The Friday Findings – December 15th 2017
The Friday Findings – December 15th, 2017
Chart Of the Week – Good Versus Bad
- Chart Of The Week
- Are We Still Underestimating GDP Growth?
- Painting Over The Cracks
- Weekly Winners & Losers
Good companies beat bad companies – hard to disagree! In the chart of the week, we show the performance for the overlap of the top quintile Industrial and Material companies based on years of EBITDA growth and those in the top quintile based on years of outperforming the S&P. This is compared with the bad boys – those in the bottom quintile overlaps. The chart is drawn from work we published around a month ago (linked here). Over that month the good guys outperformed the bad boys by an aggregate of 5.0% – chart below.
The analysis focused on what we are labeling “Corporate Self Awareness”. In the same way that you cannot treat an addict until he or she admits that they are one, you cannot manage a company properly until you recognize candidly what it is you are running – real competitive strengths, real technological moats, or lack thereof. Most of the bad boys in the exhibit continue to throw good money after bad, betting on things that often have not worked to plan in the past, because the assumption set behind the business is highly unrealistic. While GE’s strategy in Power may be a poster child for how not to do something, GE itself does not make the bad boy list! There is a chemical industry bias to the bad list, but the good list has representation from most of the industrials and materials sub-sectors.
All the incremental data we are seeing today – country by country – points to a better global economy and an acceleration. We see opportunities in materials in particular, as some of these markets could tighten up – driving further pricing increases as a consequence. IF the US follows a successful tax reform with an infrastructure bill in 2018 we would be even more positive on the materials space.
Our attention was drawn this week to the chart below – reproduced from Bloomberg data. It shows the leading indicator nature of small business optimism and GDP growth in the US as well as the current disconnect. Either we have a situation today, unlike any in the past, where small business optimism is overly inflated (possible given tax reform), or we have GDP numbers that are understated, suggesting upward revisions of recent history and stronger growth in 2018.
If we are going to see stronger growth in 2018, then many of the Industrial and Material segments remain interesting, despite strong performance in 2017. We have written about operating leverage and identified companies that have the potential for earnings momentum to take already high values higher over the last few months (for both Chemicals and Industrials).
However, the real opportunity is probably in commodities, which will gain pricing as they gain volume. As we wrote earlier this week, this is already evident in oil, which is raising the margin umbrella for US ethylene producers as the gap widens between oil and US NGLs – second chart. Ethylene itself could experience tighter market conditions in 2018 – raising pricing well above break-even pricing for marginal suppliers – further helping those in the US – we continue to recommend DWDP, WLK and LYB (in that order).
Metals have significant upside in an economic recovery and this will be further boosted if the Trump administration moves from tax to infrastructure in 2018. AA is back to interesting valuation levels and we continue to like FCX, which despite its recent run is still at half its “normal” value.
We remain very nervous about the coatings space – highlighted in multiple reports and Friday Findings over the last 6 months. SHW has been a thorn in our side in terms of this cautious stance, but the only one. We struggle to see how SHW can outperform again in 2018, especially if we see a broader rotation into materials – see above.
The first exhibit below shows the performance of chemical stocks (for which we keep long-term valuation history) year to date – aside from the commodity winners, SHW has again been a notable outperformer particularly relative to the lackluster performance of other Coatings stocks. We see risks here, both for SHW with respect to the VAL integration, and for the industry at large. While SHW has been quietly outperforming, the other major players have very publicly failed in several M&A attempts that underscore the headwinds facing the sector. Most recently AXTA (a 3% underperformer on the year versus the S&P) has been in focus – the volume and price trends shown in the second chart show why AXTA may be eager to enter into M&A discussions. The failure of major M&A in the Coatings industry contrasts with the situation in Industrial Gas, a similarly (growth) adrift industry where business combinations have now provided a multiyear runway for growth (Air Liquide’s acquisition of Airgas, the ongoing expected merger of PX and Linde). The backdrop of an improving industrial economy is an added tailwind but the real upside is driven by significant, and we believe unrecognized, synergy potential that makes PX/Linde our top idea for 2018. We will publish a more formal investment outlook for 2018 in the weeks to come.