Recap From September’s Picks
Our Most Attractive Stocks (-4.7%) outperformed the S&P 500 (-5.2%) from September 2, 2021 through October 4, 2021 by 0.5%. The best performing large cap stock gained 19% and the best performing small cap stock was up 6%. Overall, 22 out of the 40 Most Attractive stocks outperformed the S&P 500.
Our Most Dangerous Stocks (-3.0%) underperformed the S&P 500 (-5.2%) as a short portfolio from September 2, 2021 through October 4, 2021 by 2.2%. The best performing large cap stock fell by 10% and the best performing small cap stock fell by 25%. Overall, 11 out of the 33 Most Dangerous stocks outperformed the S&P 500 as shorts.
The Most Attractive/Most Dangerous Model Portfolios underperformed as an equal-weighted long/short portfolio by 0.9%.
More reliable & proprietary fundamental data, proven in The Journal of Financial Economics, drives our research. Our proprietary Robo-Analyst Technology[1] scales our forensic accounting expertise (featured in Barron's ) across thousands of stocks[2] to produce an unrivaled database of fundamental data.
Six new stocks make our Most Attractive list this month, and six new stocks fall onto the Most Dangerous list this month. October’s Most Attractive and Most Dangerous stocks were made available to members on October 6, 2021.
Our Most Attractive stocks have high and rising returns on invested capital (ROIC) and low price to economic book value ratios. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.
Most Attractive Stocks Feature for October: Omnicom Group (OMC: $74/share)
Omnicom Group is the featured stock from October’s Most Attractive Stocks Model Portfolio. We also made Omnicom a Long Idea in May 2020 and reiterated our opinion on the stock in April 2021.
Omnicom has grown revenue by 1% compounded annually and net operating profit after-tax (NOPAT) by 2% compounded annually over the last decade.
The company’s NOPAT margin increased from 9% in 2015 to 11% over the trailing twelve months (TTM), while invested capital turns remained flat at 1.3 over the same period. Rising margins help drive Omnicom’s ROIC from 12% in 2015 to 14% TTM.
Over the past five years, Omnicom generated $8.3 billion (52% of market cap) in cumulative free cash flow (FCF). Over the TTM, Omnicom has generated $2.2 billion in FCF. The company’s economic earnings, or the true cash flows of the business, have grown from $763 million in 2015 to $1.1 billion over the TTM. See Figure 1.
Figure 1: Revenue & Economic Earnings Since 2015
Sources: New Constructs, LLC and company filings
OMC Is Undervalued
At its current price of $74/share, OMC has a price-to-economic book value (PEBV) ratio of 0.5. This ratio means the market expects Omnicom’s NOPAT to permanently decline by 50%. This expectation seems overly pessimistic for a company that has grown NOPAT by 5% compounded annually over the past two decades.
Even if Omnicom’s NOPAT margin falls to 8% (equal to 20-year low, compared to 11% TTM) and the company’s NOPAT grows by just 1% compounded annually for the next decade, the stock is worth $131/share today – a 77% upside. See the math behind this reverse DCF scenario. Should Omnicom grow profits more in line with historical levels, the stock has even more upside.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Fact: we provide more reliable fundamental data and earnings models – unrivaled in the world.
Proof: Core Earnings: New Data & Evidence, forthcoming in The Journal of Financial Economics.
Below are specifics on the adjustments we make based on Robo-Analyst findings in Omnicom’s 10-K and 10-Qs:
Income Statement: we made $1.0 billion in adjustments, with a net effect of removing $359 million in non-operating expenses (3% of revenue). You can see all the adjustments made to Omnicom’s income statement here.
Balance Sheet: we made $8.2 billion in adjustments to calculate invested capital with a net decrease of $1.8 billion. One of the most notable adjustments was $1.2 billion in goodwill adjustments. This adjustment represented 10% of reported net assets. You can see all the adjustments made to Omnicom’s balance sheet here.
Valuation: we made $12.4 billion in adjustments, with a net effect of decreasing shareholder value by $5.0 billion. Other than total debt, one of the most notable adjustments to shareholder value was $3.7 billion in excess cash. This adjustment represents 5% of Omnicom’s market cap. See all adjustments to Omnicom’s valuation here.
Most Dangerous Stocks Feature: AppFolio Inc. (APPF: $125/share)
AppFolio Inc. (APPF) is the featured stock from October’s Most Dangerous Stocks Model Portfolio.
AppFolio’s economic earnings, the true cash flows of the business, fell from $7 million in 2017 to -$12 million over the TTM. The company’s NOPAT margin fell from 7% in 2017 to <1% TTM, while invested capital turns fell from 4.0 to 1.9 over the same time. Falling NOPAT margins and invested capital turns drive AppFolio’s ROIC from 27% in 2017 to <1% TTM.
Figure 2: Economic Earnings Since 2017
Sources: New Constructs, LLC and company filings
APPF Provides Poor Risk/Reward
Despite its poor fundamentals, AppFolio is still priced for significant profit growth and overvalued.
To justify its current price of $125/share, AppFolio must improve its NOPAT margin to 12% (above all time high of 11%, compared to >1% TTM) and grow NOPAT by 43% compounded annually for the next decade. See the math behind this reverse DCF scenario. Given that AppFolio’s NOPAT fell from $10 million in 2017 to >$1 million over the TTM, we think these expectations are overly optimistic.
Even if AppFolio can achieve a NOPAT margin of 12% and grow NOPAT by 31% compounded annually for the next decade, the stock is worth just $61/share today – a 51% downside to the current stock price. See the math behind this reverse DCF scenario. Should AppFolio’s NOPAT grow at a slower rate or, even worse, continue its downward trend, the stock has even more downside.
Each of these scenarios also assumes AppFolio is able to grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely but allows us to create best-case scenarios that demonstrate how high expectations embedded in the current valuation are.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Fact: we provide more reliable fundamental data and earnings models – unrivaled in the world.
Proof: Core Earnings: New Data & Evidence, forthcoming in The Journal of Financial Economics.
Below are specifics on the adjustments we make based on Robo-Analyst findings in AppFolio’s 10-K and 10-Qs:
Income Statement: we made $232 million in adjustments, with a net effect of removing $146 million in in non-operating income (47% of revenue). You can see all the adjustments made to AppFolio’s income statement here.
Balance Sheet: we made $188 million in adjustments to calculate invested capital with a net decrease of $187 million. One of the most notable adjustments was $12 million in deferred tax assets. This adjustment represented 4% of reported net assets. You can see all the adjustments made to AppFolio’s balance sheet here.
Valuation: we made $290 million in adjustments with a net effect of increasing shareholder value by $3 million. The most notable adjustment to shareholder value was $147 million in excess cash. This adjustment represents 3% of AppFolio’s market cap. See all adjustments to AppFolio’s valuation here.
This article originally published on October 13, 2021.
Disclosure: David Trainer, Kyle Guske II, Alex Sword, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.
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[1] Harvard Business School features our research automation technology in the case Disrupting Fundamental Analysis with Robo-Analysts.
[2] See how our models overcome flaws in Bloomberg and Capital IQ’s (SPGI) analytics in the detailed appendix of this paper.