Overvaluation Pervasive Among The Industrial Cyclicals - A Survey Of Timely Short-Sale Candidates

Includes: AA, CAT, CMI, NAV
by: Value Doc


Sharp declines among overvalued technology stocks and U.S. small-caps have garnered a great deal of attention in recent months, yet few are asking “which overvalued sector is next?"

A cursory review of various industrial cyclical stocks reveals peak-level valuations and frothy, overbought prices.

Current valuations, coupled with financial and operating leverage, suggest that long-term risk-reward among most industrial cyclicals is heavily skewed to the downside.

Disappointing future macroeconomic performance, likely portended by a flattening yield curve and sluggish copper prices, represents an obvious catalyst for a substantial correction in the coming months.

Given the risk-reward calculus at current valuations, short-sales of select cyclicals may be attractive as hedges on a long-oriented portfolio.

In recent months, hefty declines among momentum favorites in the social networking space, biotech industry and other frothy sectors, together with sharp underperformance by U.S. small caps, have garnered a great deal of attention in the investment community. Pundits debate whether this market action foreshadows a broad-based sell-off or merely represents a healthy rotation out of overbought, overvalued sectors into more reasonably valued large-cap stocks. Curiously, while much ink has been spilled pontificating general market direction, few analysts are asking the question of "who might be next" in terms of other overbought, overvalued sectors that are ripe for a serious correction.

A cursory review of many bellwether industrial cyclical stocks reveals huge runs since late last fall beginning at roughly the same time that the 2013 year-end consensus of rising interest rates and a robust economic rebound began to coalesce. Since that time, the year-end consensus has been soundly thrashed with U.S. Q1 GDP of only +0.1%, persistently falling long-term interest rates, a faltering U.S. housing recovery, an obviously slowing Chinese economy and stagnant industrial metals prices. Strikingly, the share prices of most industrial cyclical stocks have yet to catch up to these other indicators, though many appear to have lost momentum in recent weeks.

Multi-factor valuation analysis suggests that most cyclicals are trading at very high historical multiples despite a complete absence of revenue growth for several years and numerous recent indications of strong macroeconomic headwinds. Intriguingly, many of these names have displayed similar seasonal run-ups during each of the past four years, and in each case, sharp declines promptly ensued, in many cases, wiping out the entire previous run-up. Accordingly, many of the industrial cyclicals represent a timely short-sale opportunity particularly for investors who may wish to hedge a long-oriented portfolio for the next six months as we enter the market's typical unfavorable season.

Aside from the current macro backdrop and the historical tendency of most names in the sector to drop like a stone on any market correction, some quick hits in favor of a short position on each of the following names are set out below.

Caterpillar (NYSE:CAT)

  • Revenues declined by 15.5% last year.
  • P/S ratio of 1.2 exceeds 2006-07 period P/S ratios (an era of robust sales growth and a booming global economy).
  • Trailing P/E of 18.0 on what is likely mid-to-late cycle earnings (CAT management suggests trough earnings of $3.50, implying a current P/E of over 30 on trough earnings).
  • Highly levered to a deteriorating mining cycle.
  • Favorite short position of legendary short-seller Jim Chanos.
  • Share price has rallied 30% over the past six months. A rally to current price level (and P/S valuation level) took place during Q1 2013, and was completely unwound within a couple of months despite a robust, year-long rally in the S&P 500. This pattern was replicated during Q1 of 2012 and Q1 of 2011 as well.
  • Broadly sideways trading range action over the past three years against the backdrop of a rising S&P 500 is identical to topping patterns and relative performance prior to previous cyclical bear markets (1997-99; 2006-08).

Alcoa (NYSE:AA)

  • One of the worst large-cap performers since the 2009 market bottom with severe structural problems (i.e. overcapacity) in the global aluminum industry.
  • A multi-year turnaround effort attempting to gain traction.
  • Credit ratings downgraded to "junk" by Fitch Ratings after last month's quarterly earnings report, despite enthusiastic reaction from equity market.
  • Deteriorating cashflows over the past five years despite an economic recovery out of the Global Financial Crisis.
  • Free cash flow of $385 million last year against a market cap of US$16 billion.
  • Share price has rallied 80% over the past six months. The last rally of similar magnitude and duration occurred during late 2010 and Q1 2011 in the context of a strong global industrial rebound (backed up by rising bond yields and surging commodity prices) yet nonetheless, ended with a 50% decline in the space of a few months.

Cummins (NYSE:CMI)

  • Well-managed machinery conglomerate with strong secular performance over the past decade but zero sales growth since 2011.
  • P/S ratio of 1.7 vs. 1.0 during 2007 (an era of robust sales growth and a booming global economy).
  • Trailing P/E of 18.
  • Price-to-free cash flow ratio of 21.
  • Heavily leveraged to Chinese infrastructure and construction boom.

Navistar (NYSE:NAV)

  • Truck manufacturer with decades of dismal operating and financial performance.
  • Currently attempting to recover from a disastrous foray into engine manufacturing.
  • P/S ratio equal to that of 2007.
  • Operating cash flows have declined over the past five years despite an economic recovery out of the Global Financial Crisis.
  • Negligible free cash flow.
  • Severely strained balance sheet; may face solvency risk in the event of a severe economic downturn.
  • Open short-sale positions equal to 35.3% of the outstanding float.

This survey is obviously not exhaustive, and defenders and detractors of each of these names could make a case with far more detail than this article attempts to provide. For example, AA and NAV are in the midst of difficult, multi-year turnaround efforts, and a case could be made that these two stocks are not expensive in the event of successful turnarounds.

However, what is evident from this quick review is that pervasive overvaluation likely exists across the sector, and that the space is severely overbought based upon a premise (surging economic growth) that is inconsistent with the recent action of other markets such as bonds and industrial metals. Stronger, well-managed companies are trading at very high absolute and relative historical valuations. Turnaround situations have rallied sharply despite being loaded with risk amidst weak balance sheets and many years of horrific operating and financial underperformance. Nearly all names in the industrials sector (including many not mentioned in this article) have levitated dramatically in recent months on investor optimism that will likely prove, in the fullness of time, to be misplaced.

In the past, these valuation levels and trading patterns have invariably ended in tears. Accordingly, the industrial cyclicals sector likely represents a timely hunting ground for those looking to hedge out a long portfolio or opportunistically speculate on seasonal market declines.

Disclosure: I am short CAT, AA, NAV, CMI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.