Capital Goods – Unloved and Presenting Opportunities

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SEE LAST PAGE OF THIS REPORTFOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 3rd, 2013

Capital Goods – Unloved and Presenting Opportunities

  • The Capital Goods space has underperformed the broader market for a couple of years now and screens relatively attractive in aggregate and specifically attractive for a number of companies. In this analysis we look at different market exposures and suggest a sub-sector weighting and stock selection.
  • We would be overweight both the Mining and Ag sub-groups simply on valuation. Ag fundamentals appear better than Mining today, suggesting a better risk/reward than Mining.
  • We would also be overweight construction. Valuations are generally not as attractive as Mining and Ag (SWK and CAT would be the exceptions), but other housing and construction related sectors (home building, paint, building products, etc.) are much more richly valued today, suggesting upside here.
  • Both the Transport and Diversified groups are generally riding a wave of much better returns on capital and an overweight exposure to the better US manufacturing environment. However, valuations for the most part are discounting this and we see some relative and absolute downside in aggregate.
  • Within Industrials and Materials we would today be overweight Capital Goods, and prefer the sector to Chemicals, which has similar cyclical market and fundamental exposure but less attractive valuation.

Exhibit 1

Source: SSR Analysis

Overview

For over a year we have analyzed the Chemical group at a sub sector level. This has allowed us to draw valuation comparisons and look for significant anomalies and accordingly opportunities. We have a large enough sample set in the Capital Goods sector, but the group does not lend itself to sub-division as easily as Chemicals. There are not enough pure play companies in sub-segments like Ag, Mining and Construction to make large enough sample sets and we very quickly end up with an overwhelming group of “diversified companies”. Accordingly, we have tried something different – we have allowed companies to appear more than once. If more than 25% of a company’s revenue comes from Ag, Mining, Construction, Energy/Power, Transport, then they are included in that index. If more than 50% is spread across other sectors they are included in “diversified”. The groupings are summarized below in Exhibit 2.

Exhibit 2

We are still light in terms of sample size in Mining and Ag, but we present the results of the analysis anyway. In all the work that follows we are taking simple averages rather than market weighting, primarily because CAT’s size biases the analysis in its three sectors if we do not. Note that this is by no means a robust and rigorous quantitative analysis and we would never advertise it as such. Our goal here is to find ways to explain valuation anomalies in order to help us identify where the real mispricing might exist. We also find that presenting data in a variety of ways can lead to questions and conclusions that you might not otherwise find.

We get the results we would expect when we look at our “normal” valuation metric. Mining stocks are the least expensive and Ag follows. This makes sense given the discount in the Metals group and given that Ag is currently the cheapest sub-sector within chemicals. Note that this analysis is a measure of the valuation deviation of the sector index itself, not a weighted sum or average of the stock components.

Exhibit 3

Source: Capital IQ and SSR Analysis

Valuation

At a company level we see what looks like a much more balanced picture (Exhibit 4), but it should be noted that the Diversified, Transport and Construction sub-groups have many more components than Energy, Ag and Mining. In the valuation analysis we note that IEX, SNA, LECO and DOV are trading at either all time or ten year relative valuation highs, while no company is trading at an all time or ten year low. SWK has been close to an all time valuation low for the last couple of years, but the absolute low was in 2011. JOY is also very close to a 10 year low.

Exhibit 4

Source: Capital IQ and SSR Analysis

Return on Capital

Two of the companies displaying ten year highs in valuation are also showing ten year highs in returns on capital (Exhibit 5) versus normal, which is clearly supporting the above trend valuation – IEX and DOV. IEX appears to be reversing a long-term negative trend in return on capital, but it is noteworthy that it appeared to be doing the same in the 2000 to 2006 period only to return to its longer-term negative trend. DOV has been on an improving trend in return on capital since a low in 2001, but today remains well below its 1970-2000 average. Generally, the companies with higher valuations are also those with above trend returns, and vice versa. Anomalies are picked up in our Skepticism analysis which we cover later in the report.

Exhibit 5

Source: Capital IQ and SSR Analysis

Return on capital history and trends by subsector are included in Exhibit 6. Only the Energy sector has a negative slope, but the Diversified group is essentially flat. The best improving trend is in Mining, but we should note the small sample set. Agriculture equipment also has a good trend, although from a low starting point, and this probably reflects the significant consolidation that has taken place in this sector globally over the last 20 years. All sub-sectors show significant volatility.

Exhibit 6

Source: Capital IQ and SSR Analysis

Net Income Margin

A history of net income margin for the overall Capital Goods sector is shown in Exhibit 7. While there has been an improving trend since the early 1980s, the trend comes from a very low level and even today the margins are very poor, though no different than, for example, Chemicals.

Exhibit 7

Source: Capital IQ and SSR Analysis

If we break the analysis down into subsectors, the improving trend is widespread (Exhibit 8), but Ag lagged until recently and Energy has a flat trend but a recent high.

Exhibit 8

Source: Capital IQ and SSR Analysis

Valuation

Time series for the sub-group valuations are shown in Exhibit 9

Exhibit 9

Source: Capital IQ and SSR Analysis

How Appropriate is Current Valuation? Back to Skepticism

As we highlighted in
our recent comprehensive piece on chemicals
, the third chart in the series – the one which naturally follows 4 and 5 – is our look at Skepticism. In Exhibit 10, we show the current Skepticism Indices for the Capital Goods group. As a reminder, if the bar is above the line, valuation is lagging profitability and if the bar is below the line valuation is ahead of profitability.

The analysis highlights the out of favor status of both the Mining and Ag groups with valuations clearly discounting an expectation that earnings will decline further. The stand-out is SWK, which is still being treated as if the Black & Decker acquisition destroyed the story while earnings trajectories and expectations clearly point to the opposite.

The analysis fully supports our positive views on CAT, DE, AGCO, ETN, VMI and SWK, and would suggest a few more. It also highlights the extreme positive expectations in CLC, SNA, IEX and others.

Exhibit 10

Source: Capital IQ and SSR Analysis

How Ambitious are Earnings Estimates and Who are the Optimists?

In the last exhibit below (Exhibit 12) we compare 2015 estimates and the growth implied therein with what the companies have achieved in the recent past and what a more normalized rate looks like for each based on return on capital growth over time. What we are looking for here are inconsistencies:

  • Do expectations look out of phase with the last couple of years and the longer-term average?
  • If we have had a couple of years of growth well above trend – does consensus expect that to continue – unlikely in our view. CMI, IR, PLL, TKR, SPW and KMT are examples where the last couple of years are probably the anomaly not the new rule.
  • The Ag expectations look conservative – AGCO and DE.
  • SWK looks reasonable as the expectations going forward, while higher than the last couple of years are not inconsistent with longer-term history.

However, as you look at Exhibit 12, it is also worth noting who the optimists are. In a series of pieces of research
late last year
and
early this year
we published an analysis of optimism and created an empirical way of measuring (for better or worse) which companies had a tendency to overestimate and which had a tendency to be conservative. The performance comparisons between the group most optimistic and the group most conservative was extreme, and causes us always to be cautious around companies that have a history of over-estimating or stretching too far.

Within Capital Goods only CLC fell within the Industrials and Materials Optimism Top 20. While estimates for CLC, as shown in Exhibit 12 do not look to be out of historical context, it should be noted that the company has a history of missing rather than beating estimates.

By contrast, half of the companies in the Industrials and Materials Top 20 conservative group came from the Capital Goods sector, as summarized in Exhibit 11. This analysis would suggest that we should give CMI more of a benefit of the doubt for its forward earnings targets even though they look out of context with longer term history.

Exhibit 11

Source: Capital IQ and SSR Analysis

:

Exhibit 12

Source: Capital IQ and SSR Analysis

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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