Friday Findings – March 16th, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
March 16, 2018
- Charts of the Week – Where Do We Hide If The Economy Falters?
- GE – Not Enough Change In People Perhaps
- Liveris Leaving – The End Of Several Chapters
- Weekly Winners & Losers
Geopolitics are not having a good month! The US seems determined to pick some fights on the trade front – for better or worse and has made a significant change in removing Rex Tillerson as Secretary of State, while the poisoning incident in the UK has pitted the UK (and most of its allies) against Russia in a war of words and actions that add to uncertainty. At the same time, as we get down to the hard negotiations, it does not look like Brexit will happen without additional political/economic fall-out.
The first chart of the week shows Citi’s economic surprise measure – above the line data suggests economic growth that is coming in above expectation and the below the line numbers suggest disappointment. We would expect the chart to be volatile because there is a tendency in macro forecasting to stick close to what is happening today (look at the forward oil curve), and economic growth is seldom that stable so you get periods of underestimation because the economy is weak at the time of forecast, quickly followed by overestimation as the economy improves. The second chart shows the data for the global line in the first chart on a 24-month rolling average – to get rid of some of the noise. The chart below shows the monthly change in that 24-month average – expectations have turned – as implied in the first chart, and recent commentary suggests that Q1 2018 may disappoint, because of some of the recent rise in uncertainty.
So what do you do as an investor – especially in economically sensitive sectors like Industrials and Materials?
- First – and important – the current data point in the second chart is well below the peak of 2011, though not far from the peak in 2007. Our positive stance, especially on Materials has been driven by the expectation that the global economy still has momentum in 2018 and our preference for Materials over Industrials is driven by valuation – Materials are cheaper – chart below.
- If the global economy can push through the current distractions – requiring continued strength in the global consumer – the recommendations still stand.
- Some sort of infrastructure initiative in 2H 2018 would likely lift all sectors.
- We remain focused on the materials names most levered to pricing opportunities as markets tighten – in the large cap world this is DWDP, PX, FCX, AA and IP. Please see our monthlies for additional ideas and stocks to avoid:
- Industrials & Materials, Chemicals, SMID Cap Chemicals.
- But if the economy falters and we are at that point of inflection – as in 2011, we should expect widespread underperformance from Industrials and Materials, at least for the next 6 months – chart below.
- Note that relative valuations are higher today for Capital Goods and Conglomerates (ex GE) than they were in 2011 – they are lower for Materials, but Material stocks are generally more volatile.
We suspected that all was not right with GE before Jeff Immelt was replaced last year, with the red flag being the disconnect between reported cash flows and earnings. That suspicion has been confirmed since John Flannery took over with the following:
- Missed guidance – more than once
- The exit of the CFO
- The Insurance debacle – financial charges and investigations
- Disappointing guidance for 2018 and again a disconnect between cash flows and earnings
- A step change in goodwill as a consequence of the Baker Hughes deal
While the SEC investigation may or may not unearth something worrying in the insurance business, it is clear that the accounting standards at GE have been, at best, very poor for years. The likelihood that this chosen path of reporting earnings in advance of receipt of cash was the work of Mr. Immelt and Mr. Bornstein alone is low. So far, all we have seen is the replacement of Mr. Bornstein with an insider and a couple of other senior exits (but no new arrivals, except on the board) – so the obvious (albeit harsh) question is whether the lunatics are still in charge of the asylum? Mr. Flannery has yet to inject any significant outside blood into an organism that may require a major transfusion.
There remains an arrogance at GE that the world now knows is not justified, and it is likely that for the company to succeed some sort of further mid and senior management turn-over is needed. If we look at the better earnings and growth turnaround stories in the Industrials and Materials space, they have all come with meaningful senior management changes – either because the old team could not learn new tricks or because there were too many, or because some outside perspective is never a bad thing. The “not invented (trained) here” syndrome can be very destructive when a company is heading down the wrong strategic path as everyone ends up buying into and following the same wrong path.
Historically GE has trained and developed some of the best managers and business operators in the world and while Mr. Flannery undoubtedly has a great internal talent pool, at this point he needs some senior outside perspective, in our view. The chart below shows a very disturbing trend, which is in part explained away by the rise of GE Capital from 1990 to 2008, but we should be seeing a correction as GE Capital shrinks and we are not – adding a chunk of goodwill to the balance sheet in 2017 because of the Baker Hughes deal has not helped. DWDP has added much more goodwill in 2017 than GE (second chart), and proportionally much more as a percentage of total capital, because of the accounting of the merger as a Dow acquisition of DuPont, but despite this DWDP returns are more than 50% higher than GE. More important, DWDP’s earnings are rising quickly, GE’s are not.
We still see no reason to own GE and expect further disappointments in terms of earnings and write-downs before we hit a bottom.
The announcement this week that Andrew Liveris will step down as Chairman of DWDP at the end of March and leave the Board at the end of July, is an acceleration versus a plan that has been delayed more than once (in earnings parlance it is a negative surprise on a positive revision – if you were an Andrew fan – or a positive surprise on a negative revision if you are not).
Andrew has had his critics over the years (ourselves included from time to time) but he has presided over Dow during a 14-year tenure that has seen unprecedented swings in the one thing that Dow could not control – petrochemical feedstock pricing – and this has resulted in some swings in strategy – mostly unpopular with investors as the time – but in each case driven by the feedstock backdrop.
While we have been critical of Andrew’s optimism, it is very hard to be critical of his confidence and more important his adaptability. Andrew has consistently acted as the winds around the business have shifted and it is impossible to tell whether investors would have been better off had he buried his head in the sand and tried to pretend the changes were not happening, but it is unlikely in our view. He is leaving having completed the largest merger in the history of the chemical industry and with his stock bouncing around an all-time high. Not bad!
While the key to the investment thesis for DWDP is the shape and the timing of the separations (shape really meaning balance sheet structure and dividend policy) – Dow Materials Science (the new DOW) is in the right hands. We have the upmost confidence in Jim Fitterling to operate the business well and drive costs lower – this is the sweet spot of his skill set. We also hope that Howard Ungerleider stays with the new DOW and does not get lured into one of the other businesses as he and Jim have very complementary skills.
DWDP remains one of our best ideas for 2018 as we think that earnings estimates are way too low. That said, in a faltering economy, Materials would struggle, and DWDP would likely outperform because of its relative earnings momentum.
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