Optimists Won in 2013, but Are Now More Optimistic and Much More Expensive

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 20th, 2014

Optimists Won in 2013, but Are Now More Optimistic and Much More Expensive

  • Optimists generally overestimate growth and earnings, misallocate capital and underperform their more conservative peers – regardless of industry sector or market cap. We introduced a measure of optimism and wrote extensively about this subject 12 months ago.
  • However, in a year where earnings revisions were largely ignored, Optimists won in 2013. While they saw more negative revisions than their conservative competitors, their absolute earnings growth was higher and they outperformed the more conservative companies.
  • Optimists remain optimistic, with the group expecting 24% EPS growth in 2014, versus an historic average of around 9.0%. Earnings growth in 2013 was below this average. The conservative group remains conservative, expecting 9% EPS growth in 2014, similar to 2013 expectations and below their historic average growth. In 2013 this group saw earnings growth well below average – it was not that the optimists beat the trend, it was that the conservative group under-delivered.
  • The valuation differential between the two groups is at a 13 year extreme – the Optimist group is more overvalued relative to the Conservative group than in the past. Stand-outs on the high side and the low side are summarized in Exhibit 1. Upside opportunity increases towards the top right corner and risk increases towards the bottom left.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

At the end of 2012 we wrote a couple of pieces on estimate accuracy and the ramifications of being too bullish –
we provide links
to those pieces
here
for more background.

In the analysis we derived an empirical method of defining whether a company was inherently optimistic or inherently conservative. Once we had completed that screen we then looked at the performance of the group of companies at one extreme versus those at another, and the data is summarized in the chart below as it was presented a year ago. We aggregated the 20 most optimistic and the 20 most conservative.

Exhibit 2

Source: Capital IQ and SSR Analysis

In summary:

  • The optimist group has a 12 year return on capital trend (simple average) which rises at a rate of around 4 basis points per annum. The conservative group has a return on capital trend that rises at a rate of 61 basis points per annum.
  • The optimist group has a current return on capital of 8.0% while the conservative group has 12.7%
  • The optimists have seen an average of 8.1% EPS growth from 2002 to 2012 while the more conservative have an average EPS growth of 20.4%.
  • The optimists have a total shareholder return that is roughly 60% of the pessimist group.
  • In short, the optimists underperform on every relevant metric we can think of.
  • Additionally, the optimist group is not a more volatile group in terms of earnings – the optimist group contains companies from every sector except conglomerates. The conservative group contains all sectors except Conglomerates, Paper and E&C. Moreover, on a sector neutral basis we get essentially the same results
  • The optimist group spends marginally less as a percentage of revenue on both capital spending and R&D, so it is not necessarily about overspending.

At the time we noted that the optimist group had much more ambitious earnings estimates for 2013 than their conservative competitors – as shown in Exhibit 3 (which shows the consensus forecast 2013 EPS growth at the end of 2012).

Exhibit 3

Source: Capital IQ and SSR Analysis

So how did they do in 2013?

The conservative group saw 4% negative EPS revisions through the year.

The optimistic group saw 11% negative revision over the same 12 month period.

While the optimistic group was still more optimistic, the group saw higher earnings growth in 2013 than the conservative group; bucking the trend. Moreover, the optimist group outperformed the conservative group – also bucking the trend. These data are summarized in Exhibit 4, which also shows 2014 estimates and shows that the optimists are still optimistic and the conservative group is still conservative (or at least less optimistic). This time the difference between the two sets of growth assumptions is more significant than it was last year. We would be surprised if the optimists could buck the trend two years in a row, particularly on the performance side, given valuation.

Exhibit 4

Source: Capital IQ and SSR Analysis

Valuation – The “Risk On” attitude favors the bold (talkers)

Valuation of the optimist group has clearly benefitted from the less cautious market; more willing to buy and stick with stories. This was evidenced by a significant break-down in the relationship between revisions and performance in 2013 versus 2012 – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

If we take the average “discount from normal value” for our optimist group and do the same for the conservative group, we get the relationship shown in Exhibit 6. Today the optimists command a relative premium not seen in the last 13 years, and given that this group represents the serial earnings disappointers we would flag this as quite risky! We are probably more concerned than most given that we are strong proponents of reversion to mean.

Exhibit 6

Source: Capital IQ and SSR Analysis

As a reminder, the components of both the Optimist and Conservative groups are summarized in Exhibit 7.

Exhibit 7

Source: Capital IQ and SSR Analysis

For the Big Sectors – Not Much Different

If we focus the analysis in the Capital Goods and Chemicals sectors, where we have enough companies to create Optimistic and Conservative groups, we get very much the same picture for Capital Goods (Exhibit 8) but a different picture for Chemicals – Exhibit 9.

Note that for Capital Goods we are using sub-groups of 10 companies and for Chemicals only 5. There are two reasons for this – first we have more companies in our Capital Goods index, but second, Capital Goods was well represented at the extremes of the optimism analysis while Chemicals was not. If we use a larger group for Chemicals we would be making inclusion/exclusion decisions for each group where the “optimism” differences were within the margin of error of the analysis.

Exhibit 8

Source: Capital IQ and SSR Analysis

For the Chemical sector we get the same picture for 2013 revisions, but for 2014 the conservative group actually has higher estimates than the optimist group – more in line with historic averages.

Exhibit 9

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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