Complexity, Volatility and a Market Where Neither Extremes Work Well

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 19, 2013

Complexity, Volatility and a Market Where Neither Extremes Work Well

  • Today it appears that the market favors companies with a straightforward business structure and low volatility of returns. To test more empirically we have created a Complexity Index and tested sub groups with different levels of ROC volatility.
  • Generally there is weak evidence to show that more complex companies are valued lower than their simpler peers. However, there is a clear indication that you are penalized above a certain level of complexity.
  • While higher complexity often leads to lower earnings and return on capital volatility, again there is a limit to how well this is viewed by investors. The complexity penalty overrides the lower volatility premium at some point. Today, the best performing group contains those with moderate volatility and moderate complexity.
  • The penalty goes to those with highly complex business and those with high volatility of returns. In a true bull market it is these more risky stocks that outperform – not today.
  • Some of the more highly complex companies with low ROC volatility look attractive as the current level of discount is extreme. We would focus on CAT and DD on the long side. CAT did not screen as high or low in the ROC analysis but is one of the most complex companies in our coverage group, and has shown strong recent ROC growth with minimal volatility. CAT currently trades at a discount both in absolute terms and relative to its overall sector (see accompanying research).

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Today, more than in recent years, investors value certainty. This is in part because of the more general thirst for yield like securities and in part because of the greater degree of macro uncertainty that the market faces. But this presents a potential dilemma – simple stories, while easy to understand, tend to have more volatile earnings, because of narrow business focus – volatile earnings create uncertainty. As diversity (both geographic and end market) increases, in general, earnings volatility falls. This can be shown empirically within the Industrials and Basic Materials sectors.

However, as diversity (complexity) increases beyond a certain point, we have seen the recent market overweight the penalty of too much complexity versus the benefit of lower volatility – in other words, the most complex have underperformed.

Consequently there has been gravitation towards the middle ground, with medium complex companies outperforming their more complex and less complex peers and both high and low volatility companies underperforming the guys in the middle – Exhibit 2.

Exhibit 2

Source: Capital IQ and SSR Analysis

This valuation structure is more pronounced today than at any time in the past and it is a reason why so many of the larger cap more diverse companies appear cheap versus their sector peers: CAT, ITW, MMM, GE, DD, and DOW. We would be most concerned about overvalued low complexity and high volatility companies today, as they have the greatest opportunity to surprise most dramatically on the downside – this group would include: MWV, PWR, BDC, RS, and ALB.

We would expect the relative discount that the first group of companies is seeing today to close over time, but we would focus more immediately on those that either have low volatility (of return on capital and earnings), or those that are taking action either to reduce complexity or volatility.

CAT has done a great deal to its manufacturing process and has certainly seen a much higher cyclical low in the last cycle than in prior cycles – see accompanying call.

DD is pushing forward with a growth strategy that is creating a less volatile earnings stream, but could address this issue and its complexity issue in one move thorough divestment of its TiO2 business.

By way of example, PPG has addressed both its complexity and its earnings volatility through the divestment of its commodity chemicals business – the impact on its relative multiple is shown clearly in Exhibit 3. Interestingly, while the drop in both volatility and complexity has (based on an historical analysis) been small, the impact on the relative multiple has been extremely positive.

Exhibit 3

Source: Capital IQ and SSR Analysis

With this piece of analysis we introduce the broad subjects. In coming weeks we will drill down in more detail, at the stock and sector level.

Complexity

To create our complexity index we took our large coverage group of companies in the Industrials and Basic Material sectors and ranked by a combination of business and geographic diversity. The index was created by taking the number of reported business segments and dividing by the percentage of total revenues generated from the US: the higher the number of segments, the higher the index, and the lower the amount coming from the US, the higher the index. Some of the larger companies are summarized in the Exhibit below.

Exhibit 4

Source: Capital IQ and SSR Analysis

Historically, the high complexity group, despite its underperformance, had been afforded a high relative Price/Normal Earnings ratio – reflecting the stability of earnings. Since the financial crisis the dynamic has changed, and in recent years it is the mid complex companies that show the highest ratio. In the aftermath of a historic sell off and in the continuing uncertainty it appears that investors have paid up for the middle ground in favor of the focused risk of the low complexity group and the complexity risk of the highly complex group.

Exhibit 5

Source: Capital IQ and SSR Analysis

Taking a more granular look, if we chart the entire group we do not see much of a correlation between complexity and valuation – Exhibit 6 – but if we just look at those companies with a complexity index above 10, we highlight the discount being applied to the highly complex companies today – Exhibit 7.

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Source: Capital IQ and SSR Analysis

This complexity discount has not always appeared and if we plot the same data for 2008 we get correlation, but not all of the highly complex companies were trading at a discount to normal value – Exhibit 8.

Exhibit 8

Source: Capital IQ and SSR Analysis

The Volatility Premium

To broaden our analysis, we looked at return on capital volatility for our group. Companies were ranked by trend ROC growth from 2000 to 2012. We took a subset of companies that showed flat or nearly flat growth (± 3%) and further segregated the group into high, mid, and low ROC volatility subsets as defined by the magnitude of one standard deviation around the trend.

As was the case with the complexity analysis, the middle subset of ROC volatility shows the best performance – Exhibit 9.

Exhibit 9

Source: Capital IQ and SSR Analysis

Again we see a situation where the relative multiples of the more favored groups have expanded. Essentially we are paying more for the same level of earnings than we have historically for the low volatile group and less per dollar of earnings for the high volatile group than in the past – Exhibit 10. The reason why the mid-volatile group has outperformed is that “normal earnings” have grown more quickly, either because of a faster rate of growth of return on capital, or because of more capital deployed – or both.

Exhibit 10

Source: Capital IQ and SSR Analysis

Combining The Analysis – What To Do?

If we rank the groups by pre and post crisis performance we get the rankings shown in Exhibits 11-12. If we think about the effect of the crisis, it was more pronounced in the companies with greater volatility and complexity (where that complexity was high because of exposure to Europe and China). Investors lost so much in high volatility names, which were inflated in the pre-crisis euphoria, that they been reluctant to return. While the “middle of the road” strategy has worked since then, we would argue that the low complexity group is doing rather better than it should relative to the high complexity group and that the high complexity and high volatility categories have now lagged by so much that relative valuations probably discount most of what could go wrong.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

In the exhibit below we summarize the constituents of each group, noting that there are plenty of overlaps. We have highlighted in Red the companies that look to be outliers on the expensive side and we have highlighted in Green those that look attractive.

Exhibit 13

Source: Capital IQ and SSR Analysis

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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