Another Reason To Look at GE – Not Participating In the Rally – Yet!

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 21st, 2017

Another Reason To Look at GE – Not Participating In the Rally – Yet!

  • Most I&M stocks have rallied since the election, the question now being whether they have moved too far too fast. Here we systematically evaluate sector and stock performances compared to where current estimates stand relative to historical precedent.
    • We are cautious where skepticism is declining quickly – stock or sector value rising while earnings remain stagnant or depressed.
  • Only Conglomerates and Paper and Packaging have not seen valuations move ahead of earnings since October of 2016 – these are both sectors we like and the lack of activity only makes them more attractive in our view.
    • Prefer Paper over Packaging – specifically, IP based on this analysis.
    • Prefer GE over others in conglomerates but could make a case for all – especially relative to capital goods.
  • This analysis supports our recent Capital Goods vs Conglomerates idea and GE is more interesting as “skepticism” has increased dramatically in recent months as returns have improved while the stock has not. Exhibit 1 shows most significant sector moves.em more attractive in our view.
    • Earnings in 2017 are unlikely to justify recent stock moves for those that have moved the most – absent pricing from trade barriers or unless we get the tax cut promised.
      • Any stimulus package in the US is unlikely to impact demand based earnings for any company prior to 2018.
      • Interim risk is that estimates rise – chasing higher target prices and that this leads to earnings misses as we go through 2017.
  • Fewer stocks moving the other way – i.e. becoming more Skeptical, but there are a handful of ideas that spring up and should be looked at as possible overweights – some of which we have written about recently.
    • GNRC, GE, HUN, OLN, IP and PKG

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview – What Is Skepticism

With the recent rally in Industrials and Materials, generally in anticipation of earnings yet to come – “skepticism” has been declining – moving from positive to negative the way we measure it. In this piece, as well as reiterating our previous piece on GE versus Capital Goods, we focus on which sectors and stocks have had the fastest reduction in skepticism over the last few months and what that implies for earnings relative to current levels and forward expectations. We are looking for anticipatory moves either at the sector or stock level that look like “too much too soon”, where earnings are unlikely to follow as quickly as the stocks/sectors suggest – resulting in some underweight ideas. We also show a handful of overweight ideas, of which GE is looking even more worthy of further analysis.

As shown in Exhibit 1, only Paper and Packaging and Conglomerates have seen declines in value relative to earnings since the 4th quarter of 2016 and Transports has seen the largest anticipatory move. In Exhibit 2 we repeat our early 2017 sector preference chart – what we see in Ex 1 would make us even more positive on Paper and Packaging (though weighted to Paper) and even more negative on Electrical Equipment and Transports – note that rails are primarily driving the Transports move, mostly with the activity in CSX.

Exhibit 2

At the stock levels the most significant anticipatory moves are summarized in Exhibit 3. We were already cautious on SHW and this analysis only makes us more so – both CSX and EMR are being impacted by activists (lifting stock prices). LECO, SNA, and a few others are likely at risk from higher metal prices – see accompanying piece – making it even harder for earnings to close the gap and justify where the stocks have moved.

Exhibit 3

Source: Capital IQ and SSR Analysis

What is the SSR Skepticism Index (SI)

We introduced our Skepticism Index (SI) measures in 2013 and it is analysis we update monthly at the sector level and at the stock level within chemicals. It measures the disconnect between current valuation (relative to normal) and current earnings (relative to normal). The more positive the index the more a stock or sector is either cheap, or correctly predicting a decline in earnings. The more negative, the more the stock is anticipating improving earnings, or is simply too expensive. The index is compiled by adding our “discount from normal value” measure for a stock or a sector to the number of standard deviations return on capital is away from normal.

  • A cheap stock under-earning will have a positive “discount” and a negative “return deviation”
  • An expensive stock over-earning will have a negative “discount” and a positive “return deviation”
  • The idea being that an SI of zero suggests everything is in balance – valuation reflects returns
  • Exhibit 4 shows GEs SI progress since 1990 and we choose GE in this illustration because of the strong recent move – caused by a rise in return on capital (Exhibit 5) – above trend, while the stock has gone nowhere.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

The second chart we generally show at a stock level for this analysis – paired with Exhibit 4 – is shown as Exhibit 6 – again we use GE and we attempt to show the recent trajectory in Exhibit 7, which shows a shorter history.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Going back to our conglomerates versus Capital Goods theme – in Exhibit 8 we show recent history for the Capital Goods names that have had the largest negative moves and we also show all of the conglomerate names – this work alone would suggest an opportunity to own GE over almost anything listed in the Capital Goods space. The contrast between the conglomerate names and the Capital Goods names is stark.

Exhibit 8

Source: Capital IQ and SSR Analysis

Anticipation May Need Significant Patience

Much of what many of the sector and stock moves are showing is anticipatory – the stocks are rallying on expectation not on results. This presents a couple of problems in our view – one leading from the other:

  • Nothing that the Trump administration can put into effect will have an immediate impact on demand. We could see some pricing resulting from trade moves, but economic stimulus would likely take a year before it impacted the bottom line of any of the US companies, which in the meantime are facing significant currency headwinds from some markets.
  • Meanwhile, analysts wishing to keep positive ratings on stocks which are ahead of themselves will be tempted to raise earnings (or not cut earnings) to support higher target prices.
    • We think we have seen this with both CC and CF in the last week – both are in markets that are reasonably easy to model, but cuts in estimates would have meant cuts in target prices for stocks that were outperforming.

Consequently, we should expect earnings shortfalls or disappointments in 2017 and consequently little fundamental support for the stocks to go higher. They may move higher on sentiment, but this juts make the risk of a pull back on disappointments that much more likely.

On an absolute level the sectors stack up on Skepticism as shown below in Exhibit 9 and the 20 stock with the most negative indices are shown the Exhibit 10. These are the stock anticipating the most dramatic improvements in earnings today,

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

What to Buy Based on This Analysis

While there are not as many stocks moving the other way – i.e. where skepticism is increasing – there are a few and we highlight the most significant recent moves in Exhibit 11 and the companies with the highest SI numbers today are shown in Exhibit 12 – these are the companies where the current stock price is predicting a significant earnings decline versus consensus. We have written positively on the conglomerates space and GE in particular in recent research (link) and the paper side of Paper and Packaging is also on our watch list (link). There are also a number of companies in both tables that we have written positively on recently. This analysis would single out the following (already favored) names as possible overweights: GNRC, GE, HUN, OLN, IP and PKG

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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