Monthly Review March 2013 – More of the Same for the Industrials

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Graham Copley / Nick Lipinski



March 4th, 2013

Monthly Review March 2013More of the Same for the Industrials

  • February saw the dominant Industrial and Basic Materials themes of recent months continue to play out. The Metals sector materially underperformed while the Paper sector outpaced the market. Packaging stocks were the big winners on the month, interesting given weaker economic forecasts and higher prices for many packaging raw materials.
  • The incorporation of 2012 annual data into our valuation framework slightly altered our sector discounts from normal value. This is a minor but necessary update and in no way impacts any of the absolute or relative conclusions. The Paper sector looks marginally less expensive than it did previously, but still screens as two standard deviations above normal value. Electrical Equipment retained its valuation premium, nearly supplanting Paper as the most expensive of our sectors, but our other sectors showed little or no change (1).
  • Over the past month we expanded our work on value destroying optimism to the S&P 500, and found that the results held, not only for the index but for most of the constituent sectors. We also published a piece on the current economics of basic chemicals in the US, analyzing the sustainability of present pricing dynamics.
  • Our model portfolios produced mixed results during February. The skepticism screen was the most robust over the month but the normal value screen produced a negative return. The hedged strategy for the Overlap portfolio of the two was essentially flat versus the S&P. The January 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.

Note (1). At the end of each year we update estimated numbers in our valuation database with actual. In some cases, these can lead to changes in “normal value” as they can change the trend lines and averages that we use. This is most pronounced where a company has a materially different return on capital at the end of a new year relative to prior years. It is also more pronounced in companies with shorter history.

Exhibit 2

Source: Company Reports and SSR Analysis

See Appendix 3 for the data underlying this exhibit.

Exhibit 3


The performance of the group in February should probably not be a surprise given the economic undertones. Forecasts of global economic growth for 2013 are still trending down, but at the same time there is more uncertainty or variability in the forecasts. In an uncertain and economically weak world you generally do not want to own commodities and so it is not surprising to see Metals and Chemicals, and these factors are almost always a drag on Capital Goods also. The stories continue to do well and the prevailing story in this group is pricing power in the containerboard business. Despite some earnings disappointments in the Paper sector last month, there is still strong-buy-in to the structural change in the industry. It is likely that packaging got caught up in this in February as there is some overlap between the business lines in each sector. Our simplistic view of the fundamentals of packaging is that consumer spending is under pressure and plastics and paper pricing is higher, while aluminum cannot fall much further. Consequently we do not see a margin story here. The Metals sector was hurt by discouraging reports out of China, where manufacturing slowed and stockpiles rose. Cliffs Natural Resources lost 30% of its value over the month as the worst performer in our universe. Chemicals also had a disappointing month, highlighted by underperformance in the Coatings and Commodity subsectors.

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

After yet another month of underperformance, the Metals sector now stands at essentially two full standard deviations above normal value. Despite its pacesetting February, Paper was nearly supplanted by Electrical Equipment as the most expensive of our sectors. This was mainly a result of the incorporation of finalized 2012 data into our framework, which resulted in a slight valuation shakeup; most sectors did not experience a material change.

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. The Metals space remains the clear standout on our skepticism index framework, having risen above 2 over the past month. As we highlighted last month, previous research noted that the Metals sector has outperformed the S&P by 10% in the six month period following a skepticism index value of 1.5 or above. All of our other sectors show intermediate skepticism index values.

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.

The Packaging sector was the biggest mover on the month; its skepticism index value dropped to a nearly flat level as outperformance brought valuations into line with current returns on capital.

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 February monthly . The results are summarized in Exhibit 8, showing performance relative to the S&P, which was up about 5% month over month.

For the month, the hedged strategies for the Normal Value and Skepticism nearly offset each other. Our Skepticism screen was the most robust. The Normal Value buy side was hamstrung by CLF, which lost 30% of its value in February. Graftech (GTI) gave disappointing guidance and its subsequent poor performance dragged down the Overlap buy portfolio, resulting in a slightly negative return.

Exhibit 8

Source: Capital IQ and SSR Analysis

In 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.

Uncertainty remains the operative word in the macroeconomic landscape. In the US, home sales surged, exceeding expectations. Optimism on this front was countered by concerns about the impending “sequester” related spending cuts. Europe remains in disorder, with the Italian election debacle the latest disconcerting sign to come out of the continent. Toward month’s end, Fed Chairman Bernanke’s comments before Congress helped to calm the markets, which had grown skittish amidst Euro concerns and the implications of the Fed minutes.

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

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

Commodity Pricing

Pricing for aluminum was down on the month on discouraging data out of China; manufacturing levels are slowing while Chinese supply itself increased. Copper and steel were down as well, as stockpiles rose. Natural gas pricing moved higher in anticipation of colder weather forecasts. Prices for crude oil, which had been trending higher for several months, dipped down, narrowing the gas-oil divergence.

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

2014 net income estimate show little change from a month ago. Last month we noted that Capital Goods has dropped to the bottom of the Industrials range mainly due to Caterpillar, which has seen its 2014 net income estimate fall by $2B since last year. The Paper sector’s ascent to the top of the spectrum has in part been similarly driven by its cap leader, International Paper, for which estimates are up more than $500 million from last February; the most dramatic increases have been seen in LPX however, where estimates have more than quadrupled in a year’s time. We will move this analysis by one year in the April 1st monthly as by that time we will have complete 2012 data.


Exhibit 15 & Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17 shows how these longer term estimates have changed over the month. The Paper sector was the lone notable standout in February. Paper stocks rode these bullish revisions to 3% outperformance on the month. On an absolute basis, CLF was the only Metals stock to see material downward revisions to its 2014 net income estimate. Cap weighted however, the decline for Metals was mainly the result of loss of market cap for FCX; unweighted, the company’s estimate actually increased. E&C estimates were down due to moderate cuts to several companies’ net income forecasts.

Exhibit 17

Source: Capital IQ and SSR Analysis

2013 EPS estimates were mainly negative in February, with most of the revisions coming near month’s end. The Metals sector, unsurprisingly, was the notable standout; our group saw downward revisions of more than 4% over the month. Capital Goods, Chemicals, E&C, and Paper were all down at least 1%.

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.

Chapter 20

Exhibit 21Exhibit 22

Exhibit 23

Exhibit 24

Exhibit 25Exhibit 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

Exhibit 33

Skepticism High

Optimism High

Optimism High

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 34-36

Exhibit 34

Skepticism High

Exhibit 35

Optimism High

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

Skepticism High

Optimism High

Exhibit 42

Source: Capital IQ and SSR Analysis

Research Published in February

February 1, 2013 – Optimists Are Everywhere and Most Underperform: A Quick Look at the S&P 500

February 4, 2013 – Monthly Review February 2013: Economic Uncertainty Rules The Day

February 12, 2013 – US Basic Chemicals Economics: It Can’t Get Much Better Than This

February 15, 2013 – Chemicals Monthly: Cautious Guidance Appropriate, But A Drag On Performance


In Exhibit 43 we show a screen of stocks with low value, high Skepticism and high dividend yield. Freeport McMoran (FCX) now appears on all three screens, joining holdovers DuPont, Olin, and Stanley Black & Decker.

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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