Caution Abounds, But Guidance for 2013 Almost Certain To Be Wrong
As we move through earnings season this year, the dominant theme is caution and concern about the shape of the global economy. There is little if any heroic guidance, and where we are seeing companies support strong year on year gains it is based on something company specific and not the environment. Today, Dow Chemical talked about further weakness in China in Q4 and again pointed to the US and the global bright spot.
Of the big global bell-weathers, CAT has suggested a range of earnings for 2013, that includes the strong possibility of an earnings fall year-on year, DD has suggested limited growth, DOW has given no concrete guidance (as is its habit), but has talked about cost measures as a possible driver of improvement and UPS has been very cautious.
Most point to price deterioration in some or many business product lines and many have talked about volume disappointments. Were we are seeing earnings growth we are seeing it without revenue growth, suggesting that it is coming from cost initiatives. Recent revisions for 2013 are mostly negative but vary group to group.
Guidance is perhaps most appropriate from CAT, because of the very wide range provided. A range of $7.00-9.00 begins to capture the operating leverage that exists in most of the companies and the wide range of possibilities that creates. Companies guiding to ranges that have only small amplitudes are doing so based on a much more precise view of economic expectations and it is important that they make the assumptions clear so that investors have the context.
If we are truly at a global economic low, and if 2013 is the start of a road to recovery – most important, driving business confidence – then operating leverage will benefit all to the upside and we will have broad positive earnings revisions. Everyone’s estimate will be too low, even the top end of CAT’s wide range.
If stagnation or even further economic decline is the story for 2013, then we will see further incremental volume declines at high incremental margins. Moreover, we will begin to see impatience creep into many businesses and pricing will start to move down more quickly. As a consequence, those with a conservative stance today will miss estimates also and perhaps buy quite a high margin. In our opinion, 2013 is not a year where Industrials and Basic materials see a 5-10% move in earnings year on year; it is a year in which we are going to see plus 20% or minus 20%.
So how do you invest in this environment – you buy the cheap companies, those that are already discounting disappointment. Our Skepticism analysis segments the companies where valuation is discounting a decline in return on capital and those that are discounting an increase. In this environment, the first group gives you downside protection and real leverage to the upside, whereas the latter gives you real downside if numbers disappoint and limited upside if they improve.
The chart shows valuation versus returns on capital for all of our major sectors and subsectors – we have shown this chart before, but this version is annotated to highlight the attractive and unattractive sectors based on the commentary above.
There are interesting companies in each sector and the table below shows the 13 names that we identified as interesting at the beginning of the year. On average they have only slightly outperformed the S&P500 in January, so we would stick with this group today.