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

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Graham Copley / Nick Lipinski



May 1st, 2013

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

  • Economic uncertainty and weakening commodity pricing hit the Metals & Mining and E&C sectors hard in April. Both groups trailed the S&P by nearly 10%. The Chemicals sector was virtually flat, making it the only sector not to materially lag the market.
  • Earnings season has been another mixed bag thus far. Beats by bellwethers such as UPS and DD were countered by misses and negative outlook revisions from CAT and GE. On the whole, revenue growth has been stagnant year over year.
  • From a valuation perspective, Capital Goods shows the most compelling discount outside of the Metals sectors, after several months of underperformance. Electrical Equipment, Transports and Chemicals are all bunched up near one standard deviation above normal value; for Transports and Chemicals, premium valuations are being driven by the Trucking and Coating subsectors, respectively. Paper remains an expensive outlier.
  • This past month we published a first quarter review, looked at the fundamentals of the aluminum market, warned of potential overinvestment in the bid to exploit the US natural gas advantage, and analyzed the implications of middling economic growth on pricing and gross margins.
  • Our model portfolios gave back some of the gains from last month due mainly to the broader Industrial underperformance. The overlap portfolio of valuation and skepticism was most robust with a return of 1.6% in excess of the market. Our current screens tend to favor Capital Goods and Metals, although some Chemical names still appear attractive. Today there are three stocks that look good on valuation, display very high levels of investor skepticism and offer well above average dividend yields; FCX, GE, and OLN.

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


The S&P was able to rebound from a mid-month pullback to post a nearly 2% gain over April. The Industrials and Basic Materials sectors were not prime participants in this move higher; Chemicals was the only one of our sectors that did not significantly trail the broader market. E&C stocks, the big winners from a month ago, gave back those gains and more. Underperformance was widespread in the sector but exacerbated by a 15% decline in FLR, which has the highest market cap of the group. The company’s 30% mining exposure drove this decline as weak economic data from China specifically and the world in general combined with weakening commodity prices to weigh on Metals and Mining shares. Newmont Mining (NEM) and Allegheny Technologies (ATI) saw two of the biggest losses in our universe on the month, down 23% and 15%, respectively. Revisions to 2013 EPS in the Metals sector were resoundingly negative over the month, reflecting a global economy that remains on tenuous footing.

Earnings reports tended to underscore the dichotomy of an advancing stock market amidst a middling economy. Caterpillar lowered its 2013 outlook, indicating a demand environment that is weaker even than the slow growth environment that has been anticipated. GE warned of continuing weakness in Europe and similarly revised forecasts; the company noted several cost cutting measures to be implemented which is a worrisome sign for sales growth. Across the Industrials and Basics sectors, revenue growth year over year was generally stagnant in Q1 2013.

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.

Exhibit 4

Source: Capital IQ and SSR Analysis

The Paper sector registered slight underperformance in April but remains far and away our most expensive sector. Several events conspired to moderate the sector’s performance over the month. BKI shares soared 25% after an acquisition bid from Georgia-Pacific, while Domtar Corp (UFS) reported a major miss in Q1 2013. Additionally, LPX was down 16% on the month after a report from the National Associations of Homebuilders and Wells Fargo showed home builders’ optimism at its lowest level since last October (the stock has significant housing exposure through its oriented strand board business). This sentiment similarly drove E&C stocks to a large monthly decline. The Metals sector plunged further on downbeat forecasts and weakening commodity fundamentals.

Capital Goods has underperformed for several consecutive months now and shows the most compelling valuation outside of the obvious Metals story. Most of the valuation discount in the Conglomerates sector comes from GE; ex the mega cap, the group screens at a slight premium. Electrical Equipment lagged the market by 5% over April but remains at one standard deviation above normal value. The high valuation screens for Chemicals and Transports are in large part due to expensive subsectors. Coatings (2.86 standard deviations above normal) rose higher still on the month, while the Trucking space held its ground (3.5 SDs).

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

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. Newly incorporated 2012 data on capital employed influenced the changes over the month. The Paper sector’s ROC increased further above trend (standing now at more than 3 standard deviations above normal) while the group as a whole underperformed the market, leading to a spike in its SI value. Electrical Equipment experienced a similar effect on a smaller scale. E&C’s rise was primarily a function of its underperformance on the month.

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.

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 April monthly
. The results are summarized in Exhibit 8, showing performance relative to the S&P, which was up 1.8% month over month.

Our shorts predictably fared well amid the broader Industrial underperformance, but our long picks generally lagged as well. The Normal Value portfolio was only slightly better than flat to the market while our skepticism screen posted a loss of about 1%, influenced heavily by GE, FCX and NEM which notably weighed on the long side. The overlap portfolio, which has tended to produce the best return, once again was most robust, with market outperformance of 1.6%.

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 slow growth environment that has been widely anticipated is showing signs of being even slower than expected. First quarter US GDP came in below expectations, expanding at a rate of 2.5%. Chicago PMI fell to contractionary levels, and the employment sub component was notably uninspiring. The Dallas Fed manufacturing index was similarly disheartening, dipping to -15.6 (a reading of +5 had been anticipated). Data from China also showed weakening manufacturing activity. Europe remains embroiled in debt and political crises and there are signs that the economic lethargy is spreading to the continent’s core (namely Germany). The unemployment rate in the Euro zone stands at an all time high; in particular, the extraordinarily elevated levels of youth unemployment demonstrate the obstacles faced by a clearly fractured system.

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

Exhibit 9

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

Commodity Pricing

The collapse of Gold roiled commodity markets in April. Weak manufacturing data out of China weighed on copper prices, and Goldman cut its long term forecast for the commodity; pricing was down over 6% on the month. Steel was down almost 2% and Aluminum was relatively stable, down slightly more than 1%. The gas-oil difference narrowed further over April as natural gas moved solidly above $4 per mmBTU and crude pricing was off. Natural gas has not seen price levels this high since June of 2011.

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. Last month was the first in which full 2012 data was available. There have been few changes in the ordinal rankings over April, as Paper, Transports and Packaging still show healthy expectations, while there is less optimism for the Electrical Equipment and Capital Good sectors.

Exhibit 15 Exhibit 16

Source: Capital IQ and SSR Analysis

Exhibit 17 shows how these longer term estimates have changed over the month. Our valuation outliers occupy their customary spots in this exhibit, with Paper the beneficiary of large positive revisions and Metals enduring sharp cuts. Newmont was a prime culprit in the Metals sector, and its 2015 net income estimate has come down 41% since January. The drop in the Capital Goods’ estimate is largely reflecting a drop in Caterpillar’s estimate, which was off 19% after its earnings report.

Exhibit 17

Source: Capital IQ and SSR Analysis

2013 EPS estimates were predominantly negative over April. The Metals space took the biggest blow, down over 20% on the month; estimates were slashed 7% in January, 4.5% in February, and 1% in March, so it is worth wondering how much lower they can go. Capital Goods, Chemicals and E&C saw significant negative revisions as well. Packaging was the lone standout on the positive side, helped by increased estimates for Rock-Tenn.

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


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

April 2, 2013 – Q1 2013: A Revisions Driven Quarter – Not Good For Our January Picks

April 2, 2013 – Aluminum: Always Darkest Before the Dawn

April 10, 2013 – US Energy Advantage: Unintended Consequence – Global Overbuilding of Petrochemicals

April 25, 2013 – Price Weakness In A Slow Market: Can It Be Different This Time


In Exhibit 43 we show a screen of stocks with low value, high Skepticism and high dividend yield. Over the past month Stanley Black & Decker dropped out of the dividend screen. Replacing it in the overlap group is GE, which joins holdovers FCX and OLN. DuPont was narrowly edged out of the normal value screen, having gained 13% since
we wrote about the company in January

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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