SSR Industrials & Materials Monthly Review, January 2017: Adjusting Our Preferences As Trump Rally Rolls On

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 1st, 2017

SSR Industrials & Materials Monthly Review, January 2017: Adjusting Our Preferences as Trump Rally Rolls On

  • Q4 ’16 earnings to date have shown some top line momentum with more than half of the companies reporting above consensus revenue
    • Equivalent figure for Q4 ’15 earnings was less than one third
    • Corporate commentary generally positive around the Trump administration’s growth policies (seemingly supported by continued positive US manufacturing numbers) but the macro picture is somewhat mixed, with optimism countered by concerns about potential trade disputes
  • Less value seen at the sector level as the majority of Industrials & Materials outpaced the S&P by 1.5-3.5% in January
    • Conglomerates the only significant underperformer, inclusive and exclusive of GE
  • In January we published research on:
    • The rally in Commodity Chemicals – stock moves have not been extreme in the context of history, valuations are broadly attractive, and anti-pollution crackdowns in China could provide a pricing boost
    • Our thinking on value opportunities in 2017 – our “normal” valuation tools worked well in 2016 and we see a continuation in the new year, with Metals and Paper & Packaging the sector level value standouts – most/least attractive stocks listed by sector
    • A similar thought process applied to the Chemicals space
    • Dow and DuPont – outperformed a weak sector in 2016, and should repeat the feat the in ’17 – continue to believe the deal goes through but prefer DD in isolation
    • Air Products – purchase of Yingde make most sense if it provides a level of design competence currently lacking at legacy APD
    • SWK – a classic example of a “normal value” identified investment, recent acquisitions now provide a growth platform for the next year or two
    • SMID caps – where to look given the current landscape – taxes, US sales, labor intensity, offshore cash, recent performance, and corporate optimism all considered for a universe of 100 stocks
  • Exhibit 1 summarizes our preferences by sector and stock
    • We are now neutral on the Chemicals sector as a whole – preferences are mainly in the Commodity group where we see potential for a strong year, while the Coatings/Industrial Gas sectors appear to be facing challenges to growth in our view
    • Based on our work from early last month, we move Metals and Paper & Packaging to overweight – favorites and concerns within sectors are primarily value motivated
    • We also move Capital Goods down to Neutral – several of the larger cap stocks have performed well enough to leave the list but we see a continued path higher for SWK. The sector in aggregate is less attractive on a value basis given several strong moves in the recent Trump rally

Exhibit 1

Exhibit 2

Source: SSR Analysis – Normal Value looks at valuation relative to historical norms and the SI measures current valuation versus current return on capital and what movement in returns on capital is implied in valuation.

Exhibit 3

Source: Company Reports and SSR Analysis

See Appendix 3 for the data underlying this exhibit.

Exhibit 4

Overview

Q4 earnings to date have provided some confirming signs for several of our theses. Continued cost efforts for pre-merger Dow/DuPont led to another quarter of strong results – better versus EPS consensus for DD, better on the top line for DOW. OLN gave early support to our Commodity Chemicals work, with a report of improved pricing. AA and NUE demonstrated some revenue acceleration in the Metals space, which presents very similarly to the commodity chemical story on the dimensions of relative value and pollution-related output discipline from China. SHW was back up after a considerable beat but is facing growing pressure from input costs (TiO2) and we see signs of the type of industry wide slowdown in growth that is hampering Industrial Gases. PX was hard pressed just to meet estimates on 2% revenue growth, and APD is beginning to demonstrate cracks in a cost cutting catch up story that has made the stock a perpetual favorite.

Exhibit 5

Source: Capital IQ and SSR Analysis

Corporate commentary on the Trump administration’s goals and priorities has ranged from cautious optimism to less measured enthusiasm – at the very least, tax reform would be a major positive even if the infrastructure build out disappoints and trade actions offset some of the gains. Post-election optimism around these initiatives drove many stocks strongly higher, in certain instances without the fundamental support of positive earnings revisions. At the cross section of value post-Trump rally and earnings (revision) momentum we find a handful of the commodity names we highlighted in recent research – WLK, OLN, HUN, and MOS among them – as well as DE and NUE – Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysis

Sector performance in January is shown in Exhibit 7. GE was down on earnings, and the wider Conglomerate sector produced lackluster in-line earnings and lateral stock price movement. The big gainer in Chemicals was SHW (+13%) but we see risks going forward – the preferred commodity space contributed more widely to the sector’s performance (CF +12%, WLK +11%, LYB +9%). We show the 25 best and worst performing stocks in Appendix 1 – Metals stocks at both extremes netted out to positive performance at the sector level. CMC missed estimates badly and was punished (-6%), while AA missed similarly but guided more positively and was up 30%. STLD (-5%) reported in line but was not positive enough to move higher from what had been a strong post-election move.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8 summarizes discount from normal value by sector. There is considerably less value in the Industrials & Materials space after the Trump rally, with only the Metals sector more than half a standard deviation cheap. As we noted in our commodity chemicals call from yesterday, however, we are in most cases still very far from historic valuation peaks.

Exhibit 8

Source: Capital IQ and SSR Analysis

Values for our Skepticism Index are summarized by sector in Exhibit 9 (see our skepticism work for more detail). There are currently only a few sectors where valuations and returns are significantly unaligned. Paper & Packaging stocks continue to discount weakness that is not yet reflected in forward estimates – from value and general economic leverage perspectives we see outperformance as a more likely path to equalizing the sector’s skepticism index. On the other end of the spectrum, modest premiums relative to normal earnings in the large cap Electrical Equipment names (EMR, ETN) belie sub-trend current returns. Within Transports, the elevated SI value is due to the Rail and Trucking subsectors – Logistics returns and valuations appear fairly aligned – Exhibit 10.

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10 is a very busy chart but shows how each sector and sub-sector breaks down by skepticism index component – valuation versus ROC. We are seeing certain subsectors of the Chemical space join Paper & Packaging in the desirable top right quadrant of this exhibit.

Exhibit 10

Source: Capital IQ and SSR Analysis

Portfolio Performance

2016 was a strong rebound year for our portfolio selection methodology, particularly in the overlap of valuation and skepticism, which has started the New Year off with a modest gain – Exhibit 11. See accompanying work from early last month.

Exhibit 11

Source: Capital IQ and SSR Analysis

An alternative portfolio approach is based on our expanded skepticism index performance analysis which showed a very attractive risk-reward relationship for stocks with positive SI values, valuation discounts, and positive 3 month EPS revisions. A broadly improving revisions picture lengthens the list this month to 24 stocks (from 20 last month) that fall in these historically outperforming ranges – Exhibit 12.

Exhibit 12

Source: Capital IQ and SSR Analysis

Exhibit 13 shows the historical forward performance of the stocks meeting the criteria in Exhibit 11 at various ranges. We note that for all ranges where the SI is above 0.5, the average return is in excess of the variability (average > standard deviation).

Exhibit 13

Source: Capital IQ and SSR Analysis

Macro Environment

At SSR we are not economists, nor do we seek to be. We look at the economic indicators that are publicly available and put them into context relative to the drivers within the industries we cover. We examine trends or fundamental influences and we then look at these relative to valuation with the goal of identifying mismatches between what is implied in valuation and what is expected to happen.

The US manufacturing sector continues to gain momentum with the overall PMI accelerating again in January. New orders remain strong, and inventories are showing only slight builds. Fourth quarter US GDP was typically tepid and while the tone on many corporate earnings calls has been positive toward the new administration’s growth policies, trade disputes could threaten to offset gains from fiscal stimulus and tax reform. Business and consumer confidence is strong however.

Elsewhere, Europe is facing a series of significant elections this year at a time when Brexit uncertainty continues to hang over the region, Greece is back in the news, and the undervaluation of the Euro currency has recently come into focus. Factory activity in China is reported to be subdued given ever increasing pollution levels – in the end it may be public health rather than economics that leads China to rationalize its overcapacity. Among the other BRIC nations, Brazil was noted as possibly turning a corner on several earnings calls, while India is struggling with the fallout of its large denomination cash ban, and Russia contemplates improved relations (and reduced sanctions) with the West.

Exhibit 14

Source: Capital IQ, Government Publications, Bloomberg, SSR Analysis

Commodity Pricing

Steel pricing was weakest among major industrial metals in the first month of the year, but shows the highest increase compared to prior year levels (+50%). Pricing for aluminum and copper saw sequential gains (+6% and +10% respectively) and is 20-30% stronger now versus last January. Crude held above $50 per barrel for a marginal monthly change – the bigger move came in natural gas which finished the month just above $3.00 per mmBTU after approaching $4.00 late in 2016. Strained trade relations with Mexico, a major and increasing buyer of US natural gas, has contributed to pricing pressure.

US commodity and energy prices are indexed in Exhibits 15 through 19.

Exhibit 15                                                                                      Exhibit 16

Source: Capital IQ, IHS, CRU Steel Price Index, Bloomberg, SSR Analysis

Exhibit 17

Source: Capital IQ, Bloomberg, SSR Analysis

Exhibit 18                                                                                       Exhibit 19

Source: Capital IQ, IHS, Bloomberg, SSR Analysis

Expectation Analysis

In Exhibit 20 we look at expected net income growth by sector, and in Exhibit 21 we plot the growth figure against each sector’s current skepticism index value. Note that we have excluded the Metals sector from these exhibits as the temporary removal of AA has left the groups’ 2015 net income base below 0. This month we have moved to 2018 estimates and find the ordinal ranking of sectors essentially the same as it looked on 2017 estimates. Despite the most significant negatives revisions to longer term (2018) net income estimates on the month – Exhibit 22 – Paper & Packaging shows the most forward optimism. Estimates for the machinery sectors (Electrical Equipment, Capital Goods) reflect the most pessimism despite recent stock performance (particularly relative to the Conglomerates).

Exhibit 20                                                                                 Exhibit 21

Source: Capital IQ and SSR Analysis

Exhibit 22

Source: Capital IQ and SSR Analysis

Exhibit 23 shows average 2017 EPS revision over the past month and Exhibit 24 plots these revisions versus performance results on the month. Multiple Metals companies had significant positive revisions in the 50% range – AA, CLF, and X. Revisions in other sectors were mostly modestly negative.

Exhibit 23                                                                                 Exhibit 24

Source: Capital IQ and SSR Analysis Source: Capital IQ and SSR Analysis

Mid-Cycle “Normal” Valuation

In Exhibits 25-34 on the following pages we show the historical current discount/premium to normal mid-cycle value by sector.

Exhibit 25

Source: Capital IQ and SSR Analysis

Exhibit 26

 

Source: Capital IQ and SSR Analysis

Exhibit 27

Source: Capital IQ and SSR Analysis

Exhibit 28

Source: Capital IQ and SSR Analysis

Exhibit 29

Source: Capital IQ and SSR Analysis

Exhibit 30

Source: Capital IQ and SSR Analysis

Exhibit 31

Source: Capital IQ and SSR Analysis

Exhibit 32

Source: Capital IQ and SSR Analysis

Exhibit 33

Source: Capital IQ and SSR Analysis

Exhibit 34

Source: Capital IQ and SSR Analysis

Skepticism

Our Skepticism Analysis by sector is summarized in the Exhibits 35 through 45.

Exhibit 35

Source: Capital IQ and SSR Analysis

Exhibit 36

Source: Capital IQ and SSR Analysis

Exhibit 37

Source: Capital IQ and SSR Analysis

Exhibit 38

Source: Capital IQ and SSR Analysis

Exhibit 39

Source: Capital IQ and SSR Analysis

Exhibit 40

Source: Capital IQ and SSR Analysis

Exhibit 41

Source: Capital IQ and SSR Analysis

Exhibit 42

Source: Capital IQ and SSR Analysis

Exhibit 43

Source: Capital IQ and SSR Analysis

Exhibit 44

Source: Capital IQ and SSR Analysis

Exhibit 45

Source: Capital IQ and SSR Analysis

Research Published in January
January 31, 2017 Chemical Commodity Rally – Just Getting Started

January 23, 2017 Air Products – “Me Too” Folly or an Inspired Fix for a Tricky Problem

January 23, 2017 SWK – Right Out of the SSR Tool Box

January 17, 2017 Chemicals January – Will Trump Slow Down Investment and Deals?

January 17, 2017 SMID Cap Industrials & Materials – Where to Look Now

January 6, 2017 Chemours, DuPont and Teflon – Understanding the Dimensions of the Iceberg

January 6, 2017 Chemicals – Value and Momentum Unaligned – Limited Choices for ’17

January 5, 2017 Dow/DuPont – Again in 2017!

January 3, 2017 Industrials and Materials: Value in 2017 – Our Thinking

Dividends

In Exhibit 46 we show a screen of stocks with low value, high skepticism and high dividend yield. PKG fell out of the valuation screen, leaving holdovers EMN and OLN as the only stocks to appear on all three metrics.

Exhibit 46

Source: Capital IQ and SSR Analysis


Appendix 1

Appendix 2


Appendix 3


Appendix 3

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. 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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