SSR Industrials & Materials Monthly Review, December 2015: They Say the Darkest Hour is Right Before the Dawn…It May Not Be Dark Enough Yet

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SEE LAST PAGE OF THIS REPORT Graham Copley / Nick Lipinski

FOR IMPORTANT DISCLOSURES 203.901.1629/203.989.0412


January 4th, 2016

SSR Industrials & Materials Monthly Review, December 2015:

They Say the Darkest Hour is Right Before the Dawn…It May Not Be Dark Enough Yet

  • We enter 2016 with plenty of inexpensive stocks, but also plenty of reasons why those discounts exist, and without a realistic expectation of much fundamental improvement in the year to come
    • Our focus would be on DOW/DD – we expect incrementally positive news will make this pair the best relative bet as the true magnitude of the opportunity becomes clearer
  • US manufacturing gauges have either dipped into or are hovering just above contractionary levels – a bad indication for our sectors
    • The recent rally in natural gas pricing combined with continued downward pressure on crude has the price differential lower than at any point since 2010, which tempers some of the optimism for an inventory based domestic manufacturing rebound
    • Possible green shoots in Europe from the ECB’s aggressive QE program and lower energy pricing are unlikely to offset emerging market headwinds which cannot be cured by low energy costs and will likely be exacerbated in the near term by Fed tightening
  • Valuation dispersion across our group of 120+ stocks is currently significantly higher than at any point in the past 10 years aside from brief periods in 2008-2009
    • SNA’s 2015 performance (the year’s top returning large cap stock) demonstrates the premium placed on organic growth and US focused exposure.
    • Simultaneously, no one wants anything to do with metal/commodity exposure, and China and Brazil.
    • GE was another top gainer, after years of sideways performance, as the market reacted favorably to its spin offs and simplification of the business – DOW/DD should enjoy similar gains on similar sentiment shifts in our view
  • 2015 results are in the books and at the aggregate sector level only the Conglomerates (and really only GE) beat the S&P
    • A tough year for Transports stocks sets the group up with easy comps in ’16 and much more reasonable valuations, particularly in the Rail space
    • The same can be said for Paper & Packaging, with more valuation support
  • December research was focused on Dow/DuPont but we also published on Industrial Gases and the ethylene market – where we see risks.
  • Our preferences at the sector and stock level are shown in Exhibit 1
    • Our valuation and skepticism screens are summarized in Exhibit 2 – our models are not adequately reflecting the size of the opportunity in front of DOW/DD and we continue to view these stocks as the best relative play in our space

Exhibit 1

Source: SSR Analysis

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SI measures current valuation versus current return on capital and what movement in returns on capital is implied in valuation.

Exhibit 3

Source: Company Reports and SSR Analysis

See Appendix 3 for the data underlying this exhibit.

Exhibit 4


2015 was a largely disappointing year for Industrials & Materials. At the sector level only the Conglomerates outperformed the market and this result was entirely due to GE breaking out of its multi-year range. Early year notions that the US would remain a relative bright spot of growth were belied by rail traffic that began the year weaker than expected and continued on a downward trend throughout the year – Transports were the worst performing sector for the year and Paper & Packaging stocks suffered on this front as well. The Metals space saw continued downward pressure as commodity pricing fell further with emerging market demand moderating. Large cap Capital Goods stocks were similarly impacted by weakness in the former growth engines of China and Brazil – CAT and DE primarily drove the cap-weighted performance result.

Bottom line, the year of widespread underperformance has left many of our stocks at historic discounts, but we can find justifications for most of these. Commodity exposure is likely to remain a negative not just in 2016 but possibly for several years out. Equipment producers that enjoyed years of robust Chinese orders will struggle to reach prior growth levels as shipments to that country continue to decline. There may be easier comps in 2016 but the situation may deteriorate further particularly in products areas where China capacity additions continue. Limited growth in China has combined with continued China investments to create some significant surpluses in select product areas in 2014 and 2015, and this is likely to continue into 2016 and could be very destructive for pricing in 2016 in select areas.

Compounding these global headwinds is a weakening domestic manufacturing environment. The US PMI has dropped below 50 indicating contracting, but it is widely expected that the replenishment of drawn down inventories should offer a boost. Further developments in energy markets might offset some of this optimism – the continued weakness in crude and the recent rally in natural gas has the price differential at its lowest level since 2010 – Exhibit 5. This ties in to our cautious view on US ethylene in 2016 – see recent research.

In this cloudy context of diverse headwinds it is hard to get too excited about anything in our sectors with the notable exception of DOW/DD, where we have on multiple occasions expressed our view that these stocks have levers available to offset the low growth, low demand environment that no other stock or sector in our coverage can rival (with the possible exception of GE). GE itself is a case study of how unwinding businesses and simplifying the organizational structure can rouse investor interest – the stock gained 23% this year after being strictly range bound since essentially the aftermath of the financial crisis. The gains are also indicative of the trend of paying up for compelling stories. Organic growth is also at a premium particularly in this environment and it is no surprise that the best performing large cap stock in our coverage has perhaps the best organic growth profile (SNA). We are seeing premiums rise for these select stories as investors are paying up for growth and leaving everything else behind – valuation dispersion has been trending higher for the past several years – Exhibit 6. At the stock level we show the 25 best and worst performers on the month (and for 2015 overall) summarized in Appendix 1.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance relative to the S&P for December and 2015 is shown in Exhibit 7. The progression appears the same in each chart but the only true consistencies are at the extremes – Transports the worst performing sector in both December and 2015 overall, and Conglomerates the best in both periods. This result is mostly a GE result. The Metals sector was flat in December despite significant negative revisions, but we are aware that previous indications of stabilization in the space have been followed by further selling pressure and new lows. Weakness in Paper & Packaging in 2015 was among the most surprising results given the halving of crude pricing and expected domestic relative strength.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. The realization of the apparent values in the Metals and Capital Goods sectors is largely dependent on improved fundamentals in emerging markets where the wave of investment over the past 10 years has created glaring overcapacities in many industries. In this context, Paper & Packaging discounts appear a safer play given the domestic slant of the companies in this space.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are shown by sector in Exhibit 9 (see our skepticism work for more detail). The outliers here remain Paper & Packaging and Metals. Here again, the Packaging result appears more interesting, as valuations are ostensibly pricing in a recession – more on this below.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 is a very busy chart but shows how each sector and sub-sector breaks down by skepticism index 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 Paper & Packaging space is showing the best combination of valuation support and earnings power – if you believe we are entering a recession then valuations are already pricing in a significant decline in earnings (what would be a two standard deviation turn for the sector). Alternatively, even if returns come in a bit, the upside to equate valuations with above trend earnings is close to a two SD turn as well (~36% upside).

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

The overlap of our traditional valuation and skepticism based portfolios produced cumulative monthly gains of 15.6% in 2013 and 9.8% in 2014, but we have noted the significant volatility associated with these results – Exhibit 12. These screens also have tended to include commodity exposed names that we would view as value traps given our thesis on secular Chinese oversupply (partially explaining 2015’s poor results).

Exhibit 11

Source: Capital IQ and SSR Analysis

An alternative portfolio approach is based on our expanded skepticism index performance analysis which showed a very attractive risk-reward relationship for stocks with positive SI values, valuation discounts, and positive 3 month EPS revisions. We feel there is both a more defined holding period (our work is based on 6 month forward performance) and a greater likelihood of success in those names. This month we have a list of 25 stocks that fall in these historically outperforming ranges – these are summarized in Exhibit 12.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13 shows the historical forward performance of the stocks meeting the criteria in Exhibit 13 at various ranges. We note that for all ranges where the SI is above 0.5, the average return is in excess of the variability (average > standard deviation).

Exhibit 13

Source: Capital IQ and SSR Analysis

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.

Equity markets largely took the Fed’s long awaited rate hike in stride but even the incremental rise had an impact on interest rates both domestically and globally. The possible silver lining of the rate hike is the potential impetus to invest as the extended era of free money comes to a gradual end. Emerging markets remain challenged. Chinese growth continues to contract. In a move that is unlikely to improve its tenuous fiscal position, the Brazilian government approved raises to the minimum wage in excess of the current 10% plus inflation. The country’s economy is expected to contract again in 2016, and the real inflection point according to several of our covered companies with interests in the area, will not come until the next round of elections in 2018 (possibly sooner in the event of impeachment).

Exhibit 14

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

Commodity Pricing

Crude oil ended the month below $40 per barrel for the first time in over 10 years (2004). Natural gas pricing briefly dipped below $2.00 per mmbtu on record inventories and warm weather, but chillier forecasts drove prices back above $2.30 by month’s end. Metal pricing ended the end on a stable note, with aluminum and steel up 4% month over month and steel up 2% – from the end of 2014 prices are down 16% for aluminum, down 24% for copper, and down 35% for steel.

US commodity and energy prices are indexed in Exhibits 15 through 19.

Exhibit 15 Exhibit 16

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

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18 Exhibit 19

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 20 we look at expected net income growth by sector, and in Exhibit 21 we plot the growth figure against each sector’s current skepticism index value. E&C’s forward earnings growth is partially a function of a low 2014 base. Transports and Paper & Packaging reflect domestic strength – globally exposed commodity (Metals), machinery (Capital Goods, Electrical Equipment), and diversified industrial (Conglomerates) names are expected to endure a contraction in earnings.

Exhibit 20 Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22 shows the change to 2016 net income estimates over the month. The cuts in the Metals space are worse than even these figures suggest, as they exclude a further $0.60 cut to US Steel’s previous estimate of an $0.80 loss. The pain extended to Metals-related machinery stocks – JOY’s estimate down 64% on the month, KMT’s down 41% to drive the Capital Goods result.

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows 2016 EPS revisions during December and Exhibit 24 plots these revisions versus performance results on the month. The Metals space did not see another move lower in December despite significant negative revisions.

Exhibit 23 Exhibit 24

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Mid-Cycle “Normal” Valuation

In Exhibits 25-34 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

Exhibit 25

Exhibit 26

Exhibit 31

Exhibit 29

Exhibit 30

Exhibit 28

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 33

Exhibit 32

Exhibit 34

Source: Capital IQ and SSR Analysis


Our Skepticism Analysis by sector is summarized in the Exhibits 35 through 45.

Exhibits 35-37

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibits 38-40

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibits 41-43

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibits 44-45

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Research Published in December

December 3, 2015 – Industrial Gases: Adapt to Slow Growth, or Underperform

December 9, 2015 – DuPont/Dow: The Considerable Value is All in the Execution

December 14, 2015 – Dow/DuPont: The Very Best Looking Horse in the Glue Factory!!

December 16, 2015 – Chemicals Monthly: Pretty Quiet Month…

December 22, 150 – Ethylene: Brave to Own Heading into 2016


In Exhibit 46 we show a screen of stocks with low value, high Skepticism and high dividend yield. The same four stocks appears on all three lists for the third consecutive month: BGC, HUN, OLN, and PKG.

Exhibit 46

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2

Appendix 3

Appendix 3

©2016, 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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