Dispersion within Industrials & Basics – Opportunities at Either End of the Spectrum

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.883.1927

gcopley@/nlipinski@ssrllc.com

December 22th, 2014

Dispersion within Industrials & Basics – Opportunities at Either End of the Spectrum

  • Valuation dispersion within Industrials & Materials remains at a historically elevated level and provides opportunities on the long and short side heading into 2015. The dispersion is being driven by the Metals and E&C sectors on the cheap side and the Transports and Conglomerates sectors on the expensive side – we show historical dispersion at the sector level, the most/least expensive names in each group, and any divergence between small and large cap stocks.
  • Of the most expensive companies, RPM, SHW, SNA and HON are anticipating EPS growth in excess of their respective annual averages from the year 2000. The coatings stocks in particular are pricing in 2015 EPS growth of more than double their decade plus CAGR.
  • Of the least expensive companies, EMN, SWK, PKG, BRC and MWV show consensus 2015 earnings growth that is at or above historical averages, but not overly optimistic in our view given the respective platforms.
  • The divergence between SNA and SWK looks particularly interesting. Stanley’s Security segment has held the stock back but its Industrial & Auto Repair segment is a close comp for SNA – with the Security margins continually improving and a tactical divestment of chronically underperforming European geographies likely, it may be time for SWK to catch up. Other intriguing pairings include large caps CAT and DOW, which have historically traded closely together but are currently near a 20 year peak valuation divergence (CAT cheap vs. DOW) – a similar story is seen in large cap Electrical Equipment manufacturers EMR and ROK (EMR cheap vs. ROK).
  • Overall, if 2015 has a binary outcome in terms of GDP growth, we would look for opportunities in CSX, MWV and PKG in the scenario where the US continues to be the main source of growth; and CAT, EMN, SWK long and SHW/RPM and SNA short in the scenario where global economies accelerate – Exhibit 1.

Exhibit 1

Overview

Exhibit 2 is a graphical representation of the range of valuations for the 120+ companies in our coverage – the more dispersed, the more companies we have that fall at extreme valuation discounts and premiums.

The data in the exhibit represents the standard deviation of the valuation discounts/premiums for all the companies in our coverage, based on our return on capital generated, “normalized” value framework. The spread between the cheap and expensive stocks in our universe has been this high on only a few instances in the past and indicates there should be opportunities on either end heading into the New Year. ⅔

Exhibit 2

Source: Capital IQ, SSR Analysis

At the stock level there are some instances where 2015 expectations seem reasonable for names with valuation support, and others where more elevated valuations leave us wary of stocks with estimates that appear to be optimistic – Exhibit 3. EMN, SWK, PKG, MWV, and BRC all look like cheap stocks that should achieve consensus earnings growth. RPM, SHW, HON, and SNA are significantly expensive and should have more marginal downside if earnings fail to meet healthy expectations.

Exhibit 3

Source: Capital IQ, SSR Analysis

Note: MWV historical EPS CAGR taken from 2002 merger

At the macro level, expectations for 2015 are on par with what we have seen over the past few years – China continues to moderate, Europe struggles to stimulate growth, and the US remains a steadying force of (admittedly slow) growth. Cratering oil prices are clearly having a negative impact on equity markets but the impending effects on global economies are less clear – academia suggests that lower oil prices have not had a statistically significant negative impact on the GDP of major developed nations, though the post OPEC bust economic boom of the late 1980s would suggest otherwise. Absent an acceleration of global growth, the US focused names that we prefer include:

  • PKG – Lower crude helps demand and transport costs, still relatively attractive
  • MWV – 66% of sales derived in the US, tied to consumer non-durable goods
  • CSX – Rails an obvious play on continued domestic strength and not cheap as a group, but CSX is the cheapest of the bunch

If lower oil stimulates the world, we would look to CAT for its strong operating leverage and broad global exposure. On the short side, SHW and RPM would have less leverage to a global pickup in demand, are significantly expensive, and are discounting considerable EPS growth.

Sector Level Analysis

The dispersion data in Exhibit 2 was a simple standard deviation calculation, so to examine the sectors that are driving the wide range of valuations seen, we took a simple average of discounts/premiums to normal by sector and found that the Metals and E&C sectors are the cheap outliers and Transports and Conglomerates the expensive ones in aggregate – note these figures in Exhibit 4 are different from our market cap weighted sector valuation indices, which we
publish monthly
.

Exhibit 4

Source: Capital IQ, SSR Analysis

E&C is the cheapest sector on average but the dispersion is extreme – we have ACM, KBR and FLR all near two standard deviations above their respective “normal” values, while EME and JEC are nearing 1 standard deviations below theirs. The machinery sectors (Capital Goods and Electrical Equipment) are reasonably valued on average but have extreme valuations on either end of the spectrum and are the next most dispersed after E&C. Paper & Packaging and Metals stocks are mostly concentrated on the cheap side, and Transports are mostly concentrated on the expensive side – Exhibit 5. This chart shows the standard deviation of current valuations – we would focus on the sectors 1 or more standard deviations dispersed.

Exhibit 5

Source: Capital IQ, SSR Analysis

Below we show the dispersion for each sector, the cheapest and most expensive stocks within each group that are driving that dispersion, and a small/large cap cut (based on an even split).

Chemicals

The dispersion pattern for the Chemicals sector is broadly similar to that of the Industrials & Materials group as a whole, but has declined in recent months while the group at large has increased. At the stock level,
PX
and
EMN
are two value plays we have highlighted recently. Note that three of the five most expensive Chemical names are in the Coatings space. The dispersion gap between small and large cap stocks (based on an even split of the 30 companies in our index) has opened up again as strength in Coatings (SHW) and weakness in Commodity (WLK, LYB, DOW) has increased the valuation spread within the large cap group.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Capital Goods

As we saw with Chemicals, the Capital Goods dispersion chart looks similar to that of the group as a whole – not surprising given that together the two sectors make up 60 of the 120 plus companies in our coverage. Unlike in the Chemicals sector, dispersion here is trending higher and there is currently no dispersion gap between the small and large cap components. The SNA-SWK trade sticks out on a pure valuation basis. Of the other stocks at the extremes, our only position would be
a constructive one on DE
.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Looking across the Chemicals and Capital Goods sectors, another interesting pairing of stocks shows CAT and DOW near a 20 year valuation divergence. These stocks typically trade in tandem, but CAT has grown cheaper as global growth has slowed and construction markets have remained sluggish, while DOW has been bid up by an activist investor and has generally grown relatively expensive given the North American feedstock advantage that has existed over the past several years. With this advantage now seriously eroded, DOW could take a tumble if Third Point decides to cut its losses – we would expect the valuation gap in Exhibit 13 to close quickly in this instance.

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Paper & Packaging

Dispersion within the Paper & Packaging space is the lowest among our sectors and is not at a particularly high level relative to history. The can makers, BLL and CCK, continue to screen expensive while industry volumes are flattish. CCK is less extended than BLL on this and other metrics (EV/EBITDA, relative PE) and has superior growth prospects. ATR is expensive relative to itself, but looks cheap relative to the broader Packaging group. PKG remains our favorite here. The large cap group is more dispersed due to the premium in the can makers (BLL, CCK) and the discount in the containerboard names (PKG, IP). The smaller cap names are currently all on the cheap side, with the exception of ATR.

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

Electrical Equipment

Dispersion within Electrical Equipment is off its recent highs, but still relatively elevated with a number of stocks on both the cheap and expensive ends. Brady Corp (BRC) screened well in
our small cap analysis from October
and has performed well since then but remains undervalued. ROK is currently the most expensive stock in this group and fellow large cap EMR is among the cheapest – these stocks have tended to trade in tandem, but the divergence is currently near an all-time high – Exhibits 20 and 21. IIVI has a collection of esoteric laser businesses and technologies and has performed well since streamlining their segments a few months ago – this is one of the smallest cap stocks in our coverage and could be an interesting takeout candidate, particularly given its discount.

Exhibit 17

Source: Capital IQ, SSR Analysis

Exhibit 18

Source: Capital IQ and SSR Analysis

Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20

Source: Capital IQ and SSR Analysis

Exhibit 21

Source: Capital IQ and SSR Analysis

Metals

The Metals sector has been unloved for several years now and has underperformed considerably in recent months – the fifth most expensive stock in this group is actually undervalued on our framework. The small cap stocks have been more dispersed recently, as this group encompasses the most expensive stock in the sector (WOR) and one of the cheapest (CLF). The large caps are more uniformly cheap (FCX, NEM, NUE) and have remained so with
the notable exception of AA
. We like the AA story as we think the metal itself is in a better place from a global supply/demand perspective and because we like the strategic moves the company is making – we expect the stock to trade much further above our historic normal value.

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24

Source: Capital IQ and SSR Analysis

Transports

The Transports group has benefitted from the relative strength in the US economy. The Rail and Trucking companies have some of the most elevated valuations but the group on average is the most expensive within Industrials & Materials – the fifth cheapest stock is actually slightly overvalued (the opposite of what was seen in the Metals sector). Dispersion has been ticking up but is not exceptionally high versus history. It is perhaps not surprising to see the North American focused companies (ODFL, KSU, JBHT, LSTR, UNP) are the most expensive, while those with international exposure (UPS, EXPD, CHRW) are on the cheap side.

Exhibit 25

Source: Capital IQ and SSR Analysis

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

©2014, 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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