Outliers: Where Valuation is Inconsistent with Return on Capital and Estimates

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 9th, 2013

Outliers: Where Valuation is Inconsistent with Return on Capital and Estimates

  • We have revisited our Skepticism Index analysis, which quantifies the stock price valuation discrepancy with the deviation of the company’s return on capital from long term trend.
  • Companies with high SI’s consistently outperform across the overall universe of Industrial and Material sectors; a trend that is mirrored by capitalization level as well as by sector.
  • Clearly the SI level can close by either the stock price moving or the forward earnings estimate correcting. Our work shows that the opportunity in high SI stocks is enhanced by focusing on those that have a current positive earnings revision trend.
  • Exhibit 1 shows the list of names that meet the criteria of both high SI stocks and improving earnings estimates (attractive stocks) and low SI with downward revisions (unattractive stocks on this basis). Our analysis would suggest that attractive names have a high probability of outperforming the broader market over the next 6 months.
  • Only DD and NEM reoccur from our 13 from 13 analysis – DD remains our most interesting idea.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

We wanted to review the concept of Skepticism that we have discussed in several reports over the past year. The underlying focus on this work is to measure the discrepancy in both the valuation (as measured by deviation from normal value) and the expected return on capital (as measured by the deviation from the long term trajectory). We appreciate that the equity market has a tendency to anticipate future trends and so we account for this by looking at valuation today versus the earnings potential one year out. Of course the lead/lag relationship may be different for some specific companies at specific times but we feel this captures the essence of the markets behavior.

In the original analysis we attempted to quantify how much of any company (as well as any sector’s) current valuation is explained by current return on capital. Otherwise put; is a company’s current deviation from “normal” value explained by an equal deviation in return on capital. Where current returns suggest that valuation should be higher we have labeled it “Skepticism”. The analysis is a simple sum of the number of standard deviations that a company is trading BELOW its normal value and the number of standard deviations above the return on capital (ROC) trend. There of course are two ways for this apparent anomaly to close – either the stock price (and hence valuation) can move in line or the earnings expectations can change (up or down) to close the gap.

  • A company trading at one standard deviation below normal value (+1) and with ROC half a standard deviation below normal (-0.5) has a skepticism index (SI) of 0.5. Negative skepticism is otherwise labeled as optimism.
  • If a company has a positive SI, either the relative share price is too low or the ROC is going to fall. If a company has a negative SI either stock price will fall or returns will rise to get back to normal.
  • Almost every stock in our universe oscillates regularly around the zero line – Exhibit 2 shows the time series for PX, MMM, DE and IP as examples

Exhibit 2

Source: Capital IQ and SSR Analysis

In Exhibit 3 we show the aggregate data across all the Industrial and Materials sectors. This shows the equally weighted 6-month forward returns for stocks in each of the Skepticism Index categories. The result is interesting in that it shows a clear downward trend in forward returns as the SI level falls.

Exhibit 3

Source: Capital IQ and SSR Analysis

Given the divergent focus sometimes on large-, mid- and small-cap companies we broke the analysis down into these three cohorts and saw a consistent theme across all. See Exhibit 4 – our large cap cut was a market cap of over $10B, mid cap between $5B-10B, and small cap under $5B.

Exhibit 4

Source: Capital IQ and SSR Analysis

Clearly these results are compelling but we wondered if the efficacy was consistent across all the sectors or whether it was driven by a few of them alone. In Exhibit 5 we show that data and it is clearly seen that the trend is consistent across all sectors with the exception of Packaging Sector. A very poor return for SON (on 27 data points) drags down the group’s overall return in the above 1.5 range – if this result is omitted, the return progression in Packaging looks similar to the other sectors and the aggregate.

Exhibit 5

Source: Capital IQ and SSR Analysis

As we mentioned above the SI discrepancy can close either by the stock price changing or by the forward earnings estimate changing. The next challenge was to see if there was a way to parse the stocks out in the high SI category that were more likely to see earnings decline (as opposed to stock price changes). Again aggregating the data across all sectors we looked at earnings revision trends over 1-, 3- and 6-month periods and found that our ability to predict winners where the stock price moved was enhanced by focusing on the positive revision group and not the negative revision one. See Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

So having explained the important background we have been searching for stocks that have a high SI and positive revisions. In Exhibit 7 we show the lists of those in each capitalization bucket (large-mid- and small). Our focus is now on those bolded in the tables that have upward or flat revision bias.

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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