Monthly Review June 2013 – Industrials Reflect the Housing Comeback

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Graham Copley / Nick Lipinski



June 3rd, 2013

Monthly Review June 2013 Industrials Reflect the Housing Comeback

  • E&C stocks rebounded from a poor performance last month to outperform the S&P in excess of 7% while the Paper sector fell on negative revisions. Metals, Transports, and Chemicals all tracked the market within 1%.
  • Paper’s underperformance trimmed some of its valuation premium, and while the sector has retreated slightly since approaching three standard deviations above normal in March, it is still the most expensive sector within the Industrials. Without the discount in General Electric the Conglomerates screen as slightly expensive, leaving Capital Goods as the only sector outside of Metals to show an attractive aggregate valuation.
  • In May, in addition to our regular monthly reports, we explored the causes of the general Industrial lag versus the broader market, followed up on a DuPont report published earlier this year, and highlighted some value opportunities in the Capital Goods sector. Our recent piece on DuPont analyzed the company’s portfolio and R&D pipeline.
  • Our model portfolios rallied towards month’s end but two of the three metrics were unable to keep pace with the market. The skepticism portfolio was virtually flat, while the normal value and overlap portfolios each returned -1%. The 25 most attractive stocks in our universe are concentrated in the Capital Goods (seven stocks) and Metals (six) sectors; the composition of the least attractive group includes four of the five stocks in our Paper index as well as eight Chemical companies.

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


Reversals were a common theme over May for the Industrials. E&C rebounded from a 10% relative decline in April, overcoming cuts to longer term earnings estimates to easily post the best gain of our sectors; stocks in the group also benefited from the continuing rebound in the housing sector. Paper, which has long been the most richly valued of our sectors, saw the biggest relative loss on the month. Negative revisions drove the decline, though the extent of the loss (roughly 3.5%) was not as severe as the nearly 7% cuts to 2013 EPS estimates across the sector. Packaging declined in tandem, although estimates were little changed in May. Outside of Engineering & Construction, Capital Goods had the strongest showing, overcoming downward revisions to outpace the market by over 2%.

An unanticipated drop in consumer spending in April could indicate that the increased payroll tax and federal spending cuts are finally beginning to work their way through the economy. Favorable energy costs and the resurgent housing market have been counterbalancing forces but with revenue growth already plateauing, lower spending levels are inauspicious for the Industrials.

While our sectors were divided between market outperformance and underperformance in May, the results were not as equitably dispersed at the stock level. Only 14 of our companies lost 2% or more on the month while the same number saw gains of at least 10%. 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 4.

Gains in the E&C space were widespread, with four of the seven stocks in our index enjoying monthly gains of over 11%. KBR was the biggest winner, in the sector and in our universe overall, posting a 20% gain in May. There is an element of understandable schizophrenia in the market about this sector given the extreme leverage that the group has to any significant uptick in US industrial and infrastructure investment. There is compelling evidence to suggest that an increase in spending is both needed and likely, but the stocks are probably overvalued if it fails to happen. Consequently small data points can cause large swings in sentiment. General Electric’s performance on the month was evenly matched by its fellow Conglomerates, which outperformed the market by about 2%. While the Paper sector was the laggard of the group, none of its component stocks appeared near the worst performers of our coverage universe. Underperformance was pervasive within the group, as each Paper stock (save UFS) lagged the market, notably IP which heavily influences the weighted result.

Exhibit 4

Source: Capital IQ and SSR Analysis

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

Capital Goods outperformed in May and still shows some of the most attractive opportunities in our space –
see our recent work on the sector
. Some of the valuation in the Paper sector has been trimmed since it approached three standard deviations above normal in March, but it remains the most richly valued sector of the Industrials. E&C flipped from slightly cheap to slightly expensive after its strong month but overall valuations here appear to be in line.

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

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 6. The relative outperformance in the E&C sector lowered the group’s SI value as the increased valuations more accurately reflect current returns on capital. The Paper sector’s aggregate ROC declined slightly which, combined with underperformance, brought its skepticism value down. Chemicals supplanted Paper as the second most skeptically viewed sector behind the Metals space where valuations and returns remain well out of sync.

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 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.

Most sectors and subsectors are grouped around the trend line in the exhibit, which shows all points where valuation and returns on capital are completely in line with one another, consistent with the results in Exhibit 6 which for the most part shows moderate skepticism index values. Metals and Mining is an obvious outlier in both exhibits. The Commodity Chemicals subsector is notable in Exhibit 7 as well; the group’s ROC is well above normal (2 SDs) but valuations do not reflect these above average returns.

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 May monthly
. The results are summarized in Exhibit 8, showing performance relative to the S&P, which was up 2% month over month.

Our short side picks have been driving our portfolio returns for the past several months but bucked that trend this month with positive performance on all three metrics. The influence of large cap conglomerate HON was notable, as the stock gained over 7% on the month and currently screens as 2.5 standard deviations above its normal value. On the long side, our stocks were generally unable to compensate for the short side outperformance; only the skepticism screen produced a gain in excess of the market, while the long picks for the other two metrics were more or less flat to the S&P.

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 global economy continues to middle along as indicators remain decidedly mixed. US first quarter GDP was revised down to 2.4% yet consumer confidence surged on the month. Jobless claims were up even as the Memorial Day holiday limited processing time. Bullish sentiment in the housing market was reinforced by rising home prices. Comments from the Federal Reserve indicate that the domestic economy remains in a tenuous position, with listless job growth hindering any positive momentum.

Factory activity data out of China showed a decline for the first time since 2012. During the month, the Chinese premier told German business leaders that the emerging Asian giant faces significant hurdles in its race to achieve 7% annual growth over the decade. The resilient German economy itself has been comparatively insulated from the Eurozone’s chronic struggles but jobless claims rose for a fourth consecutive month, cautioning that the country cannot continue to bolster the beleagured continent. Consumer confidence in the Euro area rose even as unemployment data yet again showed a new record highs.

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

Exhibit 9

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

Commodity Pricing

Aluminum pricing fell 1.5% over the month and is down 12% since October; concerns of global oversupply led Moody’s to strip Alcoa (AA) of its investment grade rating. Prices for steel saw an even sharper decline in May, down 2.5%, while Copper rose 3%. Lumber pricing was particularly active in May, dropping 17%. Output has been increasing in response to increased demand from China and domestic homebuilders; a 6.5% year over year increase in production is expected for 2013. Energy prices were down in May as well. Crude oil is off 9% since January as we head into the summer season and natural gas has retreated to the $4.00 per MMBTU level.

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

In Exhibit 15 we look at expected net income growth by sector, comparing 2015 estimates with 2012 actual net income. The Capital Goods sector is still showing only a marginal three year increase in net income, highlighting not only continuing concerns about a slower growth future, but perhaps also a value opportunity in the space –
see recent research
. On the diametric extreme, Paper retains its bullish expectations despite declines in 2015 net income estimates over May.

Exhibit 15 & Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17 shows how these longer term estimates have changed over the month. On a weighted basis no sector saw a positive change in 2015 net income estimates. The decline in Capital Goods was most extreme, even as the sector outperformed; the weighted figure paints a poorer picture than the unweighted number as cuts to CMI, DE and CAT overshadowed gains for smaller cap AGCO. The opposite scenario took place in the Metals sector, where US Steel’s 2015 net income estimate was slashed by 46%; a small positive revision to cap leader FCX moderated this effect in the weighted rankings.

Exhibit 17

Source: Capital IQ and SSR Analysis

Where there were revisions to 2013 EPS estimates in May, they were predominantly negative. The Paper sector, which in recent months has been the beneficiary of large positive revisions, experienced the largest decline with estimates down over 6% from April to May. Lowered estimates in the Capital Goods and Electrical Equipment sectors did not prevent the sectors from outperforming the S&P on the month.

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 25Exhibit 26 Exhibit 27 Exhibit 28

Exhibit 30


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

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 34-36

Exhibit 34

Optimism High

Skepticism High

Exhibit 35

Exhibit 36

Skepticism High

Optimism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 37-39

Exhibit 37

Exhibit 38

Skepticism High

Optimism High

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibits 40-42

Exhibit 40

Optimism High

Skepticism High

Exhibit 41

Exhibit 42

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in April

May 1, 2013 – Monthly Review May 2013: Bulls Rave On, Industrials Sit on the Sidelines

May 9, 2013 – Getting Left Behind in the Market: Unless You Have A Story

May 13, 2013 – DuPont: Betting the Farm – But Perhaps a Need to Crop the Portfolio?

May 14, 2013 – Chemicals Monthly: Outperformance Despite Negative Revisions

May 30, 2013 – Capital Goods: Time to Play the Valuation Card


In Exhibit 43 we show a screen of stocks with low value, high Skepticism and high dividend yield. Freeport McMoran (FCX) dropped out of the Skepticism Index screen, leaving GE and OLN as the only two companies to appear on all three metrics.

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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