Q2 2013 – Not the Brightest of Outlooks Expected!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 11th, 2013

Q2 2013Not the Brightest of Outlooks Expected!

 

  • None of the Industrials and Materials sectors was able to outperform the S&P in Q2, which gained 2.4% for the quarter. Revisions continue to drive performance at a broad level. Estimate changes for Q2 showed the best relationship to performance, both at the stock and sector level.
  • Our expectation is that earnings season will disappoint; less so in the Q2 earnings generated and more so in further negative guidance for the balance of the year. As economic indicators weaken, 2013 is looking a lot like 2012.
  • The Metals sector began Q2 as a laggard and was again the big underperformer of the group. Conglomerates exclusive of GE were essentially flat to the market as the best Industrial performer. Transports and Chemicals hung in fairly well.
  • Only 40 of the 132 companies in our coverage universe matched or outpaced the broader market. Excluding BKI, which spiked on a buyout, only four stocks gained 10% while 16 posted a loss of that magnitude.
  • Seven Industrials stocks currently screen as one SD below normal value – four are in the Metals sector. The others are: GTI, OLN and SWK.
  • While it is arguably not the bellwether it was once considered, Alcoa kicked off earnings season with a predominantly upbeat report. Our position on AA has been that the upside surprise will come from stronger than expected demand growth, and this was highlighted by AA in the automotive sector.

Exhibit 1

Source: Capital IQ and SSR Analysis

Outlook

Economic estimates are coming down, with global forecasters consistently lowering their views on economic growth for the year. The estimate revisions cover countries and regions outside the US, with the consensus view on the US fairly stable. Like 2012, we are not likely to see a “back-end loaded” year this year. This suggests that negative revisions will persist for our groups, as numbers in aggregate today still look back-end loaded. Expensive stocks with opportunity for aggressive negative revisions look the most vulnerable, but as we show in the Q2 review below, revisions are the most meaningful driver of performance in these sectors in recent years regardless of valuation.

Several things are different from last year despite the similar macro back drop:

  • Those companies that spent the third quarter in denial last year, suggesting that all was OK, probably will not make the same mistake twice.
  • There may be a tendency to “kitchen sink” the quarter and the outlook given that there is very little to be gained by being bullish and more to be gained by resetting expectations both internally and externally.
  • The idea of rising interest rates has become a real “when and by how much” rather than an “if” over the last month or so. This may change the attitude of investors towards the stocks that have behaved like bond proxies over the last couple of years and some of the premiums seen in these names may decline (particularly on a relative basis)
  • We have highlighted the current discounts in the larger cap more complex companies in recent work, and while they generally have outsized exposure to the regions with declining economic expectations, they generally look so cheap when compared with simpler stories in their sectors (which we would argue are expensive), that there is a relative opportunity in these names over the next few months.
  • We have talked in detail about DD, CAT and AA this year, but we would also highlight GE, ETN, FCX, and DOW.

Notwithstanding all of this – negative revisions (which we expect) will likely drive negative performance. If we compare where we are this year to what happened last year, we see some significant risk of disappointment. Exhibit 2 shows income growth by sector 2H 2012 versus 1H 2012 – expectations for 2H growth mid-way through 2012 were generally higher than what was achieved. Today we have a much more rosy expectation of 2H 2013 than 2012 would suggest reasonable – Exhibit 3, and the implied year on year growth for the second half for some sectors does seem like a bit of a stretch – Exhibit 4.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Overview of Q2

We include some simple charts to review Q2 2013. These need limited explanation, and we make the following observations:

  • Underperformance in Q2 was widespread in the Industrial and Basic Materials sectors, but notably elevated in the Metals and Paper sectors.
  • Commodity pricing was weak on the quarter – Aluminum was down 8% and Copper lost over 11% while Steel was essentially flat. On the Energy front, crude oil was down but natural gas saw nearly double the loss.
  • The weakness in Metal pricing explains some of the group’s underperformance. Construction spending has been flat-lining thus far in 2013 and E&C stocks have suffered despite little change in the group’s EPS estimate.
  • The most effective screen for the quarter was EPS estimates – Exhibit 4. There was some correlation between valuation and performance at the sector level (with the obvious outlier being the Metals sector – Exhibit 5) but at the stock level there was no real relationship – Exhibit 6. Only 3 of the 10 most attractively valued stocks at the beginning of the quarter were among the best performers on the quarter. Our Skepticism Index was also an ineffective predictor of performance – Exhibit 7.
  • Aside from the downtrodden Metals and Paper sectors, Capital Goods had the largest negative revisions to 2013 EPS estimates; despite this, the group was in the middle of the pack in terms of performance. See Exhibit 2 below.
  • The group of 15 expensive stocks includes three of the five names in our Paper index, three companies in Electrical Equipment (our next most expensive sector) and five Chemical companies. The group of seven cheap stocks includes four Metals names. SWK sticks out as an inexpensive stock with exposure to a rebounding housing market. Exhibit 8 shows the full lists.

Exhibit 2 – EPS Estimates over Q2

Source: Capital IQ and SSR Analysis

Exhibit 3 – Performance Outliers

Source: Capital IQ and SSR Analysis

Exhibit 4 – Revisions tell much of the story

Source: Capital IQ and SSR Analysis

Exhibit 5 – Value was somewhat effective at the sector level…

Source: Capital IQ and SSR Analysis

Exhibit 6 – …but far less so on a stock basis…

Source: Capital IQ and SSR Analysis

Exhibit 7 – …and our Skepticism screen was poor also,

but at least the best fit line slopes the right way!

Source: Capital IQ and SSR Analysis

Exhibit 8 – Current Valuation Summary

Source: Capital IQ and SSR Analysis

©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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