Capital Goods – Time To Play the Valuation Card

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 30th, 2013

Capital Goods Time To Play the Valuation Card

  • In aggregate the Capital Goods sector has underperformed the broader market significantly over the last 18 months; some stocks have outperformed, but others have had more dramatic relative declines. Today, a number of larger Capital Goods companies screen as attractively valued using our framework: DE, CAT, ETN, AGCO and SWK. They represent some of the most attractive larger cap names in our overall Industrial and Basic Materials coverage universe.
  • Results from CAT this quarter explain some of the markets caution for the group, as we have gone from a period of record results, partly driven by an inventory swing, this time last year, to something slightly below what we would consider to be “normal” today. A number of others have had similar fortunes, but some have been treated as guilty by association rather than committed the crimes themselves.
  • A consensus is forming that the global economy has bottomed, perhaps late last year, but in past economic cycles in the 80s and 90s growth recovered slowly and the stocks bottomed on a relative basis in several cycles many months after the economy bottomed. Earnings bottomed on the same delayed cycle – so results generally got worse after the economy bottomed.
  • If that is repeated, we may be nearing a point of inflection in revisions, at which point the relative value will be the point of focus and the stocks could outperform significantly. Within the space, and just looking at value, on the long side we would highlight: CAT, DE, ETN, AGCO and SWK; and on the short: DCI, IEX, CMI, CLC and PCAR – Exhibit 1. We show that over time the valuation gap between the expensive group and attractive group has closed and reopened and that today it stands at an extreme.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

The Capital Goods sector looks inexpensive, particularly relative to the other components of the Industrials and Basic Materials, but the inexpensiveness is focused in a few names, and there are plenty of expensive stocks in the sector; some valuations are justified by current earnings, while some are not – Exhibits 2 and 3. In Exhibit 3, we should be most interested in the stocks in the upper right hand quadrant and less interested in the stocks in the lower left quadrant. But more generally, the further a company is away from the diagonal the more out of sync valuation is with current earnings.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

There are a couple of forces at work here, some fundamental and some emotional. On the fundamental side we have clearly seen weakness in some sub sectors of the industry, most significantly mining, but also to a degree in agriculture, both in larger part the result of a slower growth in global consumption and ensuing oversupply. On the other hand, we also see some sub-sectors working really well, such as US housing and in some cases commercial construction – though not infrastructure in the US – yet! Outside Europe, the Auto market is on a roll, and we see some additional engine opportunities in the US as rail and truck companies get serious about Natural Gas as a fuel. Further, both steel and aluminum are on their knees, lowering raw material cost for a couple of very key raw materials for many.

On the emotional side we see the market paying for stories and positive revisions and largely ignoring valuation where these two are not evident. Consequently many of the more focused companies are doing well, where focused in the right places, despite already high values. Conversely, exposure to bad or unclear trends is being punished probably more than would be in a less skittish market. This is not isolated to Capital Goods; it exists in all market sectors.

Given the high valuations placed on some of the more popular names such as DCI, IEX, and CMI etc., the market is keen to find cheap names that have an emerging story – OSK is a great recent example – but does not appear to be willing to be supportive of companies where the turn is yet to occur.

In our view these are the opportunities, particularly if you have the macro view that the global economy has turned – albeit on a slow growth trajectory this year. Notwithstanding the mining risk in both CAT and JOY, we would look at both today (CAT more than JOY), but perhaps the more interesting opportunities lie in Ag – both DE and AGCO and – and also in SWK, which has been left behind in the US housing rally. In addition, ETN looks interesting.

Reversion to Mean (Trend)

We are big believers in our “reversion to trend” valuation methodology for the Industrials and Materials space. The thesis is simple – companies tend not to deviate from a recognized return on capital trend unless they make material changes to their portfolio or unless they are in industries or sub-industries with improving market structure. Our overall methodology and our Capital Goods sector index was
introduced in our first piece of research in April of last year
and we would point you to that piece for a more granular review of our process. The sector index shows the group to be inexpensive, but comparing Exhibit 4 and Exhibit 2, we show that this is a function of market cap weighting, as the bigger names are cheap and many of the smaller companies are expensive.

Exhibit 4

Source: Capital IQ and SSR Analysis

If we look at the larger cap universe – companies with a cap in excess of $15bn – there are only a few names in the Industrial and Materials space that are valued below normal value and many of these are in the Capital Goods space – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

This methodology is not a sure thing, as while it identifies value it does not suggest when the value might be realized. Today the overall investment community is far less patient than it was 15 years ago and few have the luxury of buying with a time horizon greater than a year. We think that this is partly the driver behind some of the very quick recoveries we have seen for some stocks – such as OSK in the early part of this year. Rather than buying value and waiting, more and more investors are willing to give up the first 10% in and jump in once the turn or event has happened.

Exhibit 3 showed the relationship between current value and current earnings (using return on capital as a proxy). These factors combine to produce our skepticism index, which we publish on a sector basis each month and which was introduced in research last year. In the exhibit, the further a company is away from the diagonal, the more out of sync valuation is with earnings. If you are in the top right quadrant either the stock is undervalued, or earnings are going to decline; in the bottom left, valuation is discounting an increase in earnings (returns on capital). Skepticism would be highest today for AGCO and DOV, but interestingly, this group is quite tight to the diagonal, whereas in other sectors there are some meaningful deviations.

Upside

In the table below we show the relative opportunity in the stocks that we are suggesting, both on the long and the short side. We show current value, value at “normal” levels and value at one standard deviation above normal. For the overvalued names we only show the downside from moving to one standard deviation ABOVE normal value from their more inflated levels today.

Exhibit 6

Source: Capital IQ and SSR Analysis

Lastly, we have created indices of our top five and bottom five names and looked at their aggregate value. We have then subtracted one from the other to show how far apart they are today. As a sanity check we have looked at the historic performance of this measure (keeping the component companies the same) – Exhibit 7. As we have chosen the most disparate names today it is not surprising that the measure is most extreme today, but it is interesting that it has never been this extreme in the past. The chart shows that the gap has closed dramatically in the past and that the relative value positions have reversed – large cap more diversified names within Capital Goods have been valued more highly than the smaller cap more focused names – this can happen again.

Exhibit 7

Source: Capital IQ and SSR Analysis

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