Buy Ag Chemicals – Avoid (Short) Coatings – That’s What The Data Say!

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 23rd, 2018

Buy Ag Chemicals – Avoid (Short) Coatings – That’s What The Data Say!

  • In our recent Chemicals Monthly we commented on the valuation extremes, based on mean reversion between the Ag Chemical and Coatings subsectors.
    • While there is no obvious catalyst to ignite the Ag space today and (aside for valuation and slow growth) no obvious major bump in the road for Coatings, the mean reversion theme data is compelling.
    • Exhibit 1 shows the 12 and 24 month performance of the most and second most attractive sectors as well as the performance of the least attractive and second least.
  • On a 12 month basis there is an average performance difference of 6% (most attractive pair versus least attractive). On a 24 month basis we jump to a more than 15% difference.
    • This is consistent with the analysis we have done comparing sectors within Industrials and Materials more broadly, with the exception that at the I&M sector level you have seen more consistent upside from owning the second most attractive sector and shorting the second most expensive.
  • Today, Ag is the most attractive sector on valuation, and Industrial Gases is second. Coatings is the most expensive sector and Commodity Chemicals is the second most expensive.
    • Within the sectors, CF, MOS and PX look most interesting; SHW, AKZA and PPG look the most expensive.
    • We would not recommend a short strategy in this better global economy, as pricing could drive Commodities and Coatings higher, but we would overweight Ag and Gases with a 12-24 month view.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview/Details

The analysis in Exhibit 1 has a 2000 starting point and we show the same analysis from 2010 in Exhibit 2 – the patterns are the same and the logic equally compelling but the performance differences are a little lower.

The constituents by group are summarized in Exhibit 3 – these are the companies for which we have the longer-term history and the consistent valuation analysis. We include Akzo in our list of expensive stocks in the bullets because we think it faces some of the same slower growth problems also faced by PPG and SHW.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

The sector discounts as of January 19th, and as published in our monthly are summarized in Exhibit 4 and it is worth noting how grouped together Diversified, Specialty and Industrial Gases are today. So much so that if we adjust DWDP normal earnings to reflect expected synergies, the Diversified (small) group becomes the second cheapest sector. Both DWDP and HUN are on our focus list for 2018.

The chemical subsector valuation rankings are generated from a market cap weighted history of individual company price to normal earnings as suggested by historical return on capital trends.

Each subsector’s weighted P/Normal E is used to calculate an average relative multiple versus the S&P 500 from a common starting point of 1990 (except for Ag which only has sufficient data from 1992). We represent the divergence from this average relative multiple in standard deviations and rank the subsectors accordingly.

Performance results at the subsector level are based on the same market cap weighting, with share prices indexed to December 31, 2010 to capture all companies included (the current LYB has public history only from June 2010 for example).

For each month over the time frames analyzed (2010 to present and 2000 to present) we use the subsector valuation rankings and share price index to calculate average forward returns (12 and 24 months) by valuation position.

Exhibit 4

Source: Capital IQ and SSR Analysis

A Practical Example – The Day We Started

Exhibits 1 and 2 are aggregates of many different starting and ending points and swings between attractive and unattractive sectors. Consequently we elected to provide a practical example and decided to focus on the day we first published this sub-sector analysis – September 15th 2012. At the time, the Commodity and Diversified groups looked most interesting and Coatings and Gases most expensive. 12 and 24 month performance from that date is summarized in Exhibit 5 – not as compelling as the averages would suggest, but pretty good.

Exhibit 5

Source: Capital IQ and SSR Analysis

So What To Do Today?

Valuations of the individual companies in the most and least expensive groups are summarized in Exhibit 6. So to stick to the script you want to be overweight blue and underweight orange. Looking at the second most expensive and second most attractive groups today we have two problems:

  • Commodities should ride the economic wave better than most groups because of the pricing opportunity – you may win by underweighting this group over 24 months but probably not 12.
  • Specialty, Diversified and Industrial Gases are so closely grouped today from a valuation perspective that it is not really possible to separate them within the limits of the analysis – plus all are positively levered to a better economy:
    • Across the sectors we like DWDP, HUN, PX (Linde), and EMN.

Exhibit 6

Source: Capital IQ and SSR Analysis

©2018, 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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