13 Attractive, Bad or Overhyped Ideas for 2013 Assuming No Macro Change

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.883.1927

graham@/lipinski@ssrllc.com

January 3rd, 2013

13 Attractive, Bad or Overhyped Ideas for 2013 Assuming No Macro Change

  • We assume no real change to the economic landscape or outlook in 2013 and we make some early year selections on that basis. We look for companies that are attractively valued and do not have heroic expectations for 2013. At the margin we also look for exposure to construction (residential and commercial). On the flip side we look for the antithesis of all the factors above to choose the stocks to avoid.

  • Our large cap more attractive 13 consists of DD, MMM, SWK, DHR, FCX, AA, MOS, ETN, CAT, DE, CSX, NEW and NUE. The selection is valuation biased, but also takes into account current earnings as well as the reasonableness of next year’s expectations.
  • Our large cap less attractive 13 consists of IP, CMI, PPG, HON, ROP, SHW, ROK, PX, FDX, UTX, PCAR, UNP and PNR.
  • Medium Cap opportunities include: ROC, URS, SON, BWC
  • Unattractive Medium Cap names include: BKI, GNRC, LECO, LPX, ODFL, TKR
  • We have made no assumptions about company specific issues or predictions unless well documented and in the public domain; as such we would consider the lists above screens rather than hard recommendations.

Overview

It would be easy to suggest stocks for 2013 based on an economic recovery, or the notion that the world will turn positively from a confidence perspective. You simply take all the names that are trading as if they have risk of bankruptcy or dividend default today. They will all rally on the first sign of a swing in consensus sentiment and outperform everything else as long as the change in sentiment is maintained and supported by fundamentals like volume and pricing. These are the unloved, much maligned ugly stepchildren of the Basic Materials sectors; almost any base metal company, larger cap chemicals, the construction side of the Machinery sector and normally Paper, Transports and Building Products – though all three of these sectors are richly valued today.

It is much harder to know what to do without the “risk-on” kicker. The “risk-on” move happened early in 2012 in anticipation of a better year, but soon petered out. Our sense is that 2013 could look similar to if not worse than 2012, so how do we think about investing?

For the most part, in 2012 expensive stocks got more expensive and cheap stocks got cheaper as investors looked for earnings consistency, dividend certainty and improving results (which were focused in the already expensive stocks and away from the larger-cap names). There is a risk that this could happen again in 2013, but some of the expensive stocks now look very expensive and discount results (particularly return on capital improvements) that are not likely in 2013 given the economic backdrop. Moreover, for many, they are not predicted in 2013 earnings estimates.

We use our valuation, skepticism and earnings estimate work to look for stocks that offer attractive value combined with a positive disconnect between value and current returns on capital as well as “reasonable” estimates for 2013. In defining reasonable we want earnings growth in the forecast but we want the forecast to be reasonable in the context of both the economic backdrop and the historic ability of companies to predict forward earnings. All of these measures have been covered in detail in research published in 2012.

We then group the companies into quintiles, recognizing that an absolute ranking suggests a level of comparative accuracy that we are unlikely to achieve. Based on the quintile rank we then weight the measures; 40% valuation, 20% skepticism, 20% earnings growth and 20% estimate accuracy. This way we are in aggregate using valuation for half of the decision and revisions for the other half – our skepticism index is assumed to be 50% valuation and 50% revisions/earnings.

Note: GE screens well on all of our metrics and should by right have been included in the top 13 list. However, given the complexity of the company and given that its performance in 2013 could be governed as much by the fate of the finance business as the manufacturing and healthcare businesses, we have opted for leaving it off the recommended list.

Valuation

We want cheap but not at risk (of failure or of reduced dividends). On the large cap side that directs us towards DuPont, as the most attractive, but GE, DHR, MMM, NUE and SWK screen well. AA is the most extremely attractive on our valuation framework – a place it has held for much of the year, but without the “risk-on” trade it is likely to languish. We had expected to see more of the capital goods companies in this screen. For the most part the larger cap names are trading at a discount to normal value, but they are not cheap enough to make this screen. If we were looking at a top ten on large caps alone, CAT, JCI, MOS and FCX would have made the cut.

Exhibit 1: Valuation Standouts – Top 20

Source: Capital IQ and SSR Analysis

At the other end of the scale is the Coatings Industry for the most part, accompanied by the Paper Industry; so you are paying an awful lot for coated paper should you need it! Taking a large cap bottom 10 cut we would add CMI, HON, ROK, PCAR and PX to this list.

Exhibit 2: Most Overvalued – Bottom 20

Source: Capital IQ and SSR Analysis

Skepticism – Do Current Returns On Capital Reflect Current Valuation

Our valuation framework is based on mid-cycle earnings and so it is appropriate to determine whether current under or over valuation is supported by current under or over earning. If valuations discount a decline in returns on capital from current levels we refer to this as Skepticism – either investors do not believe that the current level of return on capital is sustainable, or are not yet willing to give the stock appropriate valuation for the returns generated.

The index is created by adding the discount from normal value (the number of standard deviations a stock is below its mid-cycle value) to the number of standard deviations return on capital is above normal. I.e. if a stock is one standard deviation below normal value (a measure of positive 1) and return on capital is one standard deviation below normal (a measure of negative 1), the index is zero – the valuation discrepancy is explained by the return on capital deviation.

As we think about investment ideas for 2013 we want stocks that are discounting a decline in returns on capital that look unlikely or an increase that looks easily achievable. We want to avoid the reverse. The best combination is an already cheap stock that is discounting further declines in returns on capital that are not reflected in estimates for the coming year. We want to avoid expensive stocks that are discounting increases in returns on capital that look like a stretch either based on history or based on earnings expectations.

The companies in Exhibit 3 are discounting the steepest decline in returns on capital or the most limited increase. In almost every case estimates for 2013 are for positive EPS growth, suggesting that returns on capital will grow in 2013 – Exhibit 4. The companies that sit at the extreme, where any correlation has broken down are circled in Exhibit 5 and are PNR, BWC, GWR, HTZ and NEM. Of course the most extreme is AA. All of these look very interesting as a result.

To get to a large cap top 10 we would add EMR, UNP, DOV and FCX to the list of 6 names below in the bottom of the exhibit below.

Exhibit 3 – Greatest Disbelief That Earnings Can Hold Up

Source: Capital IQ and SSR Analysis

Exhibit 5 – Outliers – Where the SI is most at odds with expected growth

Exhibit 4 – Earnings growth suggests skepticism is misplaced for most

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

At the other end of the scale there are a group of companies that are trading at high values that cannot be explained away by current returns on capital and consequently imply a further improvement in returns. This may be appropriate if current returns are unusually low and there are clear reasons why they should rise, but in every case in Exhibit 6 we have companies that are already earning well above normal and the expectation is that earnings and returns can rise again from current levels. To complete a bottom ten large cap group we would add, ROP, HON, LYB, PCAR and UTX.

As with the most skeptical group, the least skeptical group has estimates that show good earnings growth in 2013 (Exhibit 7), in fact the charts look very similar – so you have very similar earnings expectations for both groups while one is valued with an expectation that returns on capital will fall and the other as if returns will rise. Plotting growth against degree of optimism (negative skepticism) – Exhibit 8- the outliers are many, but those with no expected EPS growth in 2013 stand out – RBN, TKR, WLK.

Exhibit 6 – Greatest Belief That Returns On Capital Can Improve From Already High Levels

Source: Capital IQ and SSR Analysis

Exhibit 7 Exhibit 8

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Of course – earnings is only one factor in determining return on capital. Returns could improve if capital was falling. We do not have full data for 2012 on the groups but in 2011 the Skeptical group spent around 26% more on new plant and equipment than Depreciation and Amortization (D&A), while the least Skeptical group spent around 17% more than D&A. This might explain a small portion of the deviation between the two groups and investor’s confidence, but not nearly enough.

Estimates – Too High – Too Low – Too Optimistic?

In recent work we have looked at the reliability of earnings estimates and by looking at longer-term track records we have determined who is most likely to disappoint and who is most likely to surprise on the upside. This is also an important part of 2013 stock selection as it is very clear that negative revisions matter. Exhibit 9 shows revisions and performance for the broad industrials and basic materials group that we cover for 2012 and is a repeat of an exhibit that we have shown before. The correlation is not perfect, but nothing is in this business. It shows a strong link between revisions and performance, particularly at the extremes.

Exhibit 9

Source: Capital IQ and SSR Analysis

Over the last 12 years the stocks in our universe have seen EPS growth of 12.8% on a simple arithmetic average – several hundred basis points lower on a market cap weighted basis. Consensus estimates for 2013 are calling for 13.2% on the same simple average basis. This seems high in a weak economic growth environment, but is probably too low should there be a broader economic rebound.

However, for this screen we not only want to identify the highs and the lows, we also want to look at how these companies have been at forecasting correctly in the past. An above trend estimate from a company with a good or conservative track record is worth more than the same above trend forecast from an eternal optimist.

In Exhibit 10 we show a complicated chart that needs a bit of explaining. On the X axis we are showing earnings growth expectations for 2013 expressed as the number of standard deviations above or below historic average growth (looking back over the last 12 years). This adjusts for the very different volatility in earnings that exists between sectors and within sectors. The top 20 names and bottom 20 names on this basis are shown in Exhibit 11. On the Y axis we have the historic ability of each company to predict its own earnings (as covered in recent research) defined as the average annual revision each company sees from January 1st through year-end over an 11 year period.

Exhibit 10 – Earnings Growth versus Predictive Track Record

Source: Capital IQ and SSR Analysis

Exhibit 11- Expected 2013 Earnings Growth – Most Ambitious/Most Conservative

Most Ambitious Most Conservative

Source: Capital IQ and SSR Analysis

In Exhibit 12 we show the best and worst earnings predictors in our coverage universe, based on the analysis that we published in early December.

Exhibit 12

Source: Capital IQ and SSR Analysis

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