SSR Industrials & Materials Monthly Review, February 2017: Earnings, Economy Positive but Stocks (Mostly) Retrace Some Post-Trump Gains

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 1st, 2017

SSR Industrials & Materials Monthly Review, February 2017:

Earnings, Economy Positive but Stocks (Mostly) Retrace Some Post-Trump Gains

  • Q4 ’16 earnings have seen the most positive revenue surprises in the Industrials & Materials space since 2011, partly on the back of higher commodity pricing but also better demand
    • The US domestic economy appears to be in good shape, with consumer confidence at its highest level in over a decade, and improving rail traffic underpinned by increased energy production
  • Most of our sectors gave back some of their January gains in February however, reflecting an increasing awareness that the fruition of any Trump-onomics is likely a 2018 demand event (Q4 ’17 at best)
    • Only Metals and Conglomerates (ex. GE) outpaced the market
    • Metals result is as much a function of realized Chinese production cuts and the associated boost to pricing as any Trump stimulus optimism
  • February research included work on:
    • The SMID cap space – we apply the framework of relevant 2017 factors used in our analysis of the wider Industrials & Materials SMID group to Chemicals and Capital Equipment individually
    • Metals and Packaging – similar analysis as above, overlaid with our longer history valuation framework, which identified these two sectors as the most attractive heading into 2017
    • Betting Against the Sell Side – short update to our prior work highlighting sell-side recommendations as a contra-indicator – the five most bearish stocks outperformed the five most bullish by more than 10% in the four months since our initial piece, focused in the Chemicals space
    • GE – historical performance differentials with the Capital Goods sector indicate Conglomerates (largely GE) are poised to outperform – our skepticism index also supports a positive view of GE, which is a rare Industrials/Materials stock where valuations have not moved ahead of earnings since late 2016
    • Earnings driven notes on LYB and WLK
  • Exhibit 1 summarizes our preferences by sector and stock
    • We are now neutral on the Chemicals sector as a whole – preferences are mainly in the Commodity group where we see potential for a strong year, while the Coatings/Industrial Gas sectors appear to be facing challenges to growth in our view
    • Based on our work this year, we move Metals and Paper & Packaging to overweight – favorites and concerns within sectors are primarily value motivated
    • We also move Capital Goods down to Neutral – several of the larger cap stocks have performed well enough to leave the list but we see a continued path higher for SWK – the sector in aggregate is less attractive on a value basis given several strong moves in the recent Trump rally

Exhibit 1

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

Overview

Q4 earnings for our large cap group showed a slight top line beat on average, capping off a year where business conditions seemed to improve after several years of disappointment – Exhibit 5. Sentiment and stocks prices in the broader market suggest 2017 is potentially setting up as a return to overly optimistic expectations, at least in the near-term, even as the domestic economy appears reasonably healthy. Energy production is increasing with rig counts, and commercial crude in storage is at its highest level since at least 1990 – Exhibit 6. Rail traffic is improving after a rocky start to the year – Exhibit 7 – aided by coal volumes which still represented 30% of non-intermodal traffic in 2016, but also by metals shipments which suffered as the shale gale subsided and are rebounding now with crude pricing stabilized and production again on the rise. Trade cases and reduced China output have also contributed to improving metals fundamentals in the US. Most importantly, consumer confidence remains robust – the Conference Board’s index handily beat expectations in the February reading, rising to a level not seen since the summer of 2001. We would continue to focus on stocks and sectors that have room to run given historical context – certain Metals stocks where valuations remain attractive, the paper-based side of Packaging which is looking significantly attractive after a month of underperformance, and GE which has a number of factors in its favor in our view. See our recent work for more detail.

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

Sector performance for the month is shown in Exhibit 8. For many sectors the ride higher post-Trump has been choppy and we saw the downside of the whipsaw effect in February. E&C stocks were particularly affected as US stimulus is seen leaking into 2018. We show the 25 best and worst performing stocks in Appendix 1.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9 summarizes discount from normal value by sector. Updating our models with fiscal 2016 data has the group looking a bit less expensive. Significant underperformance in the Paper & Packaging space drove its discount back near an extreme, and just below Metals, which remains the cheapest sector in our group.

Exhibit 9

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 10 (see our skepticism work for more detail). The effects of 2016 capital data are evident here as well, with Metals and Paper & Packaging back up at skepticism extremes – this was in part of the basis of our work from early in the year identifying these two groups as the most attractive in our space and we explored this theme further in research this month.

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11 is a very busy chart but shows how each sector and sub-sector breaks down by skepticism index component – valuation versus ROC. We are seeing certain subsectors of the Chemical space join Metals and Paper & Packaging in the desirable top right quadrant of this exhibit.

Exhibit 11

Source: Capital IQ and SSR Analysis

Portfolio Performance

2016 was a strong rebound year for our portfolio selection methodology, particularly in the overlap of valuation and skepticism – Exhibit 12. This month was a step back after a solid start to the year in January. See accompanying work from earlier in the year.

Exhibit 12

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. 22 stocks currently fall in these historically outperforming ranges – Exhibit 13.

Exhibit 13

Source: Capital IQ and SSR Analysis

Exhibit 14 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 14

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.

Fourth quarter GDP was unchanged from prior estimates but there are positive signs moving forward. Consumer confidence in the US is reported to be at its highest level since the summer of 2001, which may be enough to sustain economic momentum until the Trump stimulus kicks in – consumer spend remains nearly two thirds of US GDP.

Europe continues to grapple with growing nationalist sentiment, with France and its spring elections a current focal point. News from China indicates the country is serious about pollution reduction as it attempts to balance its transition from the “old” industrial economy – if growth falters, the temptation to restart factories may mount.

Exhibit 15

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

Commodity Pricing

Aluminum pricing saw the biggest gain (+5%) on the month, with steel and copper little changed. The bigger metal moves are in some of the more niche products – cobalt for instance. In general we can expect the trend of rising metal prices to continue so long as China remains committed to curtailing pollution, and in turn production. Crude saw minor gains and appears to have stabilized in the mid-$50 per barrel range. Combined with another significant decline in natural gas pricing, the gas/oil spread has opened up again in favor of US producers.

US commodity and energy prices are indexed in Exhibits 16 through 20.

Exhibit 16                                                                                       Exhibit 17

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

Exhibit 18

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 19                                                                                      Exhibit 20

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 21 we look at expected net income growth by sector, and in Exhibit 22 we plot the growth figure against each sector’s current skepticism index value. We now have full 2016 data as a base. The Metals group has a somewhat low base which inflates its growth figure in Exhibit 21 but there is likely also a good deal of stimulus optimism embedded in 2018 estimates. Exhibit 22 is curious in that one would expect the line of best fit to trend in the opposite direction. The skepticism extremes in Paper & Packaging and Metals are on display here as valuations fail to reflect the forward growth expectations. Estimates for these groups are moving in opposite directions – Exhibit 23.

Exhibit 21                                                                                Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23

Source: Capital IQ and SSR Analysis

Exhibit 24 shows average 2017 EPS revision over the past month and Exhibit 25 plots these revisions versus performance results on the month. Multiple Metals companies had significant positive revisions in the 50% range – AA, CLF, and X. Revisions in other sectors were mostly modestly negative following earnings.

Exhibit 24                                                                                 Exhibit 25

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

Mid-Cycle “Normal” Valuation

In Exhibits 26-35 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

Exhibit 26

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

 

Source: Capital IQ and SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

 

 

Exhibit 35

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 36 through 46.

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Exhibit 46

Source: Capital IQ and SSR Analysis

Research Published in January

February 27, 2017: SMID Cap Capital Equipment – More Long Ideas than in Large Cap

February 21, 2017: Rising Steel Prices: Another Reason to Question the Capital Good Trade

February 21, 2017: Another Reason to Look at GE – Not Participating In the Rally – Yet!

February 20, 2017: Looking to Westlake (WLK) for Clues

February 16, 2017: Chemicals February – Headwinds Retreating, Momentum on the Rise, but Trade Risk Remains

February 13, 2017: GE(e) – Is That What The Chart Is Telling Us!

February 9, 2017: Betting Against the Sell Side – Follow-Up

February 9, 2017: Metal and Packaging – The Best Ways to Play the Most Interesting Sectors

February 7, 2017: SMID Cap Chemicals – Plenty of Interesting Ideas

February 3, 2017: Lyondell – Momentum Turning Into 2017 So Far

Dividends

In Exhibit 47 we show a screen of stocks with low value, high skepticism and high dividend yield. UPS, new to both the valuation and skepticism screens, joins holdovers EMN and OLN as the only stocks to appear on all three metrics.

Exhibit 47

Source: Capital IQ and SSR Analysis

Appendix 1

Appendix 2

Appendix 3

Appendix 3

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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