Is There Another Curse To Optimism – Does It Attract Activists?

gcopley
Print Friendly, PDF & Email

SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

January 18th, 2019

Is There Another Curse To Optimism – Does It Attract Activists?

  • We are revisiting the optimism work that we began in 2012, with no expectation of finding different results and consequently no disappointments.
    • However, we have found a link with activism, and we think that our analysis can forewarn companies and investors about possible activist investor intervention.
  • Optimists still limit shareholder value creation relative to their more conservative cousins (Exhibit 1) and are still just as easy to identify.
    • Some of the players have changed from our original analysis; in most cases, as we predicted in prior versions of this report, coincident with a regime, or a more dramatic change.
    • We have a group of 85 Industrials & Materials companies of all sizes with sufficient estimate and EPS history back to 2002 (the base year for our initial 10-year analysis published in 2012).
  • If you had bought both groups as identified in 2012 you would have achieved the aggregate results shown in Exhibit 2 – the conservative group outperforming the optimist group by 38% but not the S&P 500.
    • In this analysis, we are including the benefits of acquisition premiums where they occurred.
    • Our recommendation in prior work has been to short the optimists and buy the conservative group – with would have created a positive return over the 6-year period but would have underperformed the market.
  • Buying the conservative group at the beginning of 2018 and shorting the optimists worked in Industrials and Materials as a broad group but failed in Chemicals as many commodity biased conservative companies were taken down with the second half commodity sell-off.

Exhibit 1

Source: Capital IQ and SSR Analysis

Summary

As we showed in our weekly review on Sunday, our optimist screen generated a positive return in the broad Industrials and Materials, whether you looked at optimism over the long-term or over a shorter period – Exhibit 2. However, as also shown in the Exhibit, it did not work for the Chemicals sector. 2018 was an unpredictable and volatile year and for the broader strategy to outperform the market – as well as Chemicals on the shorter-term view – we consider it a success. As Exhibit 1 shows, there are some stark performance differences between the optimists and those who are more conservative. We began the analysis in 2012 and if you had bought the top optimists and most conservative names at that time you would have the performance in Exhibit 3. While the conservative group did not outperform the S&P500, it did outperform Industrials and Materials Indices (we are using the SPDR sector indices).

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

With several more years of data incorporated since we began this journey, there are changes in the composition of the optimist and conservative groups. Several have been bought out or split; several others are new coverage additions as we have expanded our SMID universe over the past several years.

Notable companies that were in the top 20 conservative (investable) group in our original 2012 work that have fallen out of this group include Ball Corporation, Eaton, Silgan Holdings, and Valmont Industries. There are fewer examples of companies improving enough to fall out of the optimist (negative) group: only EMCOR Group because of improvement.

We look for those with the most improving or deteriorating trends – whether or not they fall into the top or bottom quintiles. There are fewer improvers than those deteriorating – improvers include Packaging Corp of America, P.H. Glatfelter and Minerals Technologies. Those going most rapidly backwards are: Timken, Reliance Steel and Cummins.

Overview/Review of Methodology

To review, we quantify corporate “optimism” by comparing the difference between actual EPS in each year with the estimate on January 1st of that year – Exhibit 4 demonstrates this using Norfolk Southern (NSC) as an example. The key assumption/assertion for this methodology is that January 1st estimates reflect corporate guidance. Any given year may be an anomaly, but persistently optimistic companies underperform and destroy value as shown in Exhibit 1.

Exhibit 4

Source: Capital IQ and SSR Analysis

All things being equal – industry dynamics, valuation, capital structure etc. – we would always favor a conservatively managed company over an optimist as an investment.

Results

The table on the next page (Exhibit 5) shows the current 20 most optimistic and 20 least optimistic (most conservative) companies on this measure. As noted above, we have a sample set of 85 Industrials and Materials companies of all sizes that have earnings and estimate history back to 2002 (our initial optimism analysis considered a 10-year period from 2002-2011).

Exhibit 6 on the subsequent page shows the trend in return on capital for the conservaitve group versus the optimist group.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

In Exhibit 7 we show the average annual TSR of the two groups from 2002 to 2018 – note that for 2018 we are using current estimates for the year as we have almost no actuals at this point.

Exhibit 7

Source: Capital IQ and SSR Analysis

The divergent return on capital trends (Exhibit 6) suggest that the optimism embedded in earnings guidance/estimates can often extend to a company’s capital allocation decisions – optimists deploy capital with overly aggressive assumptions and fail to achieve appropriate returns.

In Exhibit 8, we show the ten stocks with the biggest positive and negative changes in optimism compared to the results through 2011. There is a bit of a mean reversion effect here, with many historical optimists seeing improved results relative to their past and many historically conservative companies seeing deteriorations.

Overall, this is a very surprising result given the positive nature of the macro environment until recently and the data in Exhibit 9, which show the increasing percentage of companies within the Industrials and Materials universe that have beaten estimates (until 2H 2018 – which is either excluded from some analysis or too small an incremental data point to change the data in Exhibit 8). Until very recently, the macro environment has made it difficult to be too optimistic!

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

In Exhibit 10 on the following page, we show for each company which quintile they sat in from 2002-2011, which quintile from 2012 to 2018 and where they are in the longer continuum – note that PKG’s stunning performance over the last 6 years is not enough to pull it out of the bottom quintile over the 2002 to 2018 period.

Exhibits 11 and 12 on the subsequent page show the constituents of the 20 most/least optimistic companies from our initial analysis in 2012 and track the developments in each company’s optimism since that time.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Does Optimism Attract Activists?

In Exhibit 13 below, we show the 2018 optimists and conservatives (adding 2018 results) using current 2018 estimates versus January 1, 2018 estimates as we do not have the full year data for most yet. The highlighted names below are new to the groups and were not found in a similar table representing 2017 optimists and conservatives. Interestingly, two companies added to the Chemicals 5 Year Optimist group, PPG and RPM, have had activist investors build stakes in 2018.

Exhibit 13