The SSR Industrials and Basics Skepticism Index

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley

203.901.1629

graham@sector-sovereign.com

May 3rd, 2012

The SSR Industrials and Basics Skepticism Index

  • We introduce our proprietary market Skepticism Index (SSRSI), which suggests that investors are most skeptical about Metals & Mining and least skeptical about Chemicals. A positive SSRSI is a predictor of positive stock performance and indicates that an industry has both good returns on capital and low relative valuation. Extreme positives in the index precede 6 months of subsequent outperformance and extreme negatives precede similar underperformance.
  • The Index looks at the relationship between current industry returns on capital and current valuation. Today, none of the sector SSRSI scores is below zero, suggesting that there is broad skepticism towards the overall group – this is consistent with a macro-driven market, and the very apparent nervousness about economic growth in Europe and Asia.
  • When we break the index results from 1980 into five ranges from least skeptical to most skeptical, we see good, but not perfect correlation with 6 month forward performance in all sectors except Capital Goods (which we will explain). Variability remains high, but in general the greater level of skepticism the greater the likelihood of future outperformance
  • This analysis clearly supports our Metals and Mining view, as discussed in recent research and confirms that other sectors are valued in a more narrow range. Metals & Mining shows good forward 6 month upside when the SSRSI is in its highest SI Range (as it is today).
  • Skepticism can be caused by uncertainty, and we introduce two measures of near-term uncertainty by looking at the tightness of earnings estimates and company returns on capital within a sector, the wider the range the greater the uncertainty.

Exhibit 1

Source: Capital IQ and SSR Analysis

Summary Skepticism Rules The Day

We have extended our “normal valuation” analysis to look at skepticism/optimism, defined as whether the valuation of a sector adequately reflects the underlying current profitability or expected profitability of the sector.

Because I have been covering basic industries for so long, I have become programmed to expect disappointment and am now naturally negative. Consequently, we are going to label it the Skepticism Index rather than the Optimism Index.

We have constructed this index by summing our discount from mid-cycle value index (
introduced in our initial report
) with a similar analysis of how significantly different return on capital (ROC) is from trend within each sector. The index is high when both the discount and ROCs are high and vice versa. We are summing two standard deviations, so any number above 2 or below -2 is very significant.

For most sectors a high Skepticism Index is followed by aggregate stock performance that exceed the market over a 6 month period, but in most cases the variability of this outcome is quite high, so that while the average is high, one standard deviation of outcome is generally higher than the average. In reverse, we find that a low Skepticism Index (low profitability/high valuation) yields equally interesting relative downside, but with similar variability.

Today, the compelling high is the Metals and Mining space, as discussed in our recent research, and there is not a compelling low. While the Paper sector screens as expensive in our normal value framework, it does not appear much out of line with its current above trend return on capital in this analysis. While Chemicals looks fairly valued in this analysis, commodity chemicals has a high Skepticism Index and we will follow up with additional research in this sector.

We extended the analysis to look at performance based on ranges of the Skepticism Index. We have defined the ranges as follows:

  • R1 – SI below -1.5 – Optimism Highest
  • R2 – SI above -1.5, but below -0.5
  • R3 – SI above -0.5, but below +0.5 – the Middle Ground
  • R4 – SI above +0.5, but below +1.5
  • R5 – SI above +1.5 – Skepticism Highest

The results are summarized in Exhibit 2:

Exhibit 2

Source: Capital IQ and SSR Analysis

In general the result show what you would expect; the more Skepticism the greater the likely upside, and the more optimism, the greater the likely downside. The most interesting sectors from a correlation/certainty of stock performance perspective are Conglomerates (Ex GE), E&C and Paper when the Index is high and Conglomerates (Ex. GE), Chemicals and Capital Goods, when the index is low.

We discuss each sector in detail below, but this analysis again serves to support the opportunity that we think exists in Metals and Mining. Given that none of the sectors sit in negative territory, this analysis would suggest that the relative downside in the group in general is limited, even in Paper, where mid-cycle or “normalized” valuation alone would suggest significant downside.

We also look at the causes of Skepticism and focus on uncertainty. We have constructed two shorter-term measures of uncertainty by looking at the divergence of near-term earnings estimates and the divergence of ROCs throughout a group. Where uncertainty (disparate earnings estimates or vary varied individual company results) is high you would expect the index to trend back to zero as a result of either or both of the variables correcting as more clarity arises – either value moves as uncertainty declines or ROCs normalize to reflect a fundamental industry change which may be reflected in some estimates and some company results but not all. Where uncertainty is low – i.e. where there is certainty around estimates and consistency around company performance, value is likely the more dominant correcting force. We look for sectors with both an extreme Skepticism Index and a high degree of certainty in terms of results or analyst views.

Today we see the following: consensus is generally quite tight, with the exception being Conglomerates. Estimate ranges are much tighter than usual for Metals & Mining, Electrical Equipment and Paper. In the case of Metals and Mining, consensus for Q1 was conservative, but negative revisions going forward have been the more dominant influence of stock performance. For Paper, consensus was generally wrong (both too high and too low) and again negative forward revisions dominated stock performance. In general we also have a period in which company returns on capital are more convergent than normal. The exception would be Paper. Paper is the only sector where the return on capital profile suggests that some companies are seeing a different environment than others. This will either normalize by ROCs at the weaker companies improving (i.e. the better earners are ahead of the trend) or by the better companies seeing a decline in ROCs (i.e. the worse performers are ahead of the trend).
Our valuation work suggests
that aggregate returns on capital for the paper group are well above trend and well above any positive benefit of the doubt that we could give to the group, so we see a negative correction here more likely than a positive one.

Exhibit 3

Source: Capital IQ and SSR Analysis

Chemicals Fairly Valued but with Earnings Uncertainty

The chemical space shows a much tighter correlation than many of the other sectors – Exhibit 4. In other words, when returns on capital are above normal, valuation tends to be above trend also, and vice versa. This leads to less volatility in the Skepticism index itself. Today, sentiment in the sector is only slightly positive, driven by ROCs that are above normal and valuations that are slightly lower than normal – in fact we are almost on the trend line.

Exhibit 4

Source: Capital IQ and SSR Analysis

For most of the other sectors the chart on the left in Exhibit 4 shows a far more widespread pattern suggesting prolonged periods when the sectors traded at high values with low ROCs and vice versa. It is not immediately evident why Chemicals would have a much tighter correlation than the other groups. It is a relatively large and diverse sample group, which might average out some extremes, but the Capital Goods group is bigger and equally diverse and shows much weaker correlation.

We are also fairly benign from an uncertainty perspective – Exhibit 5, with earnings estimate ranges close to normal for the group and returns on capital for the sector less diverse than average. The relative level of certainty (consensus), likely drives the chemical SI close to the trend line. No real surprises and consequently nothing exciting to do.

Exhibit 5

Source: Capital IQ and SSR Analysis

Capital Goods – The One Rotten Egg in This Analysis

Capital Goods is the one sector where this analysis really does not work when we back test, as the sector has underperformed when Skepticism has been at its highest Capital Goods has had only one period of extreme Skepticism (the highest SI range), and in this period the stocks on average underperformed the market – as summarized in Exhibit 2.

While frustrating we can take some comfort in looking at the period in question, which ran from June 1998 to July 2000, as shown in Exhibit 6. This was the period in which we saw significant appreciation in the S&P500 – 28% – and almost everything in the sector underperformed. Outside this period, the Capital Goods space has in general performed in line with others relative to its Skepticism Index.

Capital Goods has seen some significant periods of uncertainty over the last 12 years when estimates have diverged significantly from the norm. Over the recent quarter, there was less estimate consistency than in recent quarters, but not significantly removed from normal. ROCs within the group have converged since a divergent peak in 2009 and today are close to an all time low in terms of company to company variability.

Exhibit 6

Source: Capital IQ and SSR Analysis

Overall, we have a group that looks fairly valued (slightly inexpensive relative to ROCs) with historically average divergence on estimates and historically consistent ROCs.

Exhibit 7

Source: Capital IQ and SSR Estimates

Conglomerates – Interesting to see the Influence of GE

We show a couple of charts in this section that include GE in the analysis to show how much it biases the data. As this is a “reversion to mean” framework and as GE is so undervalued relative to its more “growth” history, it drives the (market cap weighted) SI for conglomerates to an all time high. Whereas the same analysis excluding GE yields an SI that is only slightly higher than normal – Exhibit 8.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Estimates

Like chemicals, this is a sector tracking its mid-cycle line and is not at a point of extreme that would suggest a compelling investment opportunity. Most recent quarter earnings estimate dispersion is high, however, suggesting an unusual degree of analyst uncertainty. The Return On Capital dispersion is only slightly below average, suggesting that companies are close to their normal range of relative profitability mix – Exhibit 9.

Electrical Equipment – High Rocs Raise the SSRSI, Despite High Values

Despite above normal valuation, the Electrical Equipment sector has a higher than normal Skepticism Index, driven by how far sector ROCs are above normal. Our valuation work alone would suggest steering clear of this group, and the chart does show that historically peaks in Skepticism have been higher than the current level. However, valuation in the group today does not reflect the high level of ROCs the industry is seeing today – Exhibit 10.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

The measures of divergence show the industry to be in a period of consensus and business calm, with both the earnings indicator and the ROC indicator showing current results below normal – Exhibit 11.

Metals & Mining – The Most Interesting Opportunity

The charts in exhibit 12 look a little different from what was published in
our recent research piece
on Metals and Mining two weeks ago because we have changed the time period of the analysis. As we looked at other sectors we found more and more “noise” in the 1970 to 1979 data set which had material impact on averages and standard deviations. By moving to a data set that starts in 1980 we have a more useable data set for the broader group.

This change does not affect the conclusions for the Metals & Mining space, except that what was a “record” current Skepticism Index (as shown in the prior analysis) is replaced by a high index that has been seen on two prior occasions. Following both prior Skepticism Index peaks we saw significant periods of stock outperformance.

Exhibit 12

Source: Capital IQ and SSR Analysis

More interesting is that the current level of skepticism seems to be driven almost entirely by doubt, or fear, rather than uncertainty. The charts in Exhibit 13 show that we have a tight consensus on earnings expectations, the tightest we have seen. Granted, post Q1 earnings we saw further negative revisions, but going into Q1 earnings there was minimal divergence in estimates.

Furthermore, the companies themselves are exhibiting similar ROCs, or more similar ROCs than normal. Consequently there are no outlier companies that are seeing unusual success of failure with their businesses

Exhibit 13

Source: Capital IQ and SSR Analysis

Engineering and Construction – More Skepticism than Most

This sector has less consistent history than the others and consequently we can only plot a Skepticism Index from 1995. It shows that faith in the sector has ebbed quite significantly in the last 18 months – Exhibit 14. This is a difficult industry to model and revenues are spotty and driven for most companies by very few very large contracts – consequently there are some swings in results but some much larger swings in “risk adjusted” estimates of results and sentiment. Previous instances of high skepticism have resulted in good investment returns, but we are not at a peak yet – we are, however, close.

Exhibit 14

Source: Capital IQ and SSR Analysis

As with many of the sectors we have seen earnings estimates converge for this group in recent quarters and while the return on capital divergence measure is very volatile, it is currently below average.

Exhibit 15

Source: Capital IQ and SSR Analysis

Paper – Not As Expensive as our Valuation Methodology Alone Would Suggest

Paper has the tightest correlation between ROCs and valuation than any sector except Chemicals and today this analysis results in an index that is not negative at all, and in fact slightly positive – Exhibit 16. This analysis lends support to the current valuation of the paper group, despite how much of an outlier it looks on our mid-cycle valuation framework alone. ROCs are far enough above trend to offset valuation which is well below trend. Paper has underperformed recently and this has reduced the premium to “normal value” from the levels shown the last time we published – which was based on end-March pricing.

Exhibit 16

Source: Capital IQ and SSR Analysis

Returns on Capital have diverged quite significantly across the group over the last ten years on a trend basis, but the measure has been volatile. Today, divergence is high but down from its peak. In contrast earnings estimates have been quite tight for the last three quarters, so there is a fair degree of consensus – Exhibit 17. For those who have reported Q1 earnings, we have seen some meaningful negative and positive surprises and some significant negative revisions – so while estimates were in a tight range, they were also generally wrong.

Exhibit 17

Source: Capital IQ and SSR Analysis

Packaging – Middle of the Road

There is an interesting negative trend to the Packaging Skepticism Index that really is not apparent for any other group which might suggest that investors are gaining confidence in the sector, or that they better understand the sector. Recently the sector has moved from a more optimistic position, which was primarily drive by overvaluing some fairly poor ROCs and poor trends in the face of rising costs. This was compounded by a series of acquisitions which also drove underperformance. Today the valuation looks much more realistic, with ROCs slightly above normal and value slightly below normal – Exhibit 18.

Exhibit 18

Source: Capital IQ and SSR Analysis

There is nothing particularly interesting in either the ROC or estimate dispersion analysis for the Paper sector. Both are close enough to normal to be within our range of accuracy – Exhibit 19.

Exhibit 19

Source: Capital IQ and SSR Analysis

©2012, 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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