Chemicals Skepticism – A Wide Divergence – Commodities vs Coatings
Extending our Skepticism Analysis (SSR Skepticism Index – SSRI) to look at the sub-industries within Chemicals we confirm lack of investor conviction in commodity chemicals – valuations underestimate current and expected returns. History shows that this corrects through relative outperformance of more than 11% over 6 months.
The overall Chemical SSRSI is balanced; by what appears to be significant confidence in coatings and to a lesser degree, specialty chemicals. The diversified chemicals group has a high SSRSI and agricultural chemicals and industrial gases are fairly valued in this analysis.
The coatings SSRSI is close to 20 year lows, suggesting that confidence is close to an all time high – results have been good and returns on capital are above trend or even recent averages (despite slow residential construction), but many valuation multiples are at extreme highs. Investors clearly believe in a continued earnings momentum story in this sector.
We have also looked at expected earnings growth by sector and find that growth expectations for the commodity group exceed those for most sub-sectors including coatings. As the second chart below shows; the commodity chemicals group is a significant outlier, and the difference in valuation between commodities and coatings is clearly not driven by current earnings expectations.
Source: Capital IQ, Company Reports and SSR Analysis
Agricultural chemicals appear very fairly valued with a slight premium in current returns on capital reflected in a slight premium to mid-cycle value. (Ag Equipments stocks are very similarly valued). Estimates are for strong growth, but growth that lags the broader chemical space. History shows that what is currently discounted in value is almost guaranteed to be wrong. This group does not discount any expectation of shortages and price escalation in the broader agriculture space.
In an environment where there is clearly concern about global demand, it is unlikely that we will see much outperformance from the commodity chemical group without a change in sentiment around earnings. As indicated in our earlier piece, we would expect the story to play out through the year.