Skepticism + Positive Revisions (+ Deep Discounts) = (Significant) Outperformance

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 7th, 2015

Skepticism + Positive Revisions (+ Deep Discounts) = (Significant) Outperformance

  • The combination of skepticism, positive EPS revisions, and valuation discount results in significant relative outperformance, which intuitively increases at higher levels of skepticism and discount – Exhibit 1.
  • Our Skepticism Index identifies situations where earnings trends are inconsistent with valuation trends, but on its own does not offer much insight as to when a correction will occur – the earnings revision component addresses this issue.
  • When skepticism is high and revisions are positive, performance results are more robust for stocks with greater valuation discounts
  • These results hold across sectors and market cap ranges. Capital Goods, Chemicals, Conglomerates, Paper & Packaging, and Transports show the best risk-reward relationships – see the Appendix for full tabular results. Performance is slightly enhanced at smaller cap levels but is strongly positive at the strictly large (>$20B) cap level as well.
  • Stocks currently falling into the ranges shown in Exhibit 1 are EMN, MON, and IP at the large cap level and a handful of names among the smaller caps, including BGC and CCK. The full list of stocks is shown in Exhibit 6.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

In this piece we add a valuation discount overlay to our prior introductory work on s
kepticism and earnings revisions
. To summarize, the three components in our analysis are:

  1. Skepticism – measured by the extent to which valuation is aligned with current returns (see our prior work for more detail)
  2. Earnings Momentum – we use revisions to forward 12 month EPS over the past three months as a real-time indicator of sentiment change (data available from 2000)
  3. Valuation Discount – defined by our models as the deviation from the company’s mid-cycle value, derived from that company’s long term return on capital trend

We start by reviewing the results from the combination of the first two components, which we introduced in a piece earlier this month, and then show the impact of the valuation overlay. Results are shown at the aggregate sector level and at various market cap ranges, and we narrow down to the names at the stock level that are currently in the ranges we have defined.

The Impact of Positive Revisions at Various SI Ranges

In a follow up to our Skepticism Index analysis of DE, we showed the risk-reward profiles at various ranges of SI, when accompanied by positive revisions, for several companies that are in similar positions to Deere. We expanded that analysis to our overall universe of 120+ Industrials & Materials stocks – the aggregated average results are shown in Exhibit 2. The forward returns (relative to the S&P, and using revisions data available from 2000) are substantial, but there is significant associated volatility. The risk-reward is more favorable at higher SI levels.

Exhibit 2

Source: Capital IQ, SSR Analysis

Adding a Valuation Overlay

Adding on to this work, we included a pure valuation overlay, rightly presuming that positive earnings revisions would have the most profound performance impact when stocks are showing greater discounts. This did indeed turn out to be the case, with not only enhanced returns but also lower accompanying volatility – Exhibit 3.

Exhibit 3

Source: Capital IQ, SSR Analysis

We show a sector by sector summary of this analysis in the
Appendix
. The results at the sector level are universally positive at the range highlighted in Exhibit 3 above – average return is greater than the standard deviation for all sectors. Transports show the most consistently robust risk-reward profile across the ranges. Capital Goods, Chemicals, Conglomerates and Paper & Packaging have produced historically strong results as well.

Results Hold Well for Large Cap Names

Looking at the 28 stocks in our coverage with a market cap in excess of $20 billion, we find a similar pattern. The absolute returns are lower, but the risk-reward relationship is well intact – Exhibit 4.

Exhibit 4

Source: Capital IQ, SSR Analysis

Risk-Reward Slightly Superior for Smaller Caps

If the larger cap names show slightly lower returns than the group as a whole, it follows that the smaller cap names will have relatively enhanced results. Our universe of 120+ stocks has a median market cap of ~$6.5 billion, so we looked at the top third versus the bottom two thirds as opposed to a straight split of the group. The top third by market cap runs from GE at well over $200 billion down to EMN at just over $11 billion.

Exhibit 5

Source: Capital IQ, SSR Analysis

Stocks Currently in These Tiers – Positive SI, Positive Revisions, Varying Valuations

Exhibit 6 summarizes the stocks that currently have SI values above 0.5, positive revisions, and are trading at a discount to normal on our model. Exhibit 7 depicts where these stocks fall in the ranges that we have shown throughout this piece, for both the top one third and bottom two thirds market cap groups.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis


Appendix – Sector Analysis

©2015, 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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