Monthly Review December 2013 – New Year Focus With Revisions Negative

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Graham Copley / Nick Lipinski



December 2nd, 2013

Monthly Review December 2013 – New Year Focus With Revisions Negative

  • EPS estimate revisions for 2014 are increasingly driving performance. Packaging and E&C were among the worst performing sectors in our group in November, down versus the market by the magnitude of negative 2014 estimates. However, in aggregate, the group has over the last few months, kept up with the strong broader market better than we expected.
  • Paper moved back above Electrical Equipment to reclaim the title of most richly valued sector within Industrials and Basic Materials. The Conglomerates sector was one of the few outperformers and has left Capital Goods as the only sector outside of Metals currently trading meaningfully below normal value. Metals, by far the cheapest sector, moved back above two standard deviations from its historic norm on our valuation framework.
  • November research noted extreme valuation spreads within the broad sector, explored several potentialities for LYB, and revealed sell side recommendations to be largely inaccurate predictors of performance, notably, for our purposes, in the case of DuPont.
  • We outline our preferences by and within sectors below. We would maintain our focus on the undervalued large cap group and we continue to view AA and CAT as long term value opportunities – AA attracted attention recently (as well as at least one upgrade) and we have noted that historically when the stock has moved, it has moved quickly.

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


With the calendar year end in sight, revisions continued to trickle in and were primarily negative. Perhaps not surprisingly, it was 2014 EPS revisions that were most responsible for driving performance – see Exhibit 21 later in the report.

Transports and Conglomerates were the only sectors to post meaningful outperformance. Paper was up slightly as a result of IP’s 3% relative gain, even as every other stock in the index trailed the market (LPX was one of the worst performers in our coverage). Within Transports, the large cap names led the charge higher. UPS broke $100 a share in moving to an all time high. UNP was one of the 10 best performers on the month, outpacing the market by nearly 4%, and FDX was up solidly as well.

The Packaging sector has had a very strong 2013, outperforming the S&P by 10%, but November saw the group bringing up the rear. E&C also trailed the market significantly – these moves lower were revisions driven, as both sectors saw 2014 EPS revisions that more or less matched their underperformance. Metals stocks were having a down month even before cap heavyweights FCX and NEM took turns to the downside in the days before Thanksgiving.

Electrical Equipment posted a 1% relative loss in November but performance was widely divergent within the group – PPO and BGC were the two worst performers in our coverage, each falling more than 13%, while on the flip side GTI and FELE were the two best performers, each gaining 14% plus.

We noted early in November that we would expect the underperformers for the year to play catch-up should the market continue to rally and this has broadly been the case. However, we do continue to see disappointments and stocks punished quite severely for those disappointments – AGCO was a good example in November as 2014 guidance caught the market by surprise.

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

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

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6 summarizes end-October sector discounts from normal value.

Paper snuck back above Electrical Equipment as the most richly valued sector within Industrials and Basic Materials. AA may finally be getting some love but in aggregate Metals stocks remain unloved and the group has ticked back towards two standard deviations below normal value, far and away the cheapest in the group. Packaging is still on the expensive side even after trailing the S&P by 3.5% in November – the group has had a strong year, rising 37% to outpace the market by an even 10% year to date in 2013. A month of similar outperformance would likely push the Conglomerates to the expensive side of Exhibit 7, leaving Capital Goods as the only sector outside of Metals trading below what we would consider to be “normal 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.

Last month the Paper sector supplanted Metals at the high end of the skepticism index – Paper’s index value was unchanged on the month as an increase from already high earnings was matched by an increase from already high valuations (though
these have been falling in recent months
). In aggregate the Chemicals sector is over-earning, particularly relative to its valuation but there is considerable divergence at the subsector level – see Exhibit 8.

Exhibit 7

Valuations Underestimating Current Returns on Capital

Valuations Overestimating 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 November monthly. The results are summarized in Exhibit 10, showing performance relative to the S&P, which rose 2.5% month over month.

The hedged overlap portfolio again produced the best return, posting a gain of over 3% versus the broader market. The long side picks drove most of the return here, as MON, OLN, and ROC all outpaced the S&P considerably, while even Alcoa continued to see some support. The short side contributed roughly 1% of the overlap gain – ECL and KSU struggled to move higher from lofty valuations and HON was up in absolute terms but trailed the market.

As mentioned, the overlap screen is typically most robust, and the results confirm this – aggregating monthly returns for our portfolios year to date shows an excess return on the overlap portfolio of 12% (excluding transaction costs) – 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.

Macroeconomic numbers out of the US remain enigmatic. Home prices soar the most in a month since February 2006, but consumer confidence declines to a seven month low (depending on whose index you believe). The American consumer has spent on in spite of this lackluster sentiment. Construction continues to be strong as well, and building permits stand at a five year high in the latest data. Markets have shown a high level of sensitivity to Fed announcements and the inevitable “taper” of bond purchases could roil equity shares. In the current environment, emerging economies are clearly not the engines of growth they were anticipated to be. Indian GDP is estimated to have been below 5% for the past four quarters, the longest such stretch since 2005. A Bloomberg Global Poll showed an unprecedented level of pessimism regarding Brazilian policy, and a credit downgrade is viewed by many as a near certainty. China is grappling with much needed reforms while trying to simultaneously maintain breakneck growth.

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

Exhibit 11

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

Commodity Pricing

Aluminum was the biggest mover of the major metals, down 5%. Copper was down 2% and Steel gained 2%. Lumber pricing was off a bit in November but remains near a multi-year high. Natural gas rose, and is approaching $4.00 per mmBTU, while crude oil pricing was mixed, but relatively stable – Brent crude was up and WTI was off.

US commodity prices 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 2012 actual net income. The ordinal ranking is unchanged from a month ago. The gap between the Conglomerates inclusive versus exclusive of GE has narrowed considerably since the beginning of the year. The group including GE began the year as the second most optimistic sector – despite recent positive earnings that drove the stock to levels not seen since 2008, GE’s 2015 net income estimate has come down 7.5% on the year, weighing on the overall average. The Capital Goods sector continues to show forecasts of net income that are notably depressed from 2012 levels, the only sector to show such a decline.

Exhibit 17 Exhibit 18

Source: Capital IQ and SSR Analysis

Exhibit 19 shows how these longer term estimates have changed over the month. Packaging, E&C, and Conglomerates saw the most sizable declines in 2015 net income estimates over the past month. For Packaging, this was part of a broader trend of negative revisions that drove the sector to a month of underperformance. The decline for Conglomerates was purely a GE effect; exclusive of GE, the group showed a flat to slightly positive change. Paper’s extremely rosy expectation for 2015 net income has come down a bit in recent months, but was revised up over November and is still expected to more than double from 2012 levels.

Exhibit 19

Source: Capital IQ and SSR Analysis

With 2013 winding down, we have changed Exhibit 21 to reflect changes in 2014 EPS estimates. For the month, where there were revisions they were to the downside. Packaging’s underperformance on the month was driven partly by the most extreme cuts to 2014 EPS of any of our sectors. E&C also saw significant negative revisions, and Chemicals and Metals were each off more than 1%. 2014 EPS revisions explained a substantial portion of the variation in performance in November – Exhibit 21.

Year to date, 2014 EPS revisions have been most extreme for the Metals (down a hefty 40%) and Capital Goods sectors (a still sizable 18% decline). Conglomerates (+1.7%) and Packaging (+6.5%) were the only sectors to see an increase in EPS estimates year to date.

Note that the numbers in Exhibit 20 differ from those in Exhibit 3 as the data is market cap weighted in Exhibit 20 and is a simple average in Exhibit 3.
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

Source: Capital IQ and SSR Analysis

Exhibit 29

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

Exhibit 33

Exhibit 34

Optimism High

Skepticism High

Exhibit 35

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 36-38

Exhibit 36

Exhibit 37

Optimism High

Skepticism High


Skepticism High

Optimism High

Exhibit 38

Optimism High

Source: Capital IQ and SSR Analysis

Exhibit 39

Exhibits 39-41

Exhibit 40

Skepticism High

Optimism High

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibits 42-44

Exhibit 42

Optimism High

Skepticism High


Exhibit 43

Skepticism High

Optimism High

Exhibit 44

Source: Capital IQ and SSR Analysis

Research Published in November

November 18, 2013 – The Recommendation Signal: Another Reason to Look at DuPont

November 15, 2013 – Chemicals Monthly: Energy Volatility Distracts

November 7, 2013 – Lyondell: Growth or Income, Both Have Risk

November 6, 2013 – Valuation Spreads Extreme


In Exhibit 45 we show a screen of stocks with low value, high Skepticism and high dividend yield. In November, BRC dropped out of the skepticism screen and the overlap group as a result. DD and SWK, two stocks we have been constructive on for some time, join DE and OLN (two other favorites) as the only stocks to appear on all three screens.

Exhibit 45

Source: Capital IQ and SSR Analysis

Appendix 1

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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