China – Not Just a Cyclical Story – Beware of the Secular Trends!

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 3rd, 2015

China – Not Just a Cyclical Story – Beware of the Secular Trends!

  • Strong global liquidity, which encouraged investment in many industrials and material industries globally, coupled with weaker economic conditions (particularly in China) has depressed many commodity prices to near 10-year lows. We see a secular rather than cyclical issue here.
  • a whether a “normal” cyclical recovery would . What wincreasing nce in low stock couldbe representing a value trap rather than an opportunity.
  • China now satisfies 5-15% of (ex-China) global demand through its exports of many commodities; a level that was only 0-5% ten years ago. China now controls the price.
  • In addition derivative products such as machinery and chemicals are also seeing growing export trends suggesting that China is tightening its grip on those markets as well.
  • In this new paradigm traditional “cyclically low” valuations may be misleading. The emphasis should be on companies that are insulated from this trend with a technological and/or geographical advantage both in raw materials as well as downstream products that create the widest moat possible against Chinese export influence.
  • We have ranked our universe based on six factors. The “most insulated” companies have outperformed those “least insulated” ones by 11% over the past year (more than three times the performance gap in either of the prior two years) – a trend we expect to continue. This outperformance comes despite similar non-US sales exposure – Exhibit 1.
  • Exhibit 7 highlights insulated companies with attractive valuations – our focus is on EMN, PX, DD, DE, TRN, and PKG.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview –

 

Exhibit 2

Source: Capital IQ, SSR Analysis

 

Fueled by liquidity and a coordinated drive to be raw material self-sufficient, China has spent the last 20 years aggressively back integrating into the raw materials that have been consumed in driving the finished products export led expansion of the county’s economy. Abundant foreign currency, low interest rates, easy lending and a drive to create manufacturing jobs have driven investments that would not have passed return on capital hurdles in the West and have kept facilities running despite marginal cost based cash returns.

In product after product, as China has moved from net importer to net exporter, the impact on global pricing has been dramatic, especially where global markets are oversupplied. In most areas as manufacturing returns have fallen, China has kept going while producers in the more developed regions have often thrown in the towel, closing older facilities and effectively ceding market share to Chinese exporters. This has been most significant in aluminum, where China now supplies 17% of the non-China demand, but other products are gaining global market share quickly, such as PET, Steel and PVC – Exhibit 3. A more complete history of demand and export data is summarized in the Appendix.

Exhibit 3

Source: Bloomberg, SSR Analysis

We expect these trends to continue and possibly accelerate as a consequence of China approaching self-sufficiency in energy sources for power generation. While still a significant importer of crude oil, China is now effectively self-sufficient in coal and using more coal in gasification to make natural gas and chemicals. China saw a decline in its import of natural gas in the first half of 2015 for the first time since it began importing gas – June saw an increase over May, but the overall trend is down. Lower power and coal costs help many of the basic material industries – Exhibit 4 looks at the relative price of aluminum versus Newcastle, Australia export coal prices. In absolute terms aluminum prices are very low, but relative to coal (as a proxy for electricity costs in China) they look fairly robust, suggesting that China has scope to accept lower pricing still. These lower energy costs help export economics for China in most materials, with steel being another big winner.

Exhibit 4

Source: Capital IQ, SSR Analysis

This is going to be a tough train to stop, and not surprisingly, when we group our Industrials and Materials universe into companies that have some degrees of insulation from this trend and those that do not, we see the performance difference that was highlighted in Exhibit 1. When we think about what insulates a company we are looking for geographic isolation (US Rails for example), technology differentiation (i.e. HON, MON, DD) or any other structural buffer. On the flip side we would avoid anyone with the direct commodity exposure.

The analysis yields several companies which sit in the more insulated bucket but have not performed in line with the insulated group, including two of our more favored names, EMN and PKG. On the negative side of the equation, the only good commodity exposure today is probably polyethylene/polypropylene as China remains deficit and will be that way for many years – good for LYB and DOW.

China’s Net Exports Trending Higher

The second derivative of this call is equally interesting “what happens when China effectively controls these materials markets”, but with the probable and likely exception of aluminum we are some distance from that and we will address the subject more fully in separate research.

The table in Exhibit 3 highlighted the growing importance of Chinese exports in various commodity markets over the past decade. This rise in exports out of China threatens to change the competitive landscape, disrupting market dynamics and price setting mechanisms. We have seen Chinese industry operate according to a government set plan, with companies showing little regard for profitability or return on investment – global oversupply has not stemmed the flow of exports emanating from China as yet. As China’s export share of global demand grows, the price implications become perilous. Supply constraints (real or manufactured) could result in extreme price spikes and could potentially allow Chinese producers to undercut competitors outside of China in downstream industries. In the past five years we have already seen the US’ trade deficit in Machinery widen and the EU’s trade surplus erode – Exhibit 5.

Exhibit 5

Source: US Census Bureau, Eurostat, SSR Analysis

Playing the Secular Trend – Finding the Companies Most Insulated

Given our view that China’s growing export dominance of global commodity markets is a secular rather than cyclical trend, traditional historical valuation indicators may accordingly be less relevant in this environment. To identify companies that are most insulated from/exposed to this China commodity theme, we have developed a multi-factor model as summarized below. A check in any of the green columns adds to a company’s rank and a check in the red “Commodity Exposure” column deducts.

Ranking the 120+ companies in our universe on these measures, we find:

  1. The most insulated companies on this framework have performed markedly better as headwinds have intensified over the past year
  2. EPS revisions held in significantly better for the most insulated companies in the face of dollar strengthening – this despite virtually identical non-US sales exposures on average

Exhibit 6

Source: Capital IQ, SSR Analysis

Even allowing for the possibility of a synchronous global recovery, we believe these most insulated companies will outperform moving forward as they are, by nature of the framework, the best entrenched and most profitable companies with well-established competitive positions and economic moats.

Of the most insulated companies on this analysis, the names summarized in Exhibit 7 are currently below mid-cycle valuation in our models. We highlight EMN, TRN, ALB, and PKG as companies that additionally have positive values on our Skepticism Index and have seen positive EPS revisions over the past three months – prior analysis has shown a very attractive risk-reward proposition when these conditions are met. Also refer to our recent stock-specific research on EMN, DD, DE, PX, and TRN.

Exhibit 7

Source: Capital IQ, SSR Analysis

Appendix:

©2015, 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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