Slower Growth – Harder Decisions
There appears to be reasonable consensus that the “cliff” bargain struck on New Year’s day, does not provide the resolution needed to take the uncertainty out of the minds of US corporate managements, and it constrains growth prospects in the US in 2013. Whether this is because of lower capital spending or lower consumer spending or both, we have not yet seen any US economic growth forecasts increased by what transpired in Washington this week. The growth issue for the US in 2013 is therefore a trade-off between higher taxes taking spending down and potential job growth taking spending up.
Regardless, today it looks like the US is unlikely to be the source of demand/consumption growth that the World needs to improve sentiment, earnings and economic recovery. China is showing signs of life, which is encouraging, but our concern here is that China has become increasingly self sufficient over the last couple of years and the added risk is that its manufacturing surpluses will try to find homes in slow growing Europe and the US.
As we look for ideas for 2013, we see one overwhelming risk that impacts almost everyone in the Industrial and Basic Material sectors and that is price competition. In a world with too much production capacity and slow expected growth, price competition is a real risk. While it could impact every product line and every company, the biggest risk exists in our view where current profitability is high. Here the incentive is highest for new entrants (importers for example) and where the customer incentive is the highest to reduce costs by looking at alternatives.
In research that we published last night we made an attempt to make some stock choices for 2013. We struggled with price competition at every turn as almost all companies and sectors are “over-earning” today – see chart. We made a conscious decision to avoid those names where there is not only over-earning, but expectations in valuation that earnings/returns on capital are going to improve further. Some of the more inflated names and sectors in the group are valued at such levels because of consistent recent strong performance, and they have a long way to fall if confidence falters.
Instead we chose companies that were not expensive and were not discounting some sort of heroic earnings growth or unusual margin stability in 2013. We also employed the work that we published in December 2012 to screen for companies that have a good track record of predicting forward earnings and screen out those who do not. In other words we are more interested in strong projected growth from companies that have a good predictive track record than we are from those who do not.
Combining the screens we find a few themes – we would be cautious on Paper and Coatings – there is nothing wrong with the companies or the industries, but valuations discount forward performance that will be a challenge, particularly in a slower growth US. In aggregate the stocks exposed to agriculture look interesting both on the machinery and the chemical side.
Our screens pushed DuPont to the top of the heap.