Valuation Spreads Extreme

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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

November 6th, 2013

Valuation Spreads Extreme

  • Valuation dispersion in the broad Industrials and Materials group is at a 13 year high, (Exhibit1), suggesting that the favorite stocks are being granted a much higher multiple than the less favored stocks than at any time in recent history. We think there is room for this trend to reverse as the out of favor stocks hit either earnings or valuation floors (CAT and AA for example) and the overvalued stocks miss over ambitious earnings or stop growing (MWV, IP, LYB).
  • The most undervalued stocks at the beginning of the year continued to underperform through Q1 and Q2 this year, but outperformed the S&P well in Q3 2013 and continue to do so in Q4.
  • Revisions have not surprisingly been much more negative for the underperformers during the year than for the outperformers. Negative revisions for 2014 peaked in Q3 and for 2013 in Q2 and relative revisions versus the outperformers are less out of step today.
  • The larger cap stocks that look most interesting to us today are DD, AGCO, MON, GE, DHR, MMM and DE, both on a valuation basis and on a relative revisions basis.

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Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Regardless of what the broader market does for the balance of the year, within Industrials and Materials we would expect the laggards to play catch-up with the leaders. Moreover, we have seen some anecdotal evidence of nerves at the top (MWV, LYB, IP) and relief or more confidence at the bottom (FCX, AA, CAT) as we have gone through the earnings season.

Today, the divergence of valuation across the Industrials and Materials group is at a 13 year high as shown in Exhibit 1. Note that in this analysis we are looking at 131 companies and consequently one or two that could be argued to have changed their business models permanently are not going to influence the conclusion. The spread is greater than it was in late 2007 and the following correction was significant. In this analysis we are looking at the “deviation from normal value” for each company, and plotting effectively the dispersion as measured by the standard deviation of the results – see Appendix.

The undervalued larger cap names in our coverage are summarized in Exhibit 2, and in Exhibit 3 below we show how the 30 most undervalued on January 1st 2013 (regardless of market cap) have performed on an absolute and relative basis each quarter. In Exhibit 4 we show how 2013 and 2014 EPS revisions have moved by quarter for the cheapest 30 in absolute terms and in Exhibit 5 we show revisions versus the most expensive 30 on January 1st 2013. In Exhibit 6 we show how the quarterly revisions have moved by company for the undervalued group.

Exhibit 2

Source: Capital IQ and SSR Analysis

After lagging a very strong market in the first half of 2013, the cheapest Industrial and Basics stocks outperformed in Q3 and this has continued thus far into Q4. The initial underperformance and the subsequent turnaround have been driven by the Metals sector – early laggards (notably X and CLF) have led the way higher in the second half of the year. AA has been one of the big winners a month into Q4, up 17% versus the S&P and approaching $10 a share after spending
much of the year
as the most undervalued stock in our universe.

Exhibit 3

Source: Capital IQ and SSR Analysis

The revisions story is similar. The big Metals names (X, CLF, NUE, NEM, AA) that appear near the bottom of the pack in the early quarters of the year subsequently saw sizable upward revisions. This is a possible case of overreaction – optimistic initial expectations were slashed too far to the downside and the end result was something in the middle. Ag names (MON, AGCO, DD) were among the few companies seeing positive revisions early in the year but have moved towards the median in Q4. Note that outside of Q1the only significant increases in FY 2014 earnings have been for X and CLF thus far in Q4.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Appendix – Methodology Behind Dispersion Charts

For each company we maintain a historic database of valuation and we plot and regularly use “discount from normal value” as tool – Exhibit 7 shows a historical plot for Dow Chemical.

For any given month, we have 131 companies displaying a range of discounts or premiums to normal and consequently if we express the dispersion of that data set as the standard deviation of the instantaneous range presented, we can show a time series of how tightly correlated or disperse valuations are. In Exhibits 8 and 9 we show the complete data set for August 2011 and for October 2013 – note that for August 2011 the dispersion was at a low – 0.76 standard deviations and for October 2013 it is at a high – 1.33 standard deviations.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

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