Monthly Review April 2013 – Capital Goods Out Of Favor

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Graham Copley / Nick Lipinski



April 1st, 2013

Monthly Review April 2013Capital Goods Out Of Favor

  • Similar to last month, the Paper, Packaging, and Transports sectors were outperformers in March, while Capital Goods and Chemicals trailed the market. The Capital Goods sector now has the most significant discount in our normal value analysis and most of the big names screen attractive in Exhibit 1.
  • Other major valuation stories in Industrials and Basics remain intact. The Transports space now stands at 1 full standard deviation above normal, with most of this premium coming from the Trucking subsector, which itself screens as 3 SDs above normal. Transports (particularly Trucking) also show the lowest skepticism index value of any of our sectors, suggesting that investors expect returns on capital to increase from current above trend levels.
  • In March we explored the impact of R&D in Industrial and Basic Materials. Our analysis showed little correlation between high levels of R&D spending and: EPS growth, return on capital (ROC) growth, or higher valuation multiples. A follow up piece on the subject highlighted companies that show an improving ROC trend with and without high R&D spending and showing declining ROC despite high levels of R&D. We showed an inverse correlation between the cost per patent filed and ROC
  • Our model portfolios produced good returns over the month. Our current screens tend to favor Capital Goods and Metals, although some chemical names still appear attractive. Today there are 4 stocks that look good on valuation, display very high levels of investor skepticism and offer well above average dividend yields; DD, SWK, OLN and FCX.

Exhibit 1

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SSRSI measures current valuation versus current return on capital and what movement in returns on capital is implied in valuation.

Exhibit 2

Source: Company Reports and SSR Analysis

Appendix 3
for the data underlying this exhibit.

Exhibit 3


From a stock performance perspective, March looked similar to February for the Industrial sectors. Lots of conflicting macro data around Europe cloud the view of whether we have bottomed or whether it can still get worse. US data is more consistently improving. Despite this we have some conflicting valuation movements, the most pronounced of which is the underperformance of Capital Goods, while other equally economically sensitive sectors, such as Chemicals and Conglomerates improve. The Paper and Packaging sectors once again were star performers for the month, again fuelled by positive revisions for 2013. This month we introduce a looks at longer term estimates to 2015, and the Paper sector is expected to show 100% EPS growth from 2012 to 2015. By contrast, expectations for Capital Goods longer term are very conservative.

Over the past six months, revisions have been to the downside for every sector, save Paper, so it is worth questioning how much of that uncertainty has been priced in, or if there will be more cuts to come to those overly optimistic initial expectations. For the second consecutive month, Cliffs Natural Resources lost nearly 30% of its value and was far and away the worst performer in our universe; the company’s stock is down 75% year over year. Construction optimism drove E&C stocks up on the month, with Jacobs Engineering leading the way in our group, up 15%, and URS and EME also appearing in the top 10 best performers.

Best and worst performers at the company level in our coverage universe are summarized in
Appendix 1

Exhibit 4

Source: Capital IQ and SSR Analysis

The valuation story is little changed from last month. Several sectors appear fairly valued (Capital Goods, Packaging, Conglomerates, E&C) while others stand at extremes of premium (Paper, Electrical Equipment) or discount (Metals). The valuation premium in the Transports space is being driven largely by the Trucking subsector, which screens as three full standard deviations above normal value – see Exhibit 29. The Chemicals sector had been trending toward a similar valuation, approaching the one standard deviation mark in January, but has since retreated; the historically
expensive Coatings sector
has begun to shed some of its premium, while this month, Industrial Gas and Commodity Chemical companies were the biggest drag on the space. Airgas dropped off after indicating it may miss the lower end of its initial Q4 estimate, while CBT and ASH were among the top 5 biggest losers in our universe over the month.

Note: part of the reason why almost all of our sectors look expensive on a relative basis is because other sub-sectors of the S&P are undervalued versus history – most extremely and most notably financials.

Exhibit 5 summarizes end-February sector discounts from normal value.

Exhibit 5

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 6. Already the obvious outlier in the chart, Metals’ skepticism index value ticked up again over March, rising from an even 2.00 to 2.14. The Transports space took over the other end of the spectrum from the Conglomerates (exclusive of GE).

As a reminder, our Skepticism Index measures how in or out of phase current valuation is with current returns on capital. A positive number suggests that either valuation is discounting a decline in return on capital or the stock has upside. On the flip side, a negative number suggests that returns have to rise to justify valuation, or the stock has downside. Paper is not as extremely valued on this basis as, while valuations are well above normal, so are returns on capital.

Exhibit 6

Valuations Overestimating Current Returns on Capital

Valuations Underestimating Current Returns on Capital

Source: Capital IQ and SSR Analysis

Exhibit 7 is a very busy chart but shows how each sector and sub-sector breaks down by SSRSI component – valuation versus ROC. All things being equal, you want to buy sectors in the top right corner and sell those in the bottom left.

We noted previously that the Trucking subsector of the Transports space was the driving force behind the group’s valuation premium. Exhibit 7 gives some justification for this, showing the subsector’s return on capital to be similarly, but not quite equivalently, above normal.

Exhibit 7

Source: Capital IQ and SSR Analysis

Portfolio Performance

We again tracked our model portfolios over the month, one based on our normal mid-cycle earnings screen, one based on our Skepticism Index and one based on the stocks that appeared on both metrics. Effectively, we bought the cheapest/most Skeptical and we sold short the most expensive/least Skeptical, as summarized in Exhibit 1 of
our March monthly
. The results are summarized in Exhibit 8, showing performance relative to the S&P, which was up about 3% month over month.

Our short screens finally began to capitulate and posted negative returns on all three of our portfolios. It was, however, the longs that led the overlap hedged strategy to 2% market outperformance. The Normal Value buy side was hurt by the inclusion of CLF. Our Skepticism Portfolio slightly outpaced the market on the month.

Exhibit 8

Source: Capital IQ and SSR Analysis

Appendix 2
we show the companies coming into our screens and leaving our screens.

Macro Environment

At SSR we are not economists, nor do we seek to be. We look at the economic indicators that are publicly available and put them into context relative to the drivers within the industries we cover. We examine trends or fundamental influences and we then look at these relative to valuation with the goal of identifying mismatches between what is implied in valuation and what is expected to happen.

The S&P 500 rose to an all time high in March, yet consumer confidence fell. Initial jobless claims rose, and though US fourth quarter GDP was revised up, a slow growth first half of 2013 would surprise few as federal spending cuts trickle their way through the economy. Chicago PMI numbers came in towards month’s end, and the production index fell from 60.2 to 51.8, the lowest level seen since September 2009. Earnings season could provide some clarity, with insights to be gleaned from the corporate perspective.

Tiny Cyprus caused a global stir in the latest installment of the Euro saga. The Cypriot tremors were not able to trigger a market sell off on their own, but there are concerns they could unsettle an already precarious European periphery.

The most recent Macro data changes are summarized in Exhibit 9.

Exhibit 9

Source: Capital IQ, Government Publications, Bloomberg, SSR Analysis

Commodity Pricing

Metal prices were down across the board in March. Aluminum saw the biggest drop, off nearly 5%. Chinese capacity expansions in the metals space have weighed on prices, as inventories rise. Natural Gas popped back up over $4 per mmBTU, narrowing the gas-oil difference. The rise comes as much of the country experiences an unusually cold early spring. Crude oil pricing was mixed on the month, with Brent down and WTI up.

US commodity prices and energy prices are indexed in Exhibits 10 through 14.

Exhibit 10 Exhibit 11

Source: Capital IQ, IHS, CRU Steel Price Index, Bloomberg, SSR Analysis

Exhibit 12

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 13 Exhibit 14

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

With 2012 data in for all of the companies in our coverage universe, we have updated our expectation analysis exhibits to reflect 2015 net income estimates and the 2012 actual figures. Exhibit 15 mainly stayed consistent after the change; Paper still leads the way, with estimated 2015 net income of more than double 2012 numbers, and Electrical Equipment and Capital Goods still bring up the rear. Interestingly, the much maligned Metals space is toward the top of the spectrum on this metric. Using 2011 net income and 2014 estimates, the sector showed barely more optimism than Capital Goods. The Conglomerates also saw their positioning jostled. Once the sector with the greatest expected increase in net income, the group now is now toward the bottom of the pack. The difference between the group inclusive and exclusive of GE is negligible.

Exhibit 15 Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17 shows how these longer term estimates have changed over the month. The ordering looks very similar to that of Exhibit 15. The Paper sector saw the most bullish revisions month over month, with Packaging riding its coattails. Construction optimism bolstered E&C estimates as well. Capital Goods forward estimates were cut on both a weighted and unweighted basis. However, this was almost wholly attributable to ITW, which saw its 2015 net income estimate cut by11% over the month. The monthly decline for Electrical Equipment on the other hand was mainly an issue of cap weighting; estimates were unchanged for EMR and ROK but the companies’ combined index weighting dropped to 50% from 51.8%.

Exhibit 17

Source: Capital IQ and SSR Analysis

The outliers of the Industrial and Basic Materials sectors, Paper and Metals, saw the most extreme revisions to 2013 EPS estimates on the month. CLF was a notable culprit in the Metals space, but the cuts were widely distributed; NEM and NUE saw significant declines as well. Paper’s increase was largely a function of IP. In the Transports sector, a large downward revision to FedEx was countered by positive revisions in the Trucking subsector (further validating its premium valuation).

Note that the numbers in Exhibit 18 differ from those in Exhibit 3 as the data is market cap weighted in Exhibit 18 and is a simple average in Exhibit 3.
Exhibit 18

Exhibit 19

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Mid-Cycle “Normal Valuation Analysis

Results of our valuation analysis for the end of November are summarized in Charts 20 through 30.

Exhibit 20

Exhibit 21

Exhibit 22

Exhibit 23

Exhibit 24

Exhibit 25

Exhibit 26

Exhibit 27


Source: Capital IQ and SSR Analysis

Exhibit 28

Exhibit 29



Exhibit 30

Source: Capital IQ and SSR Analysis


Our Skepticism Analysis by sector is summarized in the Exhibits 31 through 42.

Exhibits 31-33

Exhibit 31

Exhibit 32

Skepticism High

Optimism High

Optimism High

Exhibit 33

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 34-36

Optimism High

Skepticism High

Exhibit 34

Exhibit 35

Skepticism High

Optimism High

Optimism High

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Skepticism High

Optimism High

Exhibit 38

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Optimism High

Skepticism High

Exhibit 40

Optimism High

Skepticism High

Exhibit 41

Skepticism High

Optimism High

Exhibit 42

Source: Capital IQ and SSR Analysis

Research Published in March

March 4, 2013 – Monthly Review March 2013: More of the Same for the Industrials

March 5, 2013 – R&D in Industrials and Basics: Just Not Effective

March 15, 2013 – Chemicals Monthly: A Few Cheap Stocks with Housing/Construction Exposure

March 18, 2013 – Investing Around R&D: Looking For the Companies Losing the Least


In Exhibit 43 we show a screen of stocks with low value, high Skepticism and high dividend yield. There were no changes to this screen over March, leaving Freeport McMoran, DuPont, Olin, and Stanley Black & Decker as the only four to appear on all three metrics.

Exhibit 43

Source: Capital IQ and SSR Analysis


Appendix 2

Appendix 3

Appendix 3

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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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