Industrials and Materials: Value in 2017 – Our Thinking

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 3rd, 2017

Industrials and Materials: Value in 2017 – Our Thinking

  • Our thorough and well tested valuation tools provided very strong out-performance in 2016.
    • Today they suggest investors should be overweight Metals and Mining and Paper and Packaging and underweight Transports and Electrical Equipment. At the Stock level the analysis suggests:
      • Overweight within sector: OLN, GE, KBR, ATI, PKG and KSU
      • Underweight within sector: LECO, HON, EME, BRC, CMC, X and ATR
  • Our focus on identifying investment opportunities within the cyclical Industrial and Materials sectors centers around understanding average or “mid-cycle” returns on capital. Most companies (despite changing rhetoric) deliver predictable returns over multiple cycles – understanding this and what you are paying for it is a critical factor in sector and stock selection. Our framework applies a consistent approach to all companies to identify:
    1. The current level of “average earnings”, what we refer to as normal earnings, and,
    2. Using the average historical multiple determine a “normal” price
      • We then dimension how far above and below the stocks are trading at any point in time.
    • Clearly this is not the only indicator that helps predict outperformance but it is a key value based approach that can be combined with company level analysis.
    • Over time this has helped provide solid investment returns; the methodology was only applied to Chemicals from 1990 to 2004, has evolved significantly over the years, and has generated outperformance in 16 out of 19 years (there was a break from ’04 to ’12).
  • As our methodology has evolved and broadened we have added a Skepticism Index which has enhanced the efficacy of the model as it looks at whether valuation is reflective of current profitability or is expecting/lagging a change.
  • The Sector based rankings are shown in Exhibit 1 and the best and worst stock ideas on this basis are summarized in Exhibit 2.
    • In the tables we include a couple of more traditional metrics such as price to forward earnings and enterprise value versus return on tangible capital for comparison.
  • Optimism” gets to heart of management capital allocation decisions; identifying companies that consistently are too optimistic in guidance and tend to underperform as a result. We list those companies that over the last few years have moved to the top of our “optimist” pile – based on history; the companies most likely to disappoint in 2017. We also show the group at the other end of the scale – those most likely to over-deliver.
    • Screening against valuation we highlight WLK, LYB, TRN, PKG, and AGCO on the positive side and BRC on the negative.

Exhibit 1 – Sector Rankings

Source: Capital IQ and SSR Analysis

Exhibit 2 – Company Picks

Source: Capital IQ and SSR Analysis

Overview/Methodology

Our “Normal Value” screen was first developed in the early 1990s as a measure of how far companies in cyclical industries and with very different business mixes were from their valuation norm. In other words, how valuation compared with the company’s own history rather than with another company in the same space. We found that a company’s valuation deviation from its own trend was a much better predictor of performance than how it compared with others, and that by selecting companies that were most distant from their “norm” you generated better returns, both on the upside and the downside, than by comparing companies on similar metrics such as P/E or EV/EBITDA.

The model was built for a relatively small group of chemical stocks and generated positive relative returns (versus the S&P500) in 13 of the 15 years we had coverage – it generally failed late in investment cycles when momentum rather than value took over investment styles.

At SSR we have focused far more on these valuation tools than we have on trying generate “me-too” like company models and have enhanced the work in several ways:

  1. We have significantly increased the companies covered within chemicals.
  2. We have extended the methodology right across U.S. Industrials and Materials with the exception of Aerospace and Defense.
  3. We have fine-tuned our return on capital based “normal earnings” model by allowing companies with defined trends to follow those trends rather than simply using an average.
  4. We have developed a “Skepticism” model, which shows how aligned current valuation is with current earnings – i.e. whether the discount or premium in a stock is explained by current earnings deviations from normal or whether the stock is predicting a change in earnings.

In our Industrials and Materials monthly report, published alongside this report, we show how our metrics have screened in each of the four years that they have been used at SSR. The summary charts are shown again in Exhibit 3. The tool that selects stocks that look undervalued or overvalued on both our normalized and skepticism metrics has outperformed for three of the last 4 years and by an extreme in 2016. Value driven investment cycles seldom last only one year, and it is likely that these tools will work well in 2017 also.

Exhibit 3

Source: Capital IQ and SSR Analysis

Optimism

Optimists are defined as those companies who consistently miss beginning of the year guidance. We are assuming that sell-side analysts’ aggregate expectations on January 1st are a reflection of company guidance, whether it be implicit or explicit guidance (the large number of covering analysts tends to average out any outliers). This is often very management team or governance specific, and companies can improve their understanding and messaging and move off the optimist list, or become increasingly over-confident and move off the conservative list. The most optimistic and conservative companies by sectors, based on analysis of the last 5 years, are summarized in Exhibit 4. When we look this list versus the valuation metrics we see that the following optimists are expensive – suggesting downside: BRC most notably but also UPS and GE at a lesser valuation extreme.

The following conservative names look inexpensive – suggesting upside surprises and outperformance: WLK, LYB, TRN, PKG, and AGCO. In Exhibit 5 we list the companies which screen as most or least interesting based on the three metrics regardless of industry.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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