Skepticism + Positive Revisions = Outperformance

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 5th, 2015

Skepticism + Positive Revisions = Outperformance

  • Our Skepticism Index (SI) measures the degree that (forward) return on capital is consistent with valuation. Adding an earnings momentum component to the SI analysis has historically predicted future relative outperformance when the SI is positive AND EPS revisions are positive. The risk-reward relationship further improves if we control for SI values above a certain threshold. Exhibit 1 lists the current stocks that are at the top of this intersection.
  • Of this group, EMN, CAT and DE are on our favorites list for 2015 and we have written extensively on all three.
  • In Exhibits 2-4 we show the current SI positioning of the stocks in our three main cyclical sectors (Capital Goods, Chemicals, and Electrical Equipment). Exhibits 5-7 highlight SI levels with earnings revisions.
  • Several clients have inquired where other capital equipment stocks fall in this framework after seeing the detailed report on we published on DE last week. AGCO, CAT, and JOY are all in the cheap/under-earning quadrant in our Skepticism Index, and, like DE, reliant on upturns in cyclical industries that are currently at or nearing trough levels.
  • On the opposite end of the capital equipment space, SNA sits in the expensive/over-earning quadrant as a result of its remarkable run of organic growth and the expectation that this success will continue.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

The pattern in the Skepticism Index that we saw in our Deere piece from last week reflects the cyclicality of our space. For DE, we see the opportunity for a move in the stock price to precede the improvement in earnings, much as the downside in the name previously preceded the fall in earnings.

Exhibit 2

Source: Capital IQ, SSR Analysis

The SI has other applications, of course, and we have noted the trend of outperformance at extreme values of skepticism on several previous occasions . In this piece we have added an earnings momentum component to help refine the performance results – positive revisions can be seen as essentially (literally) as a sign that skepticism is misplaced, corrected by a rising share price.

Below we show the current positioning on the SI for the stocks in each of the three main cyclical sectors in our coverage: Capital Goods, Chemicals, and Electrical Equipment. We then plot the current SI value against the three month EPS revision. For those names that have seen positive revisions and are currently exhibiting positive skepticism index values, we analyze the performance history for when these conditions have been present. Presently the risk-reward is only particularly attractive for IIVI, but we find that the relationship improves at higher levels of skepticism – we will look to do further research across our sectors on this topic.

We conclude by responding to client inquiry in the aftermath of our Deere piece – Exhibits 11-13 show AGCO, CAT, and JOY occupying similar positions in the SI framework as DE. Conversely, SNA provides a good example on the other end of the SI spectrum – Exhibit 1 5.

Current Skepticism Index Positioning of Cyclical Sectors

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Adding an Earnings Component – EPS Revisions

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

If we think about positive earnings revisions as being predictive of a decline in skepticism (through share price increase), it is perhaps not surprising to see the trend of forward relative outperformance in Exhibit 9. The variability is significant however (outside of IIV and perhaps ALB). If we restrict the analysis to SI values above 0.5, the performance results look notably better for CAT and WLK in particular – Exhibit 10. Some of the increase in overall levels of volatility can be explained by the smaller sample sets. We will look to expand this analysis across our universe in future research.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Cyclicality – Looking for the Deere Turn

Client response to our SI analysis of Deere from last week led us to explore our universe for stocks currently occupying similar positions in the framework. We review some of these below.

 

AGCO

AGCO presents a similar picture to competitor DE – the plot in Exhibit 11 does not track as nicely as Deere’s did, but here again, the valuation discount preceded the fall in earnings, and we see another illustration of how cyclical stocks in particular have a tendency to invariably approach the SI equalization line. At present, it looks like the anticipatory valuation move has already started to a certain extent, as the stock began the year with its skepticism index virtually equalized and has gained modestly since even as earnings have remained weak and actually continued to decline slightly.

Exhibit 11

Source: Capital IQ, SSR Analysis

CAT

CAT has more or less followed the SI equalization line since 2012 – with the exception of a noticeable divergence in the period from mid-2013 to mid-2014. Caterpillar had been growing cheaper as earnings declined following of a run of record earnings where each of the company’s segments were hitting on all cylinders. The first half of 2013 saw a more intensified sell-off in the name, but earnings did not fall as quickly as anticipated (and actually rose slightly as a booming energy space offset growing weakness in mining). At this point we advocated a trade in CAT, and the stock did indeed rally – but only to the point where valuation and returns were once again aligned and the Skepticism Index was equalized. Since the middle of last year the stock has seen further weakness, but this has been commensurate with the decline in earnings. The current positioning sets up fairly similarly to Deere’s, but the obvious catalysts for CAT (like DE) are predicated on a broader turnaround in the fundamentals of cyclically weak industries – for DE it is agriculture, for CAT it is mining, construction, and energy. CAT is trading one standard deviation below mid-cycle value, not quite at a record valuation low, and we think the company is leaner and more efficient than it has been in the past. The stock has seen significant support at the $80 level.

Exhibit 12

Source: Capital IQ, SSR Analysis

JOY

Joy Global is a peer and competitor of CAT’s in the Mining sector, and has similarly seen returns and valuation deteriorate over the past three years. The initial move was more like what we saw in the agricultural names, with the valuation discount preceding the fall in earnings. As a mining pure-play, JOY faces obvious obstacles to achieving meaningful upside, with the global miners showing little signs of an imminent turnaround – see our recent monthly where we noted continuing underperformance from the miners in our coverage. However, the stock is approaching its all-time valuation low on our metrics, trading one and a quarter standard deviations below its mid-cycle value, and the pattern of the SI suggests a move higher could precede earnings improvement. From CAT’s perspective, global mining equipment demand appears to have stabilized to some extent – Exhibit 14.

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

SNA

In the inverse quadrant from where we have been looking, where instead of cheap and under-earning stocks we find expensive and over-earnings stocks, SNA shows the most interesting progression. The stock has more or less tracked its SI equalization line since 2012, but more recently the valuation premium afforded has begun to outpace the level of over-earning – with an organic growth profile like the one shown in Exhibit 16, it is understandable why SNA has been the beneficiary of positive investor sentiment. SNA is discounting an improvement in return on capital of nearly 300 basis points (18% versus the current 14.9%). Alternatively, if the company should remain at its current level of ROC, there is 15% downside for equalization of the Skepticism Index.

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

©2015, 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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