creating the illusion of scarcity despite abundant global supplies of what is a rather prosaic commodity. High prices of oil have attracted investment, along with a growing desire within the commentariat for the U.S. to take advantage of the oil boom to “create jobs” amid tough times for workers.

The thinking here is backwards. Unemployment is high precisely because a weak dollar either has investors in hiding, and then to some degree chasing an energy spike that is monetary in nature. Readers should be wary.

Indeed, a rush to oil is a flight of talent and capital to the basic, easily taxable and regulatable commercial concepts of yesterday. Worse, it violates arguably the most powerful economic idea ever conceived in comparative advantage. That energy is the hot sector at the moment should horrify us for it being a symptom of tragic dollar policy, and for the investors who’ve funded the flight to the oil patch, they should be rather leery. This rush to yesterday’s ideas, aided by a laudatory modern innovation in the form of hydraulic fracturing, promises to end badly.

About John Tamny:
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.

To gain access to our best stock picks and most extensive buy/sell lists, click here to sign up for our free weekly newsletter Investment Advisor Ideas.

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So far in 2011, as investors remain wary of a true economic recovery it is not a surprise that companies which pay a decent dividend have done well. Investors have sought out safety and stability through well managed dividend paying companies to provide some stable cash flow, while keeping some exposure to the equity markets. While there have been some positive signs of life relating to a potential economic recovery, such as the recent market rally as well as lower unemployment numbers, there is still plenty of uncertainty amongst money managers.

 While it is often the case that investors give up some of the potential for growth by focusing on stable dividend payers, dividend payers have tended to outperform non payers during bear markets and times of economic stagnation in the past. In the chart below we have broken down the S&P 500 into quintile groups based on dividend yield. This chart illustrates that the companies in the top quintile of dividend payers (highest yield) have done very well so far this year.

 Utilizing a strategy of purchasing companies that pay a solid dividend, coupled with AFG Valuation has proven to put investors in a position to outperform. The chart below illustrates that over time dividend paying stocks tend to outperform benchmarks, incorporating AFG's investment grade clearly enhances that performance.

 Today we will provide our readers a list of stocks that look attractive according to AFG's Investment Grade criteria (explained below) that also pay a dividend above what could be earned by purchasing a 10-year US Treasury note (current yield 2.04%) as a starting point for money managers looking for investment ideas that provide a steady income stream. We did something similar at our client conference in June, given a low Treasury yield and a "pay to wait" approach to the market.  If you are interested in accessing this Portfolio, email us at afgsales@afgltd.com.

The Applied Finance Group has been developing a new quantitative tool that helps clients easily navigate our various Valuation, Momentum, and Quality metrics. The AFG Investment Grade uses these metrics in a multi-factor model to rank all the companies within our universe of over 20,000 companies.  Companies with the best scores receive an A, whereas companies with the worst overall scores receive an F.  This grading system allows subscribers of our research to easily identify attractive investment ideas and avoid potential torpedoes. In addition to ranking companies based on Valuation, Momentum, and Quality, our model also applies different weights to each factor based on what is working in the market.

The list of stocks below earn an AFG Investment Grade of A and also currently pay a dividend above what could be earned by purchasing a 10-year US Treasury note (current yield 2.04%).

To view the entire list od attractive dividend payers, click here to subscribe to our weekly newsletter or email us at info@valueexpectations.com.

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By: John Tamny, Toreador Research & Trading (Guest Contributor)

In business school in the late '90s, like just about everyone else in my class I attended a speech given by Morgan Stanley's then CEO. Thanks to a strong dollar and relatively low taxes at the time, Wall Street was booming and Morgan Stanley was seen by most as one of the premiere jobs for an MBA student to secure.

Of note, the Morgan Stanley head stressed that as seemingly everyone desired San Francisco as a place to work, that better hiring options existed in other locales. In particular, so desperate was Morgan Stanley for India hires that he told anyone interested to approach him after his presentation.

The latter anecdote is notable considering all the talk within the commentariat - including articles written for RealClearMarkets - about California's certain decline. Supposedly high taxes, claustrophobic regulations and nosebleed spending are authoring its imminent demise; one that began with great speed several years ago.About today's conventional wisdom, it should be said by me up front that taxes are a price, and the higher the levy, the greater the cost of success. Government spending is similarly a tax that siphons capital away from otherwise productive private sector endeavors, and then regulations inhibit the profit motive as precious resources are wasted complying with rules rather than directed toward profitable ideas.

That Californians suffer hideous economic policies can't be denied, and in a perfect world they'd be reversed. The individuals populating America's most innovative state shouldn't be penalized for their productivity, but what's not acknowledged enough is that at least in modern times, it's always been this way. Certainly it was this way in the late '90s when so much of the U.S.'s intellectual talent rushed to the Golden State in order to join a party that was all about wealth creation.

So while California's taxes, spending and regulation are definitely problems that need to be addressed, they don't explain why the state suffers economically at the moment. To see the real source of its agony, one must look north, all the way to North Dakota.

As a recent Wall Street Journal editorial noted, "The oil and gas rush has led to a jobs boom. North Dakota has the nation's lowest jobless rate, at 3.5%, and the state now has some 200 rigs pumping 440,000 barrels of oil a day, four times the amount in 2006. The state reports more than 16,000 current job openings, and places like Williston have become meccas for workers seeking jobs that often pay more than $100,000 a year."

What the editorial didn't mention is how very much the "money illusion" wrought by a severely debased dollar animates this rush to North Dakota. Indeed, South Dakota's historical economic outperformance versus North Dakota was long explained by supply-siders (I consider myself one - incentives matter, and barriers to production are just that) as a function of the northern Dakota having a state income tax, while South Dakota doesn't have one at all.  Yet the north outperforms the south at present despite the tax differential.  North Dakota is also rich in oil, the price of which is very much inflated by a limping dollar.  One wonders.... 

The Journal editorial in a more broad sense pointed to an 80% increase in oil and gas sector jobs (200,000) since 2003. While not begrudging productivity or job creation for one second, that there's been a jobs boom in the oil patch since 2003 should surprise no one who witnessed the 1970s. With the dollar's collapse then predictably coinciding with a major rise in oil prices, investment rushed to the energy sector.

Importantly then just as now, the price of oil didn't change. An ounce of gold bought the same amount of oil in 1971 as it did in 1981, and looking at the present, oil's rush upward since the beginning of the new millennium doesn't point to expensive oil as much as it does a very cheap dollar.

Considering North Dakota, that there are so many $100,000 jobs available in a state not known for innovation or the existence of major human talent should strike most anyone as an oddity that won't last. If it's too good to be true it likely is, and just as California's late '90s Internet boom was to some degree a function of an overly strong dollar driving investment away from the real (how was North Dakota doing then?) and into the metaphysical, what ails California today is a severely depressed dollar that has caused an investment outflow back into the prosaic, easily taxable, mineral-based ideas of yesterday. It's the '70s all over again.

Where it gets interesting is that history points to periods of dollar devaluation which tautologically result in higher gold and oil prices that are followed by periods of dollar strength. North Dakota is booming right now while California sags, but assuming the historical reversion to a strong dollar that will lead to much lower gold and oil prices, does anyone want to make a long-term bet on North Dakota versus a state still in possession of more intellectual talent than any in the nation? North Dakota thrives with gold at $1700 and oil at $100, but how economic will this rush to energy be if and when the dollar soars and gold plummets, along with the price of oil?

Looking at California today, though rich in oil, the state's economic success in modern times has been driven by intellectual pursuits of the technological variety. Its problem is that when investors seek places to allocate their capital, they're by definition purchasing future income streams. But with the dollar still very weak, what investor in his right mind would make the risky bet on technologies of the future if, assuming a return, the latter will come back in cheapened greenbacks? Not a good bet, which explains why commodity locales such as North Dakota presently thrive. With the nominal price of oil largely driven by the value of the dollar (oil once again rises when the dollar weakens), it's less risky for investors to plow into the tangible concepts of yesteryear.

So yes, California suffers at the moment, while commodity states and countries boom. But history is history, and it points to an eventual retreat from the recessionary policies of dollar weakness.

The greatest weight on California right now is a weak dollar that is siphoning investment away from its innovators, but with a policy change in favor of dollar strength, investment will return, and when it does all the exaggerated rumors of the state's demise will be exposed as faulty, along with $100,000 jobs in North Dakota.

 About John Tamny:
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.

To gain access to our best stock picks and most extensive buy/sell lists, click here to sign up for our free weekly newsletter Investment Advisor Ideas.

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As 2011 winds down it is important to provide our readers some insight into a few of the key metrics that we use to identify investment ideas here at The Applied Finance Group (AFG). Our goal is to provide a better understanding of how we select the companies that we supply to you on a weekly basis; companies that are more likely to outperform. The process developed by AFG is used by Toreador Advisors, who select companies that look attractive based on these metrics and track the performance of these metrics in the form of indices created from companies within the Russell 1000 universe.  The Toreador Indices serve as a starting point for Toreador Advisors in their portfolio construction process and the list of constituents from within those indices serves as a good starting point for money managers looking for new ideas as additions to their own portfolio.

 All of the indexes we will highlight in today's letter are built using AFG's Economic Margin methodology and valuation framework as their foundation. All of the stocks considered by Toreador Advisors are culled from these indexes which use key criteria used in AFG's research and stock selection process. All of the metrics used have been vigorously back-tested and have proven to consistently add value to portfolios since 1995.

In today's article we would like to briefly describe some of the metrics that are used to create the indexes, as well as highlight the performance achieved from these indices since we began tracking them in 1997. 

 The metrics we will describe below are the foundation of The Applied Finance Group's stock selection process. We have tracked the performance of each of these metrics since 1997 and will illustrate the value that each one creates.

 Valuation - Using AFG's modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's valuation metric is used as the starting point for all of our investment decisions as it is backed by AFG's Economic Margin methodology.

 AFG default valuation model builds forecasted financial statements using analyst EPS forecasts as a starting point.

 When building these forecasts, a user can simply define three value drivers to help simplify the forecasting process: Sales Growth, EBITDA Margin, and Asset Turnover. By using these metrics, we can create an income statement, balance sheet, and cash flow statement relevant to our forecasting needs. Using this financial data, we would like to answer three important questions:

 What is the cash flow generated by the company's operations?
How much capital is required?
What are the opportunity costs of this capital?

 Answering these questions gives us a fundamental understanding of the wealth creation or wealth destruction of a firm in a given fiscal year.

 This methodology can be very useful to a research process - the quantitative model that can be administered to create default valuation models for over 4000 companies in AFG's universe can be helpful for identifying which companies look attractive through this broad framework. From there, an analyst can conduct his or her own research on a stock by creating user-defined forecasts within the system to create a target price based on personal assumptions. 

 The chart below illustrates how well AFG's valuation metric has worked at identifying winners and losers in the market. A significant spread has been achieved over time by separating the most undervalued, most overvalued and the Russell 1000 universe.

 Management Quality - One key element in determining a good long-term investment is the ability for management to make good strategic decisions. AFG's Management Quality variable is used as an exclusionary variable to eliminate companies with wealth-destroying management strategies from your list of candidates.

Evaluating Management:

• Assess the companies Economic Margin.
• Evaluate the ability for a company to sustain historical levels of Economic Margin performance.
• Build out future cash flows to better evaluate expected future performance relative to their peer group.
• Look at investment prospects of firms and review how they are growing or shrinking their business.

The chart below illustrates how well AFG's Management Quality variable works to help avoid firms with wealth-destroying management teams and strategies.

  Earnings Quality - AFG's Earnings Quality variable is an important indicator of companies that may be more likely to have negative earnings surprises and underperform due to high amounts of accruals. With many firms under pressure to meet sales expectations in the current environment, it is important to watch out for those firms that may be trying to pad their sales numbers, ie. Channel stuffing (sending excess inventory to stores that cannot sell their products).

 Earnings Quality: Accruals

 ·An accrual is the difference between Cash Flow and Net Income.

·Net Income = Cash Flow + Accruals

·Low Accrual companies outperform high accrual companies

Two ways to approach accruals:

1. Cash Flow Statement

·Difference between Net Income and Cash Flow

2. Balance Sheet

 
·Change in Net Operating Assets from Period t-1 to t
·Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

The chart below shows the effectiveness of AFG's Earnings Quality variable to eliminate companies from your focus list that have a high level of accruals and are more likely to experience negative earnings surprises.  

Buy Criteria - AFG's Buy criteria takes into account all of the variables we have discussed above into one metric. The chart below illustrates the spread achieved by only including companies that met the Buy Criteria relative to the rest of the Russell 1000 universe.

If you would like to learn more about this process and you are a professional money manager, please email us at info@valueexpectations.com for complimentary trial access to a more robust platform that allows portfolio managers and analysts to build pro-forma models, screen on our proprietary variables on over 4,000 companies in the US and 30,000 companies globally, as well as assist with daily due-diligence to make your process more efficient. 

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For the past four years The Applied Finance Group has used our Economic Margin methodology to evaluate the best and worst wealth creating CEO's in the S&P500.  The companies that hit the top of this list are considered "best of class."  However, it is also important to consider the expectations that are priced into each of these companies and their overall valuation attractiveness which are not part of this analysis.  

Apple Inc.'s visionary CEO Steve Jobs created extraordinary value for shareholders-but four lesser-known CEOs were even more valuable over the past three years.

Express Scripts CEO George Paz earned the title of Most Valuable CEO, followed by Exelon CEO John W. Rowe.  Priceline.com CEO Jeffery H. Boyd was #3, Varian Medical Systems CEO Timothy E. Guertin was #4 and Apple CEO Steve Jobs ranked #5.

This is the fourth year Chief Executive magazine and ChiefExecutive.net have published its Wealth Creation Index, ranking the performance of S&P 500 CEOs.  Created in collaboration with Great Numbers! and the Applied Finance Group, the ranking is based on four factors: (1) How good a company was at making real money (operating cash flow in excess of its risk-adjusted cost of capital), (2) Its prospects for continuing to make real money, (3) Its wise use of capital, and (4) How highly the market values the company's assets.

The top 50 companies in ChiefExecutive.net's ranking produced an average total shareholder return of 68.4% in the three years ended June 30, 2011.  The bottom 50 averaged -9.3%.

CEOs that had been in their roles for less than 3 years and the S&P 500's 13 REITs were not eligible, resulting in a pool of 366 chief executives (compared to 2010's 343). The ranking covered reported returns from July 2008 through June 2011.

"In creating and publishing these rankings, we're trying to help companies realize their upside potential by increasing awareness of exactly how to manage for wealth creation, and by suggesting a valid measure that can be used at all levels of an organization," said Drew Morris, CEO of Great Numbers! and the article's lead author.  "Our method also lays out opportunities to improve a company's operating cash flow."

Morris noted that, "We've created a way for the S&P 500 companies' senior-management teams to look at the reality of their performance through the same lens professional investors use and to use the insights gained to create more shareholder wealth going forward."

"CEOs are hired to create wealth for their shareholders and value for their customers and employers," says J.P. Donlon, Chief Executive magazine's Editor in Chief. "Chief Executive created the Wealth Creators Index to measure just how well some are good at this task. In a real sense it measures just how good --or how poorly--some CEOs are performing their job."

The companies/CEO’s listed below all rank in the top 10 amongst all of the CEO's within the S&P 500 for their ability to create wealth for their shareholders.

Follow the links below to view the rankings in their entirety as well as commentary about the best and worst CEO's.

Click here to see the entire rankings.

Click here to see a slideshow of the Top 10 Most Valuable CEOs
Click here to read Editor-in-Chief JP Donlon's editor's note about this year's top CEOs
Click here to read about the methodology behind the list
Click here to see the Best and the Worst and How to Improve Your Ranking

 To get more information on the methodology used to understand CEO Wealth Creation, email us at info@valueexpectations.com.

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Over the last few years, The Applied Finance Group (AFG) has been developing a new quantitative tool that helps clients easily navigate our various Valuation, Momentum, and Quality metrics. The AFG Investment Grade, as we have named it, uses these metrics in a multi-factor model to rank all the companies within our universe of over 20,000 companies.  Companies with the best scores receive an A, whereas companies with the worst overall scores receive an F.  This grading system allows subscribers of our research to easily identify attractive investment ideas and avoid potential torpedoes. In addition to ranking companies based on Valuation, Momentum, and Quality, our model also applies different weights to each factor based on what is working in the market. Following is a brief description of why we use each of these metrics when calculating the AFG Investment Grade.

Valuation:  AFG’s valuation metrics have proven successful at consistently identifying winners and losers in the market over time, and as a result, can add a significant amount of alpha to any investment portfolio.

We tend to agree with James Montier of GMO who stated that, “Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns.” Therefore, we recommend using our valuation metrics as the starting point when screening for attractive investment ideas for any quantitative-driven strategy, as they have a consistent track record of benchmark outperformance over a long-term time horizon, regardless of style, sector, size, or country.

Momentum: Despite outperformance characteristics over the long-term, there are periods of time when valuation is not relied upon by investors. Rather, during these periods investors become more concerned with short-term macroeconomic events. In these moments of irrational fear or greed, we have found it relevant to rely on momentum (EM Momentum) to uncover stocks that are set to outperform. Therefore, by utilizing a momentum variable in combination with our valuation metrics, we are able to capitalize on the outperformance capabilities driven by both metrics.

 Quality: Avoiding low-quality companies is another major factor within the AFG Investment Grade Model. Our systematic approach to grading Management Quality helps to eliminate companies with management teams that destroy shareholder wealth.

 Another factor taken into account within our model is Earnings Quality. Many studies have shown that companies which carry a high amount of accruals on their books experience the most frequent negative earnings surprises. Therefore, the AFG Investment Grade Model eliminates companies with poor Earnings Quality. 

 Altogether, the AFG Investment Grade utilizes these factors in a model we believe can be extremely effective at identifying attractive investment opportunities, and eliminating low-quality companies.

AFG’s proprietary multi-factor grading model ranks companies based on the following factors: 

• Valuation
• EM Change
• EM Momentum
• Price Momentum
• Earnings Quality
• Management Quality

The AFG Investment Grade is an effective tool for both large-cap and small-cap stocks, as well as within growth and value strategies in the US and major markets around the world. The chart below highlights the performance of this model over the last 20 years.

The companies listed below are a sample of companies that earn A and F Investment Grades. This list is a great starting point for investors looking for potential investment ideas (A grade), or to identify companies as a red flag (F grade).

To see more company grades, learn more about our Investment Grade Process or to take a free trial of our research and investment tools, email us at info@ValueExpectations.com.

Click Here to receive our weekly newsletter, Investment Advisor Ideas which contains investment ideas, sector/country analysis, macro-economic commentary and much more!

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By: John Tamny, Toreador Research & Trading (Guest Contributor)

As someone who graduated from college in 1992, I remember vividly the downcast economic outlook for me and my fellow graduates. Those who entered the real world in 1974 and 1980 no doubt faced similarly bleak futures.

 "Generation X" was the blanket adjective foisted on college graduates of the early '90s period, and with the U.S. economy still on weak footing following the 1990-91 recession, conventional wisdom said my supposed crowd had menial labor of the clothes-folding variety to look forward to, and that we wouldn't live better than the relatively well-to-do parents who had conceived us. Complaint music that chronicled my generation's despair emerged from Seattle, and many members of GenX, though fierce in their unwillingness to conform, did just that in their rush to grow the symbol of the era: a goatee.

 There was even a movie released in 1994 meant to give voice to this semi-youthful angst called Reality Bites. Starring the beautiful Winona Ryder, hippie poseur Ethan Hawke, and the annoying Janeane Garofalo (clothes folder at the Gap), the third-rate film did big box office with frustrated GenX-ers seemingly looking for comfort and excuses amid depressed economic times. The film's message was pretty basic: young adult achievers were heartless and dim, while dignity could be found in individuals who moved from job to job while spouting anti-capitalist philosophy as doors hit them on the way out.

Call it a contrarian indicator if you will, but almost in concert with Reality Bites' release the U.S. economy took off. The reasons for the rebound were pretty basic. Thanks to a Republican takeover of Congress in '94, gridlock in Washington ensued such that spending fell (are you hearing this Paul Krugman?), and with the reduction in spending more capital was made available to the productive private sector.

In 1997 a president (Clinton) not as disdainful of wealth creation as many in his Party signed a capital gains rate cut that reduced the penalty on investment success from 28 to 20 percent, and most stimulative of all, the arrival of Robert Rubin to the U.S. Treasury brought with it policy in favor of a strong dollar. The latter protected the investors tautologically necessary for growth, and with greater certainty that their investment returns wouldn't be eviscerated by mercantilist tinkering that always reveals itself in the form of currency debasement, the economy soared.

As for Generation X and its prior embrace of crunchy poverty, it went capitalist - in a big way. Not content to simply measure up to the economic status of their parents, GenX-ers blew past them financially on both Wall Street and in Silicon Valley.

Due to a strong dollar that boosted investment suddenly taxed less by Washington, an Internet boom took place out west largely authored by Generation X, and the latter was financed by GenX-ers who learned to love Wall Street. I was at Goldman Sachs at the tail end of this boom, and so fearful was Goldman of losing talent to the Silicon Valley gold rush that the firm instituted now laughable programs such as a "coolness committee" meant to keep employees in the fold (casual dress every day one of the most embarrassing "cool" benefits to emerge), along with increased stock options showered on individuals just a few years removed from perpetual, entitled adolescence.

Fast forward to the present, if we ignore for a moment the panhandling, wasted and criminal endeavor that Occupy Wall Street has become, underlying it is the basic slovenly, slacker ethos that prevailed a little less than twenty years ago. With newly-minted college grads having entered a cruel, somewhat job-free world, they've trained their sights on the alleged Millionaire's Club that is Wall Street. Wall Streeters are rich, diploma-rich twentysomethings are not, and because they're not, capitalism is once again a dirty word to a new generation of graduates; this one "Generation Zero."

What's remarkable is how very much the commentariat has once again fallen for this most unoriginal of poses. Though he should know better, Washington Post columnist Robert Samuelson nearly repeated word-for-word the musings of commentators back in the early '90s when he recently scribbled that "A specter haunts America: downward mobility. Every generation, we believe, should live better than its predecessors", but "For young Americans, the future could be dimmer."

Of course we've heard all of this before, and the simple answer is that we hear it every time Washington tacks in the wrong policy direction such that economic growth declines. Quite unlike the mid '90s when capital gains taxes and spending fell alongside a rising dollar, today government spending continues to hit previously unseen levels, capital gains taxes are set to go up in 2013, and the strong dollar necessary so that job and wealth-creating investment will reveal itself continues to test new lows.

Youth surely is an ass, college-graduated youth even worse, but the angst which underlies the protests of the latest lost generation is somewhat real. Though a job and success should never be thought of as birthrights, the simple truth is that "Generation Zero" is the latest one to suffer the ineptitude of our political class; its protests misdirected at a Wall Street that unquestionably should not have been bailed out. Washington is, as always, the miscreant here, and as taxpayers we've been bailing political profligacy out all of our working lives.

The good news is that at least if history is any kind of indicator, present policy from Washington so inimical to growth will eventually reverse itself, and with it, the fortunes of our latest "lost generation." The latter will quickly discover its love of capitalism, and will likely eclipse Generation X's economic fortunes in the process. After that, policy will eventually move in the wrong direction as prosperity invariably makes us flabby, but what's unknown is if tomorrow's Samuelsons will be as easily gulled by the policy errors that inevitably foster the next angry generation.

About John Tamny:
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.

To gain access to our best stock picks and most extensive buy/sell lists, click here to sign up for our free weekly newsletter Investment Advisor Ideas.

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The Applied Finance Group's (AFG's) framework and approach for measuring corporate performance and valuation is what sets us apart from other research providers. The AFG valuation framework has proven through vigorous back-testing to be successful at identifying companies likely to outperform index and sector peers. In the last 12 years, the spreads between companies we have labeled Strong Buys and companies we label as Strong Sells is approximately 20%.  As such, by focusing on companies that rate highly according to our valuation model and other key AFG metrics, investors can set themselves up for outperformance and avoid potential torpedo stocks. 

 Valuation is too often associated with a price multiple that signifies how much an investor will pay for each dollar of earnings generated by a company. In a price multiple framework such as P/E, an investor decides what the earnings of a company will be and then places a multiple on those earnings depending upon how confident they are about the earnings. As discussed in our explanation of why earnings fall short, the problematic nature of a price multiple is the noise in the underlying E of the equation.

Aside from the issues with earnings only represent 50% of the company's cash earnings, the price multiple also fails to link the investment the company has to make in order to generate a $1 of earnings, thereby missing half the financial picture.

Investors that use a P/E also treat companies that have high proportion of expense from research and development (R&D) exactly the same as companies with relatively little R&D even though companies with high R&D expenses are investing for the future while the others are not.

AFG's Valuation model addresses these issues by providing a systematic valuation framework which links the earnings power of a company to its invested capital, converting the company's earnings into cash flow measure and systematically modeling in the effects of competition through a company specific decay.

To identify potentially attractive investment ideas, AFG usually uses a combination of proprietary variables to develop a focused group of potential buy ideas that meet criteria based on valuation, economic performance, management quality, and earnings quality. Although this set of investment criteria has proven successful in generating buy ideas, AFG's valuation on a standalone basis has consistently been able to identify mispriced securities and investment opportunities that outperform their chosen benchmark. 

In the section below you will find a list of companies from the S&P 500 which look attractive according to AFG's Valuation Model and other key metrics used in our stock selection process. This list can serve as a solid starting point for investors looking for large-cap investment ideas.

The defining characteristics of firms selected for our S&P 500 investment ideas:

• Large Cap US Stocks
• Superior valuation attractiveness as measured by the difference between a firms estimated intrinsic value and current trading price
• Non-Wealth destroying management track records, as measured by The Applied Finance Group's Economic Margin and corporate reinvestment strategies
• Companies with acceptable levels of earnings quality as measured by The Applied Finance Group's Earning's Quality metrics

The list above is derived from our weekly investment newsletter Investment Advisor Ideas, To see the other half of the companies that were provided in our newsletter, CLICK HERE to sign up and receive it on a weekly basis.

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By: John Tamny, Toreador Research & Trading (Guest Contributor)

 The intensity of the ongoing Republican presidential debates has a very uplifting silver lining. Specifically, the competition ensures a much needed discussion of the proper mode of federal taxation.

Texas Governor Rick Perry seeks somewhat of a flat tax, and the positive implications of such a move would be quite something. Not only would this reduce the price of work for most Americans, but it would make tax preparation a snap such that a lot of fecund minds whose employment is a function of byzantine tax laws would be released into more productive lines of work; the U.S. economy a certain beneficiary of such a scenario.

After that, a flat tax (not Perry's unfortunately for now) presumes the zeroing out of the myriad economy-distorting deductions that amount to the federal government rewarding its likes and dislikes through the tax code. To put it very simply, tax rates - particularly on high earners today - are high precisely because deductions reduce the burden. A flat tax would remove politicians from the business of offering favors, and the certainty wrought by something flat would drive all manner of productive work to a higher level.

All this said, a flat tax remains a price. Worse, it's a price placed on productive work effort. As it stands now, a flat tax would serve as a cost and penalty placed on economy-boosting endeavors. We're used to being fleeced at various rates at this point, but the idea that our work costs us something per federal whim should horrify us, not to mention that a flat tax ensures that the vital few who do the most to enhance our economic spirits would pay the most to the federal government under such a regime.

So while we shouldn't let the perfect be the enemy of the near perfection that would be a flat tax, we should certainly aspire to something better. The most entrepreneurial nation on earth should not be taxing work, let alone taxing its most productive citizens the most.

All of which brings us to a national consumption tax that would lead to the abolishment of income taxes, along with taxes on estates, capital gains, and presumably everything else. This surely trumps a tax that penalizes work and investment, though like the flat tax, it has its problems.

For one, much as a flat tax would inspire lobbyists looking for deductions on what would be a simplified tax, so would the same occur with a consumption levy. Indeed, it's easy to see where lobbyists would seek waivers for the consumption of food, education, and clothing ("the children are our future and we shouldn't tax life's basics"), and then since books themselves are incorrectly correlated with brains, surely the purchase of "educational materials" would be up for a zero tax.

From there we'd have to consider our ailing industries. Though thriving economies are always and everywhere marked by constant destruction whereby failed industries and companies die so that better ideas can take their place, it's easy to see where our regularly bankrupt airlines would lobby for exemption from the tax, and they would be followed by our Big Three automakers, followed by numerous other employee intensive business sectors that the markets would prefer to leave for dead.

And then much like the flat tax, a consumption tax could easily be perverted by future Congresses eager to raise it in return for some favor handed out to a narrow part of the electorate. Just as regulations provide crooks with the legal framework that they'll eventually game, politicians get themselves elected to play with the tax code.

After that, my fellow Forbes contributor Jerry Bowyer makes the point that a consumption tax would penalize those who spent their lives paying income taxes and delaying consumption, only to enter their golden consumption years giving the federal government a big cut. The latter is no doubt a problem, but as Bowyer acknowledges, there are winners and losers with any tax change no matter how stimulative.

At the very least, the savers that Bowyer properly elevates (every economic advance in the history of mankind has resulted from the savings being matched with a brilliant idea) would no longer suffer capital gains taxes on their economy-enhancing investments. Also, so great would the economy be under a flat or consumption scenario, most Americans nominally harmed in the transition probably wouldn't care.

So with at least some of the objections to a consumption tax addressed, the positives are many. Under such a tax savings and investment would no longer be penalized, but with consumption taxed, there would exist a greater incentive for individuals to save. Entrepreneurs can't innovate without capital, and the capital formation possibilities under a consumption tax would be very grand.

About John Tamny:
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.

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by, Grey Owl Capital Management (Guest Contributor)

October 31, 2011

“Ben, the two of us need look no more
We both found what we were looking for
With a friend to call my own
I'll never be alone”

-          Michael Jackson, Ben

“Good things happen to cheap stocks.”

-          Steven Romick, manager of the FPA Crescent Fund

While we outperformed the market by almost 300bps in the third quarter, September was a far more brutal month than we would have expected given the concentration of high quality businesses that make up the bulk of our portfolio and the large cash position we have held.

Correlation and volatility remain extraordinarily high.  Cryptic statements from Ben Bernanke (and the even more obtuse European leadership consortium) carry far more weight than underlying company fundamentals in today’s “risk on, risk off” trading environment.

When the noise becomes loudest, we find it most useful to get back to basics.  We’ll spend a portion of this effort discussing the current market environment, but the bulk is dedicated to a fundamental discussion of our four largest equity positions which make up approximately 23% of our equity separate accounts.  But first, our typical performance table as of September 30, 2011.

Bizzaro World

It seems like we’ve been transplanted to the fictional planet in the DC Comics universe where everything is inverted.  How else do you explain the behavior of assets subsequent to Standard and Poor’s downgrading US Treasury debt on August 5th?  Here is a comparison of select asset class returns from that date through the end of the quarter:

Despite the headline downgrade of US debt, in a fear-driven market, investors are conditioned to seek safety in what has been, since World War II, the world’s reserve currency.  It will likely take years for this muscle memory to atrophy.  With the US debt ceiling drama giving way to sovereign financial concerns in Europe, the fear gauge was high.

The uncertainty was equally manifest in equity markets.  The S&P 500 traded half a dozen eight percent swings in just August and September.  Real issues of slow economic growth, expensive markets, and unserviceable debt caused investors to sell.  Then “our friend Ben” (or his European counterparts) responded with a “twist” or “QE” or the concept of a “stability” package and traders were off to the races:  RISK ON!  (As if money printing could create wealth.)

The correlation data further demonstrates that macro events, not business fundamentals drive day-to-day price movements in today’s markets.  Eighty percent of stocks have traded in directional sync for the last two months.

Unfortunately, until such time as global, developed world debt levels become sustainable and constant fiscal and monetary tinkering abates, we expect volatility and correlation to remain high.  We don’t pretend to have an edge in anticipating these actions.  Where we do have an edge is in our ability to make “time arbitrage” investments.  Companies that trade at low valuations and that can consistently grow intrinsic value provide very strong returns over multi-year periods.  This is the core of our portfolio and where we turn next.

Review of Four Largest Positions:  23% of Portfolio Assets

We run a concentrated portfolio.  As of September 30, 2011, our top four positions made up almost 23% of total assets.  Typically, our top positions are “core holdings” that we would expect to own for many years.  While it would sure make life easier if the market values of our securities positions increased at a steady rate, that will never be reality.  Security returns will be lumpy, even in high-quality businesses.  Thus, we tend to spend more time worrying about the underlying business dynamics than day-to-day, week-to-week, or quarter-to-quarter investment returns.  For each of our top four holdings, the underlying business dynamics remain quite strong and improving while the stock prices remain cheap.

Microsoft
Position size on 9/30:  7.3%

We have discussed Microsoft at length, most recently in a blog post and prior to that in our third quarter 2010 letter.  While the market price for Microsoft stock has barely budged in the last year, its business fundamentals have greatly improved.  Annual earnings per share (EPS) are up 19% year over year, shares outstanding have shrunk, and the dividend was increased 25%.  The company continues to make gains.  We own Microsoft at a current P/E excluding net cash of 7 and a dividend yield of 3%.  This price projects a massive deterioration in Microsoft’s business going forward.  Based on all the available evidence, nothing is further from the case.  Good things happen to cheap stocks.

Berkshire Hathaway
Position size on 9/30: 5.7%

Over the past three years, Berkshire Hathaway has been able to compound per share book value at an average rate of 9.4% per year.  This includes the bottom of the recent recession and related stock market selloff.  (Berkshire’s very large equity portfolio is a significant percentage of book value and is marked to market.)  In addition, free cash flow from Berkshire’s operating businesses has grown out of the recessionary trough at an extraordinary rate.  We expect Berkshire should be able to grow book at a low double-digit rate for several years.  Given this, we think the stock should trade at between 1.5 and 1.75x book.   Today it trades at 1.15x book.  Good things happen to cheap stocks.

Lexmark
Position size on 9/30: 5.3%

We discussed our Lexmark investment thesis at length in our last quarterly letter.  Lexmark is transitioning out of its consumer printing business to focus exclusively on business printing.  We want to see their “core” business printing segment grow as a percentage of revenue quarter by quarter and year over year.  This is happening.  We also want to see the operating margin continue to expand, as this higher margin business becomes a greater percentage of revenue.  This too is happening.  Thus, while Lexmark’s revenue growth is anemic, its EPS growth is quite reasonable.  Once the consumer business is fully exited, modest top line growth should resume.  Frankly, trading at 4.61x EPS (excluding net cash) Lexmark is priced like a wasting asset:  a royalty trust with a six year life and a flat payout structure would provide an 8% annualized return if you paid 4.6x its payout.  Given a reasonable expectation of mid-single digit earnings growth, a high return business like Lexmark should trade at a mid-teens multiple.  Good things happen to cheap stocks.

Markel
Position size on 9/30: 4.9%

Over the past three years, Markel has been able to grow book value per share at an average rate of 12.26%.  This includes the recession and market trough and like Berkshire, equity securities make up a meaningful portion of Markel’s book value.  Markel is far smaller than Berkshire.  Whereas Berkshire has in many ways become a broad industrial company, Markel is still almost purely an insurance operation and has thus suffered more directly in the current soft insurance market.  We expect Markel will be able to grow its book value in the low double digits for many years and could experience significant book value growth when insurance markets harden.  Therefore, we think the stock should trade between 1.6 and 1.9x book.  Today, Markel trades, like Berkshire, at just 1.15x book.  Good things happen to cheap stocks.

Conclusion

Buckle your seat belts.  We fully expect markets to remain manic and co-dependent.  The market can’t live without its friend Ben, so a few weeks of weak data and no intervention and we’ll have a selloff.  Likewise, as soon as rumors of the next hundred billion dollar intervention surface, traders won’t be able to buy equities quickly enough.  The situation in Europe is a mirror image.  Thankfully, in a world of 20,000+ individual securities there are always pockets of opportunity.  We must be prepared for our individual ideas to trade with the market for periods of time, but over the long-haul “good things happen to cheap stocks.”  When possible and prudent, we will use manic periods to lighten our exposure and depressed periods to add to our best ideas.  In addition, we are working hard to mute volatility if we can do so without sacrificing long-term results.

As always, if you have any thoughts regarding the above ideas or your specific portfolio that you would like to discuss, please feel free to call us at 1-888-GREY-OWL.

Sincerely,

Grey Owl Capital Management

Grey Owl Capital Management

Grey Owl Capital Management, LLC

This newsletter contains general information that is not suitable for everyone.  The information contained herein should not be construed as personalized investment advice.  Past performance is no guarantee of future results.  There is no guarantee that the views and opinions expressed in this newsletter will come to pass.  Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors.  Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.  Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information.

Grey Owl Capital Management, LLC (“Grey Owl”) is an SEC registered investment adviser with its principal place of business in the Commonwealth of Virginia.  Grey Owl and its representatives are in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which Grey Owl maintains clients. Grey Owl may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements.  This newsletter is limited to the dissemination of general information pertaining to its investment advisory services.  Any subsequent, direct communication by Grey Owl with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides.  For information pertaining to the registration status of Grey Owl, please contact Grey Owl or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).

For additional information about Grey Owl, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein.  Please read the disclosure statement carefully before you invest or send money.

The performance information presented above is reflective of one account invested in our model and is not representative of all clients. While clients were invested in the same securities, this chart does not reflect a composite return. The returns presented are net of all adviser fees and include the reinvestment of dividends and income. Clients may also incur other transactions costs such as brokerage commissions, custodial costs, and other expenses. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period, and the investment performance. Grey Owl Capital Management registered as an investment adviser in May 2009. The performance results shown prior to May 2009 represents performance results of the account as managed by current Grey Owl investment adviser representatives during their employment with a prior firm. The data shown represents past performance and is no guarantee of future results. No current or prospective client should assume that future performance results will be profitable or equal the performance presented herein. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.

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