The Recommendation Signal – Another Reason to Look at DuPont

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

November 18th, 2013

The Recommendation Signal – Another Reason to Look at DuPont

  • Sell Side recommendations tend to follow stock performance, with aggregate dislike generally signaling a good time to buy and aggregate adoration generally a signal that a story is well played out. Recommendations do not correlate with value – cheap stocks have no greater analyst support than expensive stocks.
  • At a sector level, this relationship has broken down for both Chemicals and Capital Goods as the market and sectors have rallied over the last two years.
  • The breakdown is in part the result of extreme valuation divergence (especially in the case of Capital Goods), where some high valued stocks have attracted sell side skepticism as values have increased. The same is true to a degree in Chemicals, though not as pronounced.
  • At the stock level there are some clear repeat patterns and some clear divergences. The aggregate recommendation for LYB, for example is a clear “sell signal”, but for DD the recommendation analysis would suggest further upside despite the strong run this year.
  • History would support owning DuPont today on the basis of this analysis as 6 and 12 month relative returns have been consistently high following lows in Sell-Side sentiment. Conversely, you do not want to own DD when everyone loves the story – Exhibit 1.
  • The analysis is supportive of our more neutral stance on Dow Chemical, but at the margin would perhaps make us more positive.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

While it could be argued that we are straying beyond our empirical borders with this piece, it is sometimes interesting to look at the psychology of the market. In this instance we are looking at the relationship between sell side sentiment and subsequent stock performance. Note: we introduce the analysis in this report but we focus on Chemicals and DuPont in particular. We will follow-up on other sectors and other interesting stories.

Recommendations today are not correlated with value and show a much stronger correlation with recent performance. In aggregate, the better a stock has done the more people like it. Exhibits 2 and 3 show these data for Capital Goods and Chemicals, using the Capital IQ aggregate recommendation index – where the lower the number the more popular the stock.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

In the two charts below – Exhibits 4 and 5, we show a time series forward 12 month relative performance and analyst sentiment for the Capital Goods sector and the Chemicals sector. The pattern in the Capital Goods chart is quite compelling, though it breaks down somewhat in the last couple of years. At the aggregate level this might be explained by the extreme valuation divergence in the group today, something we
highlighted in our positive report on CAT
.

Exhibit 4

Source: Capital IQ and SSR Analysis

The Chemicals chart has also broken down in the last couple of years but we suspect that this has as much to do with the positive impact of cheap natural gas in the US and the restructuring of the coatings industry as it does any divergence of value. In our view, while historically analysts tended to ride a momentum wave and follow performance with recommendations, today the aggregate value of the sectors is high enough to worry many. Coming back to an earlier point, we see valuation divergence high in the Capital Goods space, suggesting that the momentum story is alive and well for many stocks but not all. The same is true, but to a lesser degree in Chemicals.

Exhibit 5

Source: Capital IQ and SSR Analysis

The message here is that you want to be walking away when everyone loves them and building positions when they are widely hated.
Our positive view on the Capital Goods space
is in part reflected in this analysis. However, by the same token we should probably be a bit more positive on Chemicals.

The Story is More Interesting for Some Stocks than for Others

At a stock level it is possible to draw some interesting conclusions and we have focused on DuPont only because it is a story we are following closely at this time. The chart for DD suggests very much that you want to swim against the stream – Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

Taking the analysis a step further we have looked at sentiment peaks and troughs and the relative performance of the stock in the 6 and 12 month periods following a peak or trough in sentiment and these are summarized in Exhibit 7. Note that in the most recent period – DD has outperformed a very strong broader market. The stock was slightly more unloved in the summer than it is today, but it is still close to a peak. The difference with prior periods is that sentiment is at a low when the absolute stock price is at a high. The momentum in DuPont’s stock has not encouraged support from the sell-side as it has in the past. The stock is suggesting a great story that no-one believes. If we were to look at Lyondell (one of the most loved stocks in the chemical space), although we only have limited history, the stock performance is suggesting a story that everyone believes.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Some quick comments on Dow Chemical

The same analysis on Dow Chemical leads to some similar patterns and might suggest more upside in the stock today. The story is not much less popular than DuPont’s but the stock has lagged DD off the bottom, perhaps because we still do not see any improvement in returns on capital despite the repositioning of the portfolio and perhaps because Dow has been less definitive around splitting the company. The results of this analysis are summarized in Exhibits 9 and 10.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

©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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