Monthly Review March 2014 – Divergent Month for Industrials & Basics as Market Rallies

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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

March 3rd, 2014

Monthly Review March 2014Divergent Month for Industrials & Basics as Market Rallies

  • The S&P retraced all of January’s losses and more, but February was a mixed month for Industrials and Basic Materials – our sectors were spread across a continuum of over and underperformance. Chemicals and Packaging each gained more than 3% versus the market; Transports brought up the rear as all three of its subsectors were relatively weak.
  • 2013 results are nearly all in the books – in our coverage only ROC, JOY, URS, and HTZ have yet to report. Revenue growth year over year was positive for all sectors, most strongly in Packaging (8.8%), Electrical Equipment (8.4%), and Transports (11.1%), less so for Conglomerates (1.7%) and E&C (1.6%).
  • The incorporation of full year 2013 data (particularly net capital) into our models has lessened the valuation premiums seen in the Paper and Electrical Equipment sectors. Both are still expensive at a level (1 standard deviation above our normal value). The Metals sector, long the most undervalued in our space, retains its record discount (2.5 SDs below norm).
  • February research included an early month screen of expensive companies with healthy Q1 estimates and US exposure likely to be affected by the notoriously cold weather year to date; a cautionary stance on Commodity chemical stocks, where rising estimates are questionable given the weather related spike in natural gas pricing; and two pieces on Dow Chemical, one focused on the likely battle between company management and its current activist investor, and one offering our own optimal path for DOW.
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. AA appears to have some real momentum behind it– we noted in 2013 that the stock has tended to move quickly when it moves. It remains attractively valued despite this recent gain. Another longtime favorite, CAT, spiked in January on positive earnings and we see further upside. Our Chemical concerns have been adjusted to reflect our cautious Q1 outlook for Commodity companies LYB and WLK.

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

With 2013 earnings largely in the books, and the associated full year data incorporated into our valuation models, we are left with the same basic picture of the Industrials and Basic Materials space – with a few slight alterations. Paper and Electrical Equipment still look expensive, but somewhat less so. The Capital Goods sector lost some of its valuation discount but remains the best value outside of the still cheap Metals group – part of this gain can be attributed to the +2% relative performance for the month.

Indeed, machinery stocks were the best performers over February, with Capital Goods and Electrical Equipment companies dominating the list of largest gainers. TRN, GNRC, PCAR, CMI, FLS, CR and GGG were all up over 10%. Ag focused equipment companies continue to lag however, as DE, AGCO and VMI were among the worst performers in our coverage on the month.

KSU continues to struggle after a very poor earnings report and subsequent drop in January. Rail stocks on the whole have been trailing the market; fourth quarter US GDP was revised down, and this is a group that is inherently very sensitive to the fortunes of the domestic economy. Another domestically exposed sector, E&C, had two of the four worst performers, KBR (which fell 14% on the last day of February alone after significantly lowering guidance) and URS (yet to report, but pre-released lower guidance). Best and worst performers at the company level in our coverage universe are summarized in Appendix 1 .

With earnings invariably come revisions – Metals, Paper and Transports all saw EPS estimates sizably cut, which was reflected in their performance on the month. Likewise, Packaging stocks were among the few to see upward revisions and this was the best performing sector for the month.

Exhibit 5 summarizes 2013 year over year revenue growth by sector and subsector. Parentheses indicate the number of companies that have reported. Note that for Capital Goods the sum of companies reporting by subsector does not equal the sector total, as some stocks are included in multiple subsectors.

Revenue in the Conglomerates sector was actually up 5% year over year, excluding the smallest constituent of our index, CSL, which saw revenues decline by 14% from Q4 2012. The Transports sector as a whole was boosted about five percentage points by a strong 72% increase in revenue from GWR.

Exhibit 5

Source: Capital IQ and SSR Analysis

Sector performance relative to the S&P is shown in Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 summarizes end-January sector discounts from normal value. The valuation discount in the Metals sector remains at the highest level seen since 1980, unchanged from a month ago at exactly 2.5 standard deviations below our “normal” value. Electrical Equipment and Paper are still the two most richly valued sectors, but as mentioned previously, the magnitude of the premium has moderated with the inclusion of updated capital data; actual net capital was higher than the trends indicated, resulting in a slightly higher “normal earnings”/“normal value” and in turn a diminished premium. As the Exhibit suggests, GE is indeed the cheapest Conglomerate; however, while without GE the sector is the third most expensive, this premium is driven by the lofty valuation for HON (3.13 standard deviations above normal). DHR is slightly under normal value, MMM and UTX slightly over.

Exhibit 7

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 8. 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 and Paper switched places at the top of the sector Skepticism Index chart – Exhibit 8. Full year 2013 data produced only marginal changes in the sector SI values. Electrical Equipment has been creeping up in the Skepticism Index rankings for the past several months and now shows the most extreme value outside of the Paper and Metals sectors; returns here are anticipated to be higher even than the group’s valuation premium would indicate.

Exhibit 8

Valuations Overestimating Current Returns on Capital

Valuations Underestimating Current Returns on Capital

Source: Capital IQ and SSR Analysis

Exhibit 9 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 9

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 February monthly.

After a very good showing in 2013, our portfolio picks have stumbled early on in 2014. February performance was negative across the board. The Overlap screen continues to be the most effective.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

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.

The US economy expanded at a slower pace in Q4 than first estimated, growing 2.4% versus the initial gauge of 3.4%. Orders for core capital goods, however, rose unexpectedly in January at the strongest rate since last May. This is a fair proxy for capital expenditures; business spending will need to be robust to buoy an American economy and consumer that appeared to grow colder with the weather . Overall, despite some (perhaps weather driven) mixed data, investors appear convinced of Janet Yellen’s control of the economy, and the market recouped all of January’s losses and continued to reach new highs.

The Chinese yuan has notably weakened versus the US dollar recently; the country is believed to be widening the range it allows its currency to trade it, after notoriously pegging it over the past several years. This is but one of the areas in need of reform in China. The Russian Ruble has significantly weakened as well, as the conflict in Ukraine weighs on the regional power.

The most recent Macro data changes are summarized in Exhibit 12.

Exhibit 12

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

Commodity Pricing

Natural gas pricing was off its highs after cold weather tapped inventories. Prices for crude oil were up, 3% each for WTI and Brent.

Metals pricing was stable; Copper and Steel were little changed month over month, while aluminum rose 3%

US commodity and energy prices are indexed in Exhibits 13 through 17.

Exhibit 13

Exhibit 14

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

Exhibit 15

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 16

Exhibit 17

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 18 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 next month, as complete full year data comes in. Transports supplanted Paper at the top of the ranking in Exhibit 18. Capital Goods remains the only sector to show a decline from 2012 net income levels, but the Metals sector narrowly avoids joining this list.

 

Exhibit 18 & Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 shows how these longer term estimates have changed over the month. Transports ascension over Paper was due more to Paper’s loss than Transports’ gain. Outside of Metals, the Paper sector showed the biggest weighted decline month over month. Capital Goods actually saw a gain in February but it was not nearly large enough to raise the group to a positive expectation for three year net income growth.

Exhibit 20

Source: Capital IQ and SSR Analysis

Exhibit 21 summarizes changes in 2014 EPS estimates over the past month. Paper, Metals, and E&C were notable decliners. Paper was driven down by its cap leader IP, whose estimate dropped 11% on the month, more than overshadowing a 6% at UFS. LPX’s 2014 EPS estimate was down sharply as well, off 32% from $1.10 to $0.74. NEM in the Metals sector saw an even greater decline, heavily influencing the group result. E&C’s change was largely a function of URS, which guided down, shaving 24% off of its estimate.

Note that the numbers in Exhibit 21 differ from those in Exhibit 4 as the data is a market cap weighted index in Exhibit 21 and a cap weighted average of percentage changes in Exhibit 4.

Exhibit 21

Exhibit 22

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 23 through 33.

Exhibit 23

Exhibit 24 Exhibit 25

Exhibit 26

Exhibit 27

Exhibit 28 Exhibit 29

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Exhibit 32

Exhibit 33

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 34 through 45.

Exhibits 34-36

Exhibit 34

Optimism High

Skepticism High

Exhibit 35

Exhibit 36

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Optimism High

Skepticism High

Exhibit 38

Optimism High

Exhibit 39

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Exhibit 41

Skepticism High

Optimism High

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibits 43-45

Exhibit 43

Optimism High

Skepticism High

Exhibit 44

Exhibit 45

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in February

February 3, 2014 – Should We Care About the Weather?

February 9, 2014 – Rising Natural Gas Prices AND Rising Commodity Chemical Company Estimates: How Can This Be?

February 17, 2014 – DOW: Loeb vs. Liveris – Watch From a Distance

February 24, 2014 – DOW: A More Optimal Path, But a Hard Destination to Reach

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. A month after falling out of the valuation screen, DuPont reappears on all three metrics, joining longtime holdover SWK, and OLN (which returns this month to the SI screen)

Exhibit 46

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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