Monthly Review January 2013 – Basic Materials Set to Open the Year at Extremes

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@ssrllc.com

January 2, 2013

Monthly Review January 2013Basic Materials Set to Open the Year at Extremes

  • Industrials and Basic Materials enter 2013 with many of our conclusions for 2012 still intact. In our valuation framework, the Paper sector, fueled by optimistic forward expectations, now screens as three standard deviations above normal value. The Coatings subsector of the Chemicals looks equally overvalued. Conversely, our Metals index closed the calendar year at roughly 1.5 standard deviations below normal.
  • Stock performance over December reinforced these valuation divergences. Paper posted the best gain of the Industrials, while Metals brought up the rear as the only sector in our universe to trail the S&P 500 in December.
  • Over the past month we extended our work on historic EPS revisions in addition to publishing our monthly piece on the Chemicals sector. Separating the Industrials into Optimistic (over-estimating earnings) and Conservative (under-estimating earnings) subgroups, we found that the Conservative group considerably outperforms the Optimists on most relevant metrics.
  • Results for our model portfolios were universally positive. While our short side screens underperformed, our long portfolio outperformed more significantly. The hedged strategy was profitable as a result. The December components are summarized in Exhibit 1 and the changes in the composition of the portfolios are shown in Appendix 2.

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

See
Appendix 3
for the data underlying this exhibit.

Exhibit 3

Overview

The Industrials rounded out the calendar year mainly on a high note. Only the Metals sector trailed the S&P, which pushed the sector further still below normal value. There was some divergence within the sector itself, with CLF posting the largest gain over the month of any of our covered stocks, and FCX posting the largest loss. The Paper sector substantially outperformed over December; every Paper stock in our index saw a gain en route to a sector return of 10% in excess of the market. This move is based on some very positive revisions and bullish earnings projections for 2013 from a group that does not have the best track record in terms of estimate accuracy. Chemicals, Capital Goods, Electrical Equipment and E&C also stayed positive, even as the early makings of a Santa Claus rally faded amidst fiscal cliff fears.

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 Paper sector was the best monthly performer of our group for the fifth time since we began publishing monthly reviews in July. That initial report marked the only month over that span where the sector failed to outpace the market. Such sustained outperformance has the sector entering into 2013 at nearly 3 full standard deviations above normal value. Metals and Mining has been the parallel at the other end of the spectrum. The extreme laggard for the third time since initiation of our monthly review, the Metals space remains the cheapest of our covered sectors. Over the month, Electrical Equipment shot up to 2 standard deviations above normal value. Part of this is explained by double digit increases in PPO and BDC, but the removal of CBE from the index following the completion of the Eaton acquisition also altered the sector dynamics slightly.

Exhibit 5 summarizes end-November sector discount from normal value.

Exhibit 5

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 6. In recent months, Skepticism Index values have trended toward zero for several sectors, indicating that valuations accurately discount current ROC levels. Chemicals saw a decline of 0.26 over the month, leaving it essentially flat. The Electrical Equipment sector had a decrease of similar magnitude, due to increased valuations that more accurately reflect a currently high ROC but also as a result of the readjustment following the removal of CBE.

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 sock 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 Underestimating Current Returns on Capital

Valuations Overestimating 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.

The Coatings subsector of the Chemicals space received an additional valuation boost after PPG announced its acquisition of Akzo Nobel’s North American paint business. This resulted in the largest month over month change in skepticism value in our universe, particularly interesting as the very high valuation clearly anticipates an increase in already high returns on capital. However, as
we showed in recent research
, not only does the sector have very conservative growth in 2013 consensus estimates, even allowing for the PPG basic chemicals divestment, but the sector is a good predictor of forward earnings.

Exhibit 7

Source: Capital IQ and SSR Analysis

Portfolio Performance

We again tracked our model portfolios over the month, one based on our 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
December monthly
. The results are summarized in Exhibit 8, showing performance relative to the S&P, which was up about 1% month over month.

The hedged strategy produced positive returns on all three screens, but the buy strategy alone would have been most profitable. Our short side portfolios universally outperformed the market, unsurprising considering that sectors already screening as expensive (Paper, Electrical Equipment, Chemicals) outperformed the market again on the month. Many valuations within this portfolio appear stretched.

Exhibit 8

Source: Capital IQ and SSR Analysis

In
Appendix 2
we show the companies coming into our screens and leaving our screens – both for November and for December.

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.

Apprehension over the looming fiscal cliff overshadowed the month’s mixed economic data. Pending home sales exceeded expectations for November as housing continues to be the major support for the domestic economy. Orders for durable goods were up as well. However, US PMI dipped back below 50 and industrial bellwether GE offered a cautionary outlook on 2013.

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 little changed as the year wound down. Steel saw a modest gain while aluminum and copper were essentially flat. Inventories of aluminum tracked by the LME rose to record highs, possibly indicating future price weakness. Lumber prices spiked up in anticipation of increased construction in the US and China. Canadian production is expected to rise to meet this demand, which could temper prices in 2013. The gas-oil difference continued to widen in December, with crude oil up and natural gas down.

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

Paper surged ahead of Conglomerates once again, and is the sector with the most optimism behind 2014 net income estimates heading into the New Year. Such rosy expectations offer some explanation for the valuation premium afforded the sector, though in our view the Paper space looks expensive and will struggle to produce the anticipated returns. Most of the optimism for the Conglomerates is in GE, but in December the company guided expectations lower; estimates could continue to fall going forward into a very uncertain demand environment in 2013.

Exhibit 15 & Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17 shows how longer term estimates have changed over the month. Metals dropped down several spots in the Industrial ranking after its estimate was cut sharply month over month. This was mainly a cap effect; the sector’s unweighted estimate change was much closer to flat but a transfer in cap weight from FCX to CLF drove the weighted decline. At the brighter end of the spectrum, large upward revisions for 2014 estimates gave the much loved Paper sector additional support for current valuations. The negative revisions in the Chemicals sector were mainly to smaller cap names; on a weighted basis the estimate showed little change. Most of the decline in the Conglomerates was a function of GE, as the company scaled back its forward estimates.

Exhibit 17

Source: Capital IQ and SSR Analysis

Looking forward to 2013, revisions to EPS estimates were mostly negative. The Metals sector was the clear loser as the beaten down group saw a negative revision of over 3%. No other sector had its estimate revised down by more than 1%.

Over the past few months, where there have been revisions to EPS they have been mostly negative. This could reflect increasing pessimism amid an ostensibly weaker global economy, or could be a function of poor initial guidance (
see recent research
).

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

Skepticism

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

Exhibits 31-33

Exhibit 31

Exhibit 32

Exhibit 33

Skepticism High

Optimism High

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 34-36

Exhibit 34

Exhibit 35

Optimism High

Skepticism High

Exhibit 36

Skepticism High

Optimism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Exhibit 38

Exhibit 39

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Exhibit 41

Optimism High

Skepticism High

Exhibit 42

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in December

December 10, 2012 – Overconfidence Destroys Value

December 18, 2012 – Chemicals Monthly: The Rise (or Fall) of Propane

New Screens: Dividends, Best & Worst Performers

In Exhibit 43 we show a screen of stocks with low value, high Skepticism and high dividend yield. This month Olin joined Stanley Black & Decker and DuPont as the only stocks to appear on all three screens.

Exhibit 43

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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