Monthly Review October 2013 – Industrials Riding the Wave of Easy Money

Print Friendly, PDF & Email


Graham Copley / Nick Lipinski



October 1st, 2013

Monthly Review October 2013 – Industrials Riding the Wave of Easy Money

  • With the Syrian dilemma defused and the punch bowl left in place by the Fed, the market retraced most of its August decline. As earnings season gets underway, FedEx lowered their estimate of 2013 GDP growth, but maintained a 2014 forecast of 2.5% and noticed encouraging trends in Europe and China. The US government shut down on the last day of September compounded an already uncertain economic and political environment.
  • Paper and Packing posted nearly identical relative losses of 4% in September as the only two sectors in our group to trail the market. Electrical Equipment had the strongest move to the upside but Metals and Capital Goods were also beneficiaries of the Fed’s decision not to taper.
  • Paper’s month of underperformance has brought the group back down below two standard deviations above its normal value, while Electrical Equipment grew more expensive and is now challenging the Paper sector for the title of most richly valued. At two standard deviations below normal, the Metals sector remains far and away the most undervalued of the Industrials and Basics sectors.
  • In September we updated our work on Skepticism and published two pieces on Chemicals – a state of the industry review and a look at optimism and forecasting within the sector.
  • Year to date our model portfolios have produced cumulative excess returns of 4.7% on the skepticism screen, 0.5% on the valuation screen, and 9.4% on the overlap of both (excluding transaction costs). We would maintain our focus on the undervalued large cap group and we continue to view AA and CAT as long term value opportunities. DE currently screens as an inexpensive stock with a high yield and high skepticism – other Ag exposed stocks also look interesting. We have recently highlighted ROC and HUN as attractive within the Chemicals sector.

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


Though the gains of the Bernanke rally were pared by month’s end, the broader market still managed to recoup the losses from August. Industrials and Basic Materials showed relative strength, with most sectors outstripping the S&P’s 3% monthly gain.

The Metals sector rallied on the news of continuing Fed stimulus and was matched only by Electrical Equipment within Industrials and Basics. ENS was the only Electrical Equipment company to appear in the top 10 performers on the month, but gains were widespread within the group. BDC, ROK, GTI, and BWC all saw gains of 8% or more in September. Best and worst performers at the company level in our coverage universe are summarized in
Appendix 1

The Paper sector’s underperformance was largely a function of market cap. International Paper announced it is shutting down a key manufacturing facility, which gave a big boost to competitor Domtar (UFS), the second best performer in our group on the month. IP’s closure of its paper mill in Alabama is expected to decrease North American supply capacity by 8%. Estimates for this sector have been consistently coming down for several months, and
we have been wary of our most richly valued sector for some time

Transports estimates have been falling at an even faster pace – this month the negative revisions are attributable to HTZ, which lowered its 2013 EPS forecast (but maintained 2014 estimates).

Sector performance relative to the S&P is shown in Exhibit 4.

Exhibit 4

Source: Capital IQ and SSR Analysis

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

Most sectors are on the expensive side, but only Paper and Electrical Equipment are at a level of statistical significance. The Transports sector has retreated after approaching one standard deviation above normal, but the Trucking subsector continues to look expensive. Conglomerates and Capital Goods flipped places in the ranking but Metals remains the clear play on the cheap side.

Exhibit 5

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 6.

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.

Exhibit 6

Valuations Overestimating Current Returns on Capital

Valuations Underestimating Current Returns on Capital

Source: Capital IQ and SSR Analysis

The Paper sector’s valuation has begun to come into line, but forward earnings have yet to follow, giving the group a very high ROC relative to historical norms and lifting its Skepticism value above 1. As a group, Chemicals are over-earning as well, more so than valuations would suggest; this varies by subsector – Exhibit 7.

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 September monthly. The results are summarized in Exhibit 9, showing performance relative to the S&P, which rose 3% month over month.

September saw the valuation screen produce a return essentially flat to the market, while the skepticism and overlap screens outpaced the S%P by 1% and 2%, respectively. 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 9.4% (excluding transaction costs) – Exhibit 8.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

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 Fed’s decision to delay its easing of stimulative bond purchases, while an obvious boon to the equity markets, indicates that there is not enough traction for the economy to proceed unaided. Gains in the stock and real estate markets have raised household net worth, but we have not seen corresponding gains in disposable income,
as our colleague Rob Campagnino noted recently
. Consumer spending remains strong regardless. Industrial indicators have been mixed of late, strong domestically but weak internationally. HSBC reported the Chinese PMI came in a point below estimates, and barely in expansionary territory. Europe continues to struggle to regain its footing after a record long recession (technically) came to an end last quarter. Industrial production on the troubled continent fell month over month in the latest data and remains depressed relative even to 2011 levels.

Government inefficacy adds further uncertainty to these mixed readings, and the US government had shutdown as of publication of this report.

The most recent Macro data changes are summarized in Exhibit 10.

Exhibit 10

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

Commodity Pricing

Metal pricing was relatively stable in September. Steel showed a slight decline, Aluminum showed a modest gain of 1.5%, and Copper rose 3% on an encouraging demand outlook from China.

Crude oil prices eased (dropping 5%) and natural gas ticked down as well (down 3.4%). After popping above $4.00/mm BTU in March through May, natural gas has since been relatively steady in the $3.50/mmBTU range.

Lumber pricing is down 11% from its February peak but has recovered 18% after a sharp decline May.

US commodity prices and energy prices are indexed in Exhibits 11 through 15.

Exhibit 11

Exhibit 12

Source: Capital IQ, IHS, CRU Steel Price Index, Bloomberg, SSR Analysis

Exhibit 13

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 14

Exhibit 15

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 16 we look at expected net income growth by sector, comparing 2015 estimates with 2012 actual net income. Paper’s optimism is driven mainly by LPX (which is projected to grow net income by 278% from 2012 levels) but cap leader IP is also showing healthy estimates (three year net income growth of 118%). Competitor Domtar (UFS) however, has far more conservative estimates, and in fact estimates show a 7% decrease over the three years. For Transports, an easy 2012 comparable for UPS is a contributing factor but the Trucking subsector also shows rosy estimates, particularly HTZ. Capital Goods is hindered by expectations of net income declines from record 2012 levels in large caps CAT and DE, but JOY, PH, and KMT all show flat or declining figures.

Exhibit 16 & Exhibit 17

Source: Capital IQ and SSR Analysis

Exhibit 18 shows how these longer term estimates have changed over the month. Paper’s weighted decline is simply a cap issue – IP was the lone company to show an unweighted decline (of only 1%) but this was amplified in the cap weighting. Metals also show the influence of market capitalization. Freeport’s 1% estimate increase was not enough to counter 7 and 10% drops for NEM and X in the unweighted ranking, but its larger absolute net income figure was exaggerated in the cap weighting (FCX accounts for roughly one third of our Metals sector’s capitalization). In the Chemicals sector, Mosaic saw its 2015 net income estimate decline by 31%, but its small cap weighting muted the effect for the group as a whole.

Exhibit 18

Source: Capital IQ and SSR Analysis

Paper, the worst performer on the month, showed the most significant change in 2013 EPS estimates as year’s end comes into view. The sector’s 2% decline matched that of IP, the dominant force in the sector’s weighting, which shut down its Alabama paper mill in a move that is expected to shave 8% off North American supply capacity. Packaging, which was the only other underperformer, also showed a decline, as did Capital Goods (a one cent drop in big cap CAT’s estimate largely accounted for this).

Note that the numbers in Exhibit 19 differ from those in Exhibit 3 as the data is market cap weighted in Exhibit 19 and is a simple average in Exhibit 3.

Exhibit 19

Exhibit 20

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 21 through 31.

Exhibit 21

Exhibit 22

Exhibit 23

Exhibit 24

Exhibit 25

Exhibit 26Exhibit 27

Exhibit 28

Source: Capital IQ and SSR Analysis

Exhibit 29

Exhibit 30 Exhibit 31


Source: Capital IQ and SSR Analysis


Our Skepticism Analysis by sector is summarized in the Exhibits 32 through 43.

Exhibits 32-34

Exhibit 32

Exhibit 33

Exhibit 34

Skepticism High

Optimism High

Optimism High

Exhibit 35

Skepticism High

Source: Capital IQ and SSR Analysis

Exhibits 35-37

Exhibit 35

Optimism High

Skepticism High

Exhibit 36

Exhibit 37

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Exhibits 38-40

Exhibit 38

Exhibit 39

Skepticism High

Optimism High

Exhibit 40

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibits 41-43

Exhibit 41

Exhibit 42

Exhibit 43

Skepticism High

Optimism High

Source: Capital IQ and SSR Analysis

Research Published in September

September 23, 2013 – The State of the US Chemical Industry: September 2013

September 16, 2013 – Chemicals Monthly: A Richer Sector with Limited Upside

September 16, 2013 – Optimism and Forecasting in the Chemical Industry

September 9, 2013 – Outliers: Where Valuation is Inconsistent with Return on Capital and Estimates

September 3, 2013 – Monthly Review September 2013: Industrials and Basics Hold In as Markets Brace for Taper


In Exhibit 44 we show a screen of stocks with low value, high Skepticism and high dividend yield. OLN is joined this month by DE as the only stocks that appear on all three screens.

Exhibit 44

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.

Print Friendly, PDF & Email