Getting Left Behind in the Market – Unless You Have A Story

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 9th, 2013

Getting Left Behind in the Market – Unless You Have A Story

  • The market rally of 2013 is generally leaving the Industrials and Materials sectors in its wake as concerns about fundamentals are exposing how absolutely expensive some of these groups have become. Transports and packaging have managed to keep ahead of the market, but all others have lagged. While Packaging has rallied it remains very cheap relative to the Paper sector.
  • The Metals space has lagged badly, setting new relative value lows for the sector and many stocks. The driving force has been weaker fundamentals and falling prices. All of the metal producers look very attractive, but we see no immediate catalyst with AA the most likely to see an inflection point first. (1)
  • Valuation has not worked. Many stocks that were cheap at the beginning of the year are cheaper today, and many expensive stocks have continued to outperform. Revisions have been a better predictor of performance, particularly where there is not a concerning macro backdrop.
  • The market is buying stories. Restructuring in the case of Transports, Coatings and to a degree packaging. It is also buying specific stories such as business focus in the case of PPG, AXLL, HTZ and OSK. HTZ and OSK remain attractively valued.
  • The following stocks look like they have been left behind; out of favor because of serial disappointments or grouped with others that sound similar but are not, in our opinion; SWK, OLN, ITW, DHR, ETN, FLR and DD.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

Early in the year we commented on the relative high value of most of the Industrials and Materials sector and suggested that it would be hard for the group to outperform a rising market. The market has been rising quite quickly – the S&P 500 is up 14% year to date – and the Industrials and Materials group has lagged. We would expect this lag to continue given that we see no signs of a quick recovery in the global economy and given the importance of overall consumption growth to these sectors.

Only two subsectors are staying ahead of the market this year – Transports and Packaging. Transports was expensive to start with, so what we see is investors continuing to favor the consolidation and market structure story here – pushing many stocks to new highs. The exception here would be FDX which has underperformed following a couple of earnings misses ( see our piece from December on Optimism ). The Packaging story is more of a value play, with stocks that looked cheap reacting to more positive expectations. The packaging sector has also seen significant consolidation, but these moves are quite recent and we have yet to see any return on capital improvement at the sector level, of the type that has propelled the Transports sector. Both of these groups are consumers of energy – fuel and plastics/glass/aluminum – and as we see oil prices moderate this might also be a boost.

Broadly we continue to see limited – if any – correlation to value. The Transport sector was clearly not a value proposition at the beginning of the year, while the Packaging was. On the other end of the scale, the Metals sector, which has been the screaming value opportunity for more than a year, continues to underperform. We have seen a relative decline in the Paper and Electrical Equipment spaces – the two that appeared most richly valued on January 1st.

At a company level there is no correlation at all between value and performance this year. Steel has been the big loser, driving down the metals group, but a handful of expensive names have also pulled back. If we look at the best performing 20 stocks in our coverage (Exhibit 2) only 4 or 5 could be considered reactions to value opportunities at year-end – the rest are either sitting in more consolidated industries, like Transports, or are story specific.

However, some companies have been left behind further than others, and while most of these names are in the Capital Goods space, we would highlight: SWK, ITW, OLN, DHR, FLR and ETN. We also still favor DD, as while it has outperformed year to date, it remains at a 10% discount to its “normal” relative value. While all of the base metals names screen as very attractive, we are not going to pound the table in this piece and will review the group separately.

(1). One concern with AA is cash flow this year and next, given weak aluminum prices, debt repayment needs, capital spending and pension funding needs. While the company does have significant cash on the balance sheet and can borrow, there is a scenario where a minor equity raise may be needed to avoid a debt downgrade. Our view on the stock is that there is so much upside once sentiment turns, that an equity dilution would not change the conclusion.

Exhibit 2

Source: Capital IQ and SSR Analysis

Finding It Hard To Keep Up

One of the reasons why the Industrials and Materials sector has looked quite richly valued versus the broader market for the last 18-24 months has been because the “normalized” market multiple has been held down by weakness in other areas – most notably financials. The market rally this year has included a recovery in financials and consequently the Industrials space has in aggregate underperformed, albeit not by much – Exhibit 3. The negative outlier is the Metals space, with all metal producers, base and precious under pressure from falling commodity pricing and a more bleak economic and demand outlook. In the base metals space an already relatively cheap sector looks even more extreme today than it did on January first. The Metals sector requires its own dedicated analysis and we are not going to focus on the space in this report.

Exhibit 3

Source: Capital IQ and SSR Analysis

The positive outliers are Transports and Packaging, the latter being a possible play on value and both possibly impacted by positive restructuring stories. While the packaging space has seen incrementally positive revisions year to date, transports has seen more negative revisions. Only Paper has seen any real positive revisions as this is mostly a function of some significant changes at LPX – Exhibit 4.

Exhibit 4

Source: Capital IQ and SSR Analysis

Value Still Taking a Backseat…

If we look at how stocks have performed relative to how they were valued at the end of 2012, we get absolutely no correlation – Exhibit 5. On a relative basis some expensive stocks have got more expensive: notably; WOR, IP, ECL, PKG, KSU, GWR and HON. Some cheap stocks have got cheaper: excluding metals, these would include; SWK, ITW, JOY, FLR and CBT.

Exhibit 5

Source: Capital IQ and SSR Analysis

 

…Revisions are Hanging in There…

Unlike valuation, revisions do appear to be working, though the correlation is not great – Exhibit 6. In this chart we have omitted both X and LPX, because their revisions were extremes – low in the case of X and high in the case of LPX. This did not change the slope or correlation of the trend. The negative revisions are not surprisingly most extreme for base metals. The more positive revisions are generally stock specific.

Exhibit 6

Source: Capital IQ and SSR Analysis

..But the Stories Are Winning

The top performers remain those companies that are either riding a wave of positive sentiment or are generating their own, either through their positioning in the current raw materials environment or through portfolio restructuring. Exhibit 7 shows the best performing companies year to date together with some metrics around what might have driven that performance.

Exhibit 7

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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