Monthly Review January 2014 – Charging Into the New Year

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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

January 1st, 2014

Monthly Review January 2014Charging Into the New Year

  • Stocks remained very strong in December despite the taper confirmation – every sector within Industrials and Basic Materials outperformed the S&P in the final month of 2013. E&C and Chemicals were the “weakest” outperformers, and Paper, Packaging, and Metals the strongest.
  • Paper and Metals exit 2013 in the same positions in which they entered; the expensive and cheap outliers, respectively, in our group. Outside of Metals, only the Capital Goods sector shows any aggregate valuation discount; the others exhibit varying degrees of premium, most pronounced in Electrical Equipment and Transports, most marginal in Conglomerates, E&C and Chemicals.
  • Aggregating monthly returns for our portfolios, the hedged overlap portfolio of valuation and skepticism screens produced a robust relative return of 15.6% in 2013. December’s gain contributed 3.1% of that total. This screen was far more effective in the second half of the year than the first.
  • December research included a review of our investment thesis on DuPont, a look forward to the US ethylene market in 2014, and our perspective on exporting shale.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. AA, a longtime favorite, took off in Q4 2013 (31% quarterly gain), finishing the year above $10 per share – we noted earlier in the year that the stock has tended to move quickly when it moves. It remains attractively valued despite this gain.

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SSRSI measures current valuation versus current return on capital and what movement in returns on capital is implied in valuation.

Exhibit 3

Source: Company Reports and SSR Analysis

See
Appendix 3
for the data underlying this exhibit.

Exhibit 4

Overview

Indicators heading into 2014 give reasons for cautious optimism. Industrial production data has been strong for the past several months, and consumer and construction spending rose steadily throughout 2013.

Revisions to 2014 EPS estimates were modest during December, down 1% for Capital Goods, Conglomerates, and Metals, and little changed for the other sectors. Year end portfolio rebalancing could have been the driver behind the widespread outperformance within the group. We saw very strong performance in December from many of the laggards in each group.

The Chemicals group as a whole beat the S&P by a modest 1.5% over the month, but strength was concentrated in the Commodity subsector – OLN (+17.2% in December) and DOW (+14%) were two of the three best performers in our universe. Transports had been the second weakest sector until late in the month when widespread rail gains and the HTZ activist driven move pushed the group to the middle of the pack.

Best and worst performers at the company level in our coverage universe are summarized in
Appendix 1
.

We will publish our best ideas for 2014 on the 6th, and we will continue to focus on the undervalued names that have reasonable estimates for 2014 and where valuation suggests that investors are skeptical about the ability to meet those estimates.

Sector performance relative to the S&P is shown in Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6 summarizes end-December sector discounts from normal value, and shows how valuations have changed over the year. Metals stocks entered 2013 cheap, and will enter 2014 even cheaper. A strong year for Conglomerates has brought the group near fair valuation after starting the year looking attractively valued. Electrical Equipment and Transports grew more expensive, while Packaging flipped from slightly cheap to modestly expensive. Capital Goods lost some (but not much)of its valuation discount over 2013 but in aggregate the sector remains undervalued. Our Paper index lost one of its components to a buyout during 2013 (BKI), and its discount from normal value nearly exactly reflects that of its biggest constituent by market cap, International Paper – MWV and LPX are both significantly above normal value on our framework as well, while UFS is the only undervalued stock in the index.

Exhibit 6

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 7. As a reminder, our Skepticism Index measures how in or out of phase current valuation is with current returns on capital. A positive number suggests that either valuation is discounting a decline in return on capital or the stock has upside. On the flip side, a negative number suggests that returns have to rise to justify valuation, or the stock has downside.

Metals moved back in front of Paper at the top of Exhibit 7. The Paper sector’s up month merely brought valuation closer into line with currently very above average returns. Values and rankings for the other sectors are otherwise little changed month over month. Note that the return on capital metric captures forward 12 month earnings estimates and part of the reason why the Paper sector screens here as it does is because consensus estimates for 2014 call for huge earnings gains over 2013.

Exhibit 7

Valuations Underestimating Current Returns on Capital

Valuations Overestimating Current Returns on Capital

Source: Capital IQ and SSR Analysis

Exhibit 8 is a very busy chart but shows how each sector and sub-sector breaks down by SSRSI component – valuation versus ROC. All things being equal, you want to buy sectors in the top right corner and sell those in the bottom left.

Exhibit 8

Source: Capital IQ and SSR Analysis

Portfolio Performance

We again tracked our model portfolios over the month, one based on our normal mid-cycle earnings screen, one based on our Skepticism Index and one based on the stocks that appeared on both metrics. Effectively, we bought the cheapest/most Skeptical and we sold short the most expensive/least Skeptical, as summarized in Exhibit 2 of our December monthly. The results are summarized in Exhibit 10, showing performance relative to the S&P, which rose 2% month over month.

As it has for most of the year, the hedged overlap portfolio produced the best return. Valuation and skepticism screens were also notably positive in December. Aggregating 2013 monthly returns for our portfolios shows an excess return on the overlap portfolio of nearly 16% (excluding transaction costs) – Exhibit 9.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

In
Appendix 2
we show the companies coming into our screens and leaving our screens.

Macro Environment

At SSR we are not economists, nor do we seek to be. We look at the economic indicators that are publicly available and put them into context relative to the drivers within the industries we cover. We examine trends or fundamental influences and we then look at these relative to valuation with the goal of identifying mismatches between what is implied in valuation and what is expected to happen.

Chairman Bernanke disclosed definitive details on the long awaited Federal Reserve tapering of bond purchases, and investors reacted favorably to the announcement. Employment indicators are strong enough for the Fed to feel comfortable tightening the reins just a bit, and the central bank appears committed to stepping in again should weakness persist in the labor market. The notorious fiscal drags of 2013 are unlikely to plague the economy again in 2014 as legislators have reached a budget agreement. Simply eliminating the political uncertainty should prove a boon to the economy at large, and bullish sentiment appears high, even with the S&P coming off a 29% yearly gain.

A recent report forecasts that the British economy will overtake Germany as Europe’s largest by 2030, highlighting the limitations German participation in the EU presents to the country. Europe enters 2014 still shackled by debt and facing continually stagnant economic growth. China, meanwhile, has sidestepped a “cash crunch” but its banking sector remains one of several areas in need of reform.

The most recent Macro data changes are summarized in Exhibit 11.

Exhibit 11

Source: Capital IQ, Government Publications, Bloomberg, SSR Analysis

Commodity Pricing

Natural gas pricing shot up over December, rising 13% to eclipse $4.00/ per mmBTU. This was partly a function of a colder than expected start to 2014. Crude oil was up as well, but less sharply so.

Metal pricing was mixed and moderate – Aluminum up 1%, Steel down 3%. Copper rose 5% to a multi-month high. On the whole, pricing here was less sensitive to the announcement of the Fed taper than might have been expected. Commodities tended to recoup losses suffered in the immediate aftermath of the tapering decision.

US commodity prices and energy prices are indexed in Exhibits 12 through 16.

Exhibit 12

Exhibit 13

Source: Capital IQ, IHS, CRU Steel Price Index, Bloomberg, SSR Analysis

Exhibit 14

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 15

Exhibit 16

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 17 we look at expected net income growth by sector, comparing 2015 estimates with 2012 actual net income. This exhibit will be updated with 2013 net income figures as full year data comes in. 2015 net income estimates have changed considerably in some instances. Capital Goods, Metals, and Conglomerates notably have seen declines in estimates over the year, with Cap Goods now actually showing net income contraction from 2012 levels. At the optimistic end of the spectrum, the Paper, Transports, Packaging, E&C, and Chemicals sectors are all anticipating higher levels of income in 2015 than they were at the start of this year.

Exhibit 17 & Exhibit 18

Source: Capital IQ and SSR Analysis

Exhibit 19 shows how these longer term estimates have changed over the month. Changes were most negative for Conglomerates and Metals. The Paper sector saw an increase on an unweighted basis, but IP’s estimate was little changed, which is more reflected in the weighted rankings. Similarly, the aggregate Packaging sector estimate was flat (unweighted) but RKT’s increase was more pronounced with cap weighting.

Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 summarizes changes in 2014 EPS estimates over the past month. Revisions were modest, and mostly negatively so. Paper and Packaging were the only sectors with even slight increases in 2014 EPS estimates (and also the two best performing sectors in December).

Over this past year, 2014 EPS revisions have been most extreme for the Metals (down 41%) and Capital Goods sectors (a 19% decline). Conglomerates (+2.2%) and Packaging (+3%) were the only sectors to see an increase in 2014 EPS estimates over the year just ended.

Note that the numbers in Exhibit 20 differ from those in Exhibit 3 as the data is market cap weighted in Exhibit 20 and is a simple average in Exhibit 3.


Exhibit 20

Exhibit 21

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Mid-Cycle “Normal Valuation Analysis

Results of our valuation analysis for the end of November are summarized in Charts 22 through 32.

Exhibit 22

Exhibit 23

Exhibit 24

Exhibit 25

Exhibit 26

Exhibit 27Exhibit 28

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Exhibit 31

Exhibit 32

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 33 through 44.

Exhibits 33-35

Exhibit 33

Optimism High

Skepticism High

Exhibit 34

Exhibit 35

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibit 36

Exhibit 37

Optimism High

Skepticism High

Exhibit 38

Optimism High

Exhibit 39

Exhibit 40

Skepticism High

Optimism High

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibits 42-44

Exhibit 42

Optimism High

Skepticism High

Exhibit 43

Exhibit 44

Source: Capital IQ and SSR Analysis

Research Published in December

December 30, 2013 – DD: Still An Interesting Investment

December 16, 2013 – US Ethylene: The Case for a Better 2014

December 16, 2013 – Chemicals Monthly: Looking Pricey as We Enter a New Year

December 10, 2013 – Exporting Shale: A More Logical Perspective

December 2, 2013 – Monthly Review December 2013: New Year Focus With Revisions Negative

Dividends

In Exhibit 45 we show a screen of stocks with low value, high Skepticism and high dividend yield. DD had been appearing on all three screens for the past several months, but has dropped out of the valuation screen after another strong month –
see recent
and
past research
. DE also popped up on all three screens last month but has fallen out of the top 25 yielding stocks in our coverage. OLN, another recent fixture in the overlap, has fallen out of the skepticism screen, leaving SWK as the only stock to appear on all three metrics.

Exhibit 45

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2


Appendix 3


Appendix 3

©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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