Monthly Review April 2014 – March Madness No Cure as Industrials Lag in Q1

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Graham Copley / Nick Lipinski



March 31st, 2014

Monthly Review April 2014March Madness No Cure as Industrials Lag in Q1

  • Q1 has seen Industrials & Basics largely out of favor as only Packaging, E&C, and the increasingly expensive looking Chemicals sector have outperformed the S&P. This is even after a very strong March in which Paper was the only sector to trail the sideways moving market.
  • The valuation story is somewhat changed, with Paper’s poor Q1 (4.8% relative loss) leaving the sector less expensive than it has been in some time. Electrical Equipment is now the only sector trading one standard deviation above its normal value, while Metals is still the cheap outlier.
  • In March we wrote about the relative attractive of PX versus APD, screened a list of companies that we believe would make attractive targets on any weather related Q1 dip, noted peak valuations in certain commodity chemicals stocks, expressed our skeptical view of basic chemical investments in the US, and published a broad agricultural piece in conjunction with our colleague Rob Campagnino as well as a corollary ag piece focused on Industrials (Ag equipment and chemicals).
  • Our preferences at the sector and stock level are shown in Exhibit 1 below. AA continued its climb higher, nearing $13 per share as the 6thbest performer in our coverage on the month. Another longtime favorite, CAT, also outperformed again in March and we see further upside here as well. Our Chemical concerns reflect our cautious Q1 outlook for Commodity companies LYB and WLK.

Exhibit 1

Source: SSR Analysis

Exhibit 2

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 3

Source: Company Reports and SSR Analysis

Appendix 3
for the data underlying this exhibit.

Exhibit 4


Q1 2014 has seen one of the longest standing valuation stories within Industrials & Basics finally turn around with some real momentum. Paper, long the most expensive sector in our group, has been the worst performing sector year to date, down 4.8% relative to the S&P. Revisions have been behind this decline – only the Metals space has seen estimates lowered by a greater magnitude over the past three to six months.

As estimates continue to come down in the Metals sector, valuations appear to have little left to give on the downside. Metals stocks accounted for four of the six best performers in our coverage in March (ATI, X, CRS and AA) but weakness elsewhere (notably WOR, the only fully valued stock in the space) left the sector behind Capital Goods, E&C and Chemicals for the month. Strength in the Chemicals space was widespread, led by AXLL (+11.8%); CBT, SMG, NEU, ASH and OLN were all also among the top performers. DOV weighed on the Capital Goods sector; the stock traded down following the completed spin off of subsidiary Knowles Corp (KN). BGC was the other big loser on the month, down 16% after citing weather related impediments in its Q1 guidance. Best and worst performers at the company level in our coverage universe are summarized in
Appendix 1

As Q1 earnings results start to come in we would not be surprised to see weather-attributed misses from many of the companies in our space (even considering the guidance that has been offered thus far). We would be buyers of HUN, OLN, SWK, DE and AGCO (
among others
) on any Q1 dip. On the other side, earnings light of lofty expectations for SHW, CYT, GNRC, HON, RPM, SEE and GWR could be the catalyst for a wider exit and further downside.

Sector performance relative to the S&P is shown in Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6 summarizes end-March sector discounts from normal value. The valuation discount in the Metals sector remains at the highest level seen since 1980, at two and a half standard deviations below our normal value. Paper’s weak first quarter has brought the group’s valuation premium down to a less statistically significant level. Electrical Equipment is now the most expensive sector, and all of the large cap names (EMR, ROK, AME) indeed screen at a premium. Niche competitors like GNRC also show rich valuations. As Exhibit 6 suggests, most of the discount in the Conglomerates sector is attributable to GE; however, the group’s premium exclusive of GE is driven by the lofty valuation for HON (2.8 standard deviations above normal). DHR is the cheapest Conglomerate, while MMM and UTX are nearly at fair value.

Exhibit 6

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 7. 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.

The valuation premium in Electrical Equipment is actually understating the group’s current return on capital. A similar situation is exhibited in the Paper sector, where valuations are declining ahead of returns, which remain strongly above trend. In the Metals space, valuation is discounted more than the group’s below trend earnings would support.

Exhibit 7

Valuations Overestimating Current Returns on Capital

Valuations Underestimating Current Returns on Capital

Source: Capital IQ and SSR Analysis

Exhibit 8 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.

Exhibit 8

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 2 of our March monthly.

The results for March were very strong. The overlap screen, as per usual, was most robust – Exhibit 10. This positive performance comes on the heels of lackluster returns in the first two months of 2014. One quarter in, the aggregate results exclusive of transactions costs has turned positive for the overlap screen (+2.5%) and flat for the valuation screen (-0.1%), but the SI screen continues to lag (-3%) – Exhibit 9.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

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.

Markets quavered mid-month on thoughts that the Fed would raise interest rates faster than expected, but Fed Chair Yellen helped allay these concerns on the last day of March and the market rallied. Ms. Yellen noted the “considerable slack” that remains in the US labor market, which has struggled to gain traction even as corporate margins and stock indices hover near all time highs.

A Chinese slowdown is increasingly in focus, and several high profile defaults have raised questions about the quality of burgeoning debts in the nation. Tensions have largely defused in Ukraine as Russia has recently turned more amenable to a diplomatic resolution.

The most recent Macro data changes are summarized in Exhibit 11.

Exhibit 11

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

Commodity Pricing

Natural gas pricing continues to moderate as the record cold winter mercifully draws to a close (as the calendar might claim – the snow in the northeast this morning would indicate otherwise). Crude pricing has been relatively stable over the past month.

Copper was down again, reflecting a cooling demand environment in China. Aluminum was virtually flat on the month. Alcoa announced capacity cuts at two of its Brazilian smelters. Court rulings derailed the proposed LME reforms, which could keep upward pressure on prices in the near term. Q1 has seen Copper down double digits, and aluminum off 2.5%, while steel has been essentially flat.

US commodity and energy prices are indexed in Exhibits 12 through 16.

Exhibit 12 Exhibit 13

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

Exhibit 14

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 15 Exhibit 16

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 17 we look at expected net income growth by sector, comparing 2015 estimates with 2013 actual net income. This is the first month we have been able to incorporate full 2013 net income figures. The Metals sector was showing only a small increase over 2012 net income levels, but has an easier comparison with 2013 levels that were subdued as a result of a poor year for large cap gold miner NEM. The Transports sector had been showing a much greater degree of forward optimism but this was partly driven by a very low 2012 figure for UPS. Paper still shows the most long term growth in forecast net income.

Exhibit 17 Exhibit 18

Source: Capital IQ and SSR Analysis

Exhibit 19 shows how these longer term estimates have changed over the month. Metals and E&C saw the worst declines on both a weighted and an unweighted basis. Notable culprits included FCX in the Metals space and KBR in E&C. The Capital Goods sector was flat unweighted – small gains for CAT and DE translated into a weighted gain for the group. Conglomerates led the way, or rather GE did, and the group was flat on both metrics otherwise.

Exhibit 19

Source: Capital IQ and SSR Analysis

In Exhibit 20 we show the change in 2014 EPS estimates over the past month. Metals saw the most sever revisions, but Packaging and E&C were also down over 1%.Capital Goods, Chemicals, and Paper saw marginally positive changes. In recent months revisions have been driving performance, but that correlation broke down significantly in March, primarily as a result of Paper underperforming despite seeing positive revisions – Exhibit 21.

Note that the numbers in Exhibit 20 differ from those in Exhibit 4 as the data is cap weighted at each index point in Exhibit 20 and a current cap weighted average of percentage changes in Exhibit 4.

Exhibit 20

Exhibit 21

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 22 through 32.

Exhibit 22

Exhibit 23

Exhibit 24

Exhibit 25

Exhibit 26

Exhibit 27

Exhibit 28

Exhibit 29


Source: Capital IQ and SSR Analysis

Exhibit 30

Exhibit 31

Exhibit 32


Source: Capital IQ and SSR Analysis


Our Skepticism Analysis by sector is summarized in the Exhibits 33 through 44.

Exhibits 33-35

Optimism High

Skepticism High

Exhibit 33

Exhibit 34

Optimism High

Exhibit 35

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 36-38

Optimism High

Skepticism High

Exhibit 36

Optimism High

Exhibit 37

Skepticism High

Optimism High

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibits 39-41

Exhibit 39

Skepticism High

Optimism High

Exhibit 40

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibits 42-44

Optimism High

Skepticism High

Exhibit 42

Exhibit 43

Skepticism High

Optimism High

Exhibit 44

Source: Capital IQ and SSR Analysis

Research Published in March

March 31, 2014 – Petrochemical-Fest: A Summary of the Texas Gathering

March 24, 2014 – Seeding a Better Investment

March 23, 2014 – Why the Basic Chemical Investments in the US Will Likely Disappoint

March 19, 2014 – Peak Valuation in Some Commodity Chemicals: Something to Watch

March 13, 2014 – After the Storm Clouds Clear: What to Buy on a Dip

March 5, 2014 – APD: Time to Move to the Sidelines – PX More Interesting


In Exhibit 45 we show a screen of stocks with low value, high Skepticism and high dividend yield. SWK and OLN are the only companies to appear on all three screens.

Exhibit 45

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2

Appendix 3

Appendix 3

©2014, 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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