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April 4, 2012 – Sector and Sovereign Industrials Launch – Graham Copley

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Today we have initiated coverage [2] of the Industrials and Basic Industries Sectors.

Outperformance over the past 6 months despite negative revisions has sadly led the group as a whole to be, in aggregate, fairly valued – limiting our initial conclusions.  There are some outliers and we have introduced a robust, return on capital valuation framework, which shows that the US metals sector looks pretty attractive, while both paper and electrical equipment appear to be meaningfully overvalued relative to history.

Returns on capital have negative long-term trends for most sub-industries and it appears that only extreme, prolonged, financial pain drives enough change to reverse these trends.  Paper may have been through such a reversal but current values discount returns (7-8%) that even assuming structural improvements are well above the 20 year average of 4.5%.

Valuation matters in cyclical industries and we have seen sub-industries bounce off cyclical relative lows, in the last year, despite broad negative revisions.  Economic conditions, which ultimately drive profitability in this group, are still under pressure in Asia and Europe and in the US are floating around mid-cycle.  The outlook does not suggest a demand tailwind for stock performance absent a strong valuation base.  If fact we see demand as a possible mild but broad negative risk, particularly where capacity is not constrained (almost everywhere except some precious metals and construction/mining equipment).

As the broader space is in a territory that it has only been in a few times in that last 40 years; high margins, high returns on incremental sales and, for many companies, record returns on capital, some corporate and analyst rhetoric suggests that “it is different this time”.  This is as much an unreasonable a conclusion as it was in the late 70s, in 1988, in 1996 and 2006.  To assume that a set of industries that have shown volatile cyclicality over a 40+ year period have suddenly changed this time around is ill-advised and very likely to lead to meaningful disappointment. All of the sub-industries except Metals and Mining have a declining slope to their 40 year return on capital trend lines, though there is some improvement when you look at a 30 years trend in all cases.  While these trends should not decline to “zero” they are compelling, persistent and in most cases have not reached levels low enough to drive the kind of industry wide remedial action required to turn things around.

There is evidence to suggest that industries show little signs of structural change until long-term returns are consistently lower than the cost of debt.  Operating with consistent returns below the cost of capital, but above the cost of debt seems to be commonplace, which would suggest that cyclical trends will continue in those industries until the cost of debt threshold is breached.  Paper and Metals have spent long period below this threshold – paper more recently than metals.  The two sectors that have operated most consistently in this returns “no man’s land” between the cost of debt and the cost of capital are chemicals and capital goods.

Accordingly, you have to be disciplined about valuation and view other short term factors, such as revisions, momentum, and product pricing in the context of both absolute and relative valuation indicators. Metals appears to be a classic case in point where short term negative pricing trends are driving emotion and the sector looks very interesting on a relative and absolute basis.

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