Monthly Review November 2013 – Industrials Trail the Bull

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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

October 31st, 2013

Monthly Review November 2013 – Industrials Trail the Bull

  • Earnings continue to paint a mixed picture; on the whole earnings have surprised to the upside and revenues are up year over year, but revisions to Q4 earnings have been predominantly negative. Our view is that they might not be negative enough, given bleak views of US industrial production painted by PX and ARG.
  • Our most extremely valued sectors heading into the month were on opposite ends of the performance spectrum for October – Metals was the lone notable outperformer, while Paper suffered a 6% loss relative to the S&P. Capital Goods, Conglomerates (ex. GE), and Electrical Equipment also trailed a resilient October that saw the S&P up nearly 4.5%.
  • Paper’s poor month dropped it below Electrical Equipment on our valuation framework; the first month since we initiated coverage that Paper has not been the most richly valued sector. Metals ticked underneath two full standard deviations below normal value – it will take several similar months to bring this sector to fair valuation.
  • In October we wrote about the Capital Goods sector in general, Stanley specifically, and offered some thoughts on possible restructuring in the Chemical industry. We think CAT is unlikely to break $80 a share on the downside and believe SWK’s drop on an earnings miss makes it even more interesting.
  • For the first time, we outline our preferences by and within sectors below. We would maintain our focus on the undervalued large cap group and we continue to view AA and CAT as long term value opportunities – AA seems to have caught a bid recently and we have noted that historically when the stock has moved, it has moved quickly.

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

Another mixed earnings season has not dampened the enthusiasm in the broader markets which stand at or near all time highs. Overall, Industrials and Basic Materials have averaged an EPS surprise of 3.8% above consensus. Revenue growth year over year has been generally positive, averaging 5.7%. Large cap bellwethers have been a drag on these aggregated figures. Caterpillar in particular reported revenues that were 19% lower than a year earlier; the stock was down after earnings but held above the $80 level that has been the lower bound of its range for most of the year.
We believe further downside is limited in CAT
.

Strong earnings have sent transportation giants UPS and FDX to all time highs. Railroad earnings were mainly positive as well. UNP was the only rail stock to underperform; the company beat estimates and revenue grew 5%, but executives offered a cautious outlook for 2014 in the earnings report. In Exhibit 5 below we summarize Q3 so far in terms of earnings and revenue growth by sector – we only include those companies that have reported. The columns to the right show the surprises by group – the major negative surprises were in Capital Goods, from CAT and SWK.

Exhibit 5

Source: Capital IQ and SSR Analysis

The Metals space was driven higher by widespread outperformance within the group; the top three performers on the month were Metals stocks (CLF, X, WOR) while AA (14.2%) and FCX (11.1%) were strong as well. Altogether, the group has had the most positive EPS surprise among our sectors, beatings consensus by 18.2% on average (though this number is somewhat inflated by a 120% beat from Alcoa, $0.11 actual vs. $0.05 estimate). Revisions have stabilized and even turned positive in the past three months after being consistently beaten down for much of the year.

The Paper sector was already the worst performer in our group before MWV announced the sale of its US timberlands for $1.09 billion – the market reacted poorly to the news and shares fell 10%. The group as a whole had a resoundingly negative month, down nearly 7% versus the S&P.

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

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

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7 summarizes end-October sector discounts from normal value.

The gap between Paper and Electrical Equipment has been narrowing in recent months, and the Paper sector is no longer the most expensive among Industrials and Basic Materials, for the first time since we initiated coverage. At the other end of the range, there has been little change – the Metals sector is still the cheap standout. EPS surprises were the most positive in the group however, and revisions appear to have stabilized in recent months. Metals stocks were the best performers in October and dipped slightly below two standard deviations below normal value – there is still a long way to fair valuation.

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.

The Paper sector has supplanted Metals at the high end of the skepticism index; Paper companies are still substantially over-earning, but valuations have finally begun to capitulate after many months as the most fully valued in our group. We have
long been wary
of the very rosy expectations embedded in the Paper sector, and it is possible that valuation is leading returns. Electrical Equipment’s valuation appears warranted by equally above average returns.

Exhibit 8

Valuations Underestimating Current Returns on Capital

Valuations Overestimating 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 1 of our October monthly. The results are summarized in Exhibit 11, showing performance relative to the S&P, which rose 4.5% month over month.

October was a middling month for our portfolios. The skepticism screen produced the best result, outpacing the market by 1.5%. Our other two screens were off 1% or less. Thought it was not the case this past month, the overlap screen is typically most robust, and the results confirm this – aggregating monthly returns for our portfolios year to date shows an excess return on the overlap portfolio of 9% (excluding transaction costs) – Exhibit 10.

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 government shutdown mercifully came to a conclusion in October, but its effects on consumer and business confidence continue to trickle through the economy.
We wrote towards month’s end
that earnings reports from manufacturing sensitive companies cited a stagnant US industrial environment. Flash PMI readings showed a sharp drop in output, below the 50 level indicating expansion, to 49.5 from 55.3 in the prior month. The Fed held tight in its accommodative policy but, given the indications of slowing economic activity, there are concerns that the time to taper may have passed.

Europe’s weakness continues, and Euro zone unemployment data showed a record high 12.2% in September. Germany is one of the few bright spots on the continent; the peripheral countries remain in a struggle to reduce historically elevated levels of unemployment.

In Asia, Chinese growth continues to ease, and it was reported that the top four Chinese banks saw the largest jump in defaulted loans since 2010. This is just one of the challenges facing China as it attempts to reign in lending while maintaining target growth levels.

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

Exhibit 12

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

Commodity Pricing

Metal pricing was mixed in October and remains strongly tied to Chinese demand and interest rates influenced by the Fed’s easy monetary policy. Aluminum was up 2%, Steel gained 4% and Copper was essentially flat. Prices for crude oil were essentially flat – Brent crude rose slightly, while WTI was off similarly. Natural gas ticked up 4%, ending the month near $3.75/mmBTU.

Lumber pricing has been strong in recent months, and is approaching the multi year high reached earlier in 2013. The US Paper industry has seen some changes in the competitive landscape; last month IP closed its Alabama paper mill, clipping 8% of North American supply, while MWV recently sold its US timber interests for $1 billion. Two Canadian firms have announced plans to close sawmills in British Columbia, sparking supply concerns and driving the pricing increase. The B.C. interior is still dealing with the effects of a pine beetle infestation that decimated forests in the region.

US commodity prices 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. The gap between the Conglomerates inclusive versus exclusive of GE has narrowed considerably since the beginning of the year. The group including GE began the year as the second most optimistic sector – despite recent positive earnings that drove the stock to levels not seen since 2008, GE’s 2015 net income estimate has come down 7.5% on the year, weighing on the overall average. Capital Goods continues to show forecasts of net income that are notably depressed from 2012 levels, the only sector to show such a decline.

Exhibit 18 & Exhibit 19

Source: Capital IQ and SSR Analysis

Exhibit 20 shows how these longer term estimates have changed over the month. The Capital Goods sector saw the most extreme negative revisions after CAT reported continued weakness in the mining sector. Paper’s estimates were also slashed; the group still shows the most forward optimism in Exhibit 18 above, but estimates have been coming down consistently in recent months. Revisions were most positive in the Packaging sector, on both a weighted and unweighted basis, and have been strong for the past several months; the group is challenging Transports in the ordinal rankings above in Exhibit 18.

Exhibit 20

Source: Capital IQ and SSR Analysis

Metals was the only sector to see positive revisions to 2013 EPS estimates, as companies consistently lowered their Q4 targets in earnings reports. Capital Goods saw the most severe cuts, highlighted by a 13% decline in CAT’s full year EPS guidance.

Note that the numbers in Exhibit 21 differ from those in Exhibit 3 as the data is market cap weighted in Exhibit 21 and is a simple average in Exhibit 3.


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 28Exhibit 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

Skepticism High

Optimism High

Exhibit 39

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

Optimism High

Skepticism High

Exhibit 43

Exhibit 44

Exhibit 45

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in October

October 29, 2103 – PPG: What Do You Have to Believe

October 28, 2013 – MOS/CF: Clever Bit of Financial Engineering for Both Companies

October 21, 2013 – Common Sense Restructuring: Some Money To Be Made

October 16, 2013 – Chemicals Monthly: More Concerns Than Opportunities

October 6, 2013 – The Case for Stanley: Why Reversion to the Mean Often Works

October 3, 2013 – Capital Goods: Unloved and Presenting Opportunities

October 1, 2013 – Monthly Review October 2013: Industrials Riding the Wave of Easy Money

Dividends

In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. This month BRC joins holdovers DE and OLN as the only stocks that appear on all three screens.

Exhibit 46

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2


Appendix 3


Appendix 3

©2013, 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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