A picture is worth a thousand words – so let’s start with four pictures.
From Bloomberg – This chart depicts value pricing based on forward earnings ratio to growth’s forward earnings. The range is from 1998 to January 2022. The last time the ratio was this low was in the middle of 2000 during the tech bubble bursting.
The chart below shows the massive divergence in the Vanguard S&P 500 ETFs for Value and Growth from 2011 to the present.
The chart below is from the Nasdaq showing the extreme valuation differences between Growth and Value from 1994 to May of 2021. Obviously, this divergence increased from May 2021 through today.
And lastly, also from Nasdaq, this chart perhaps illustrates the divergence between growth and value the best of all, with the concentration for investors into growth vs. value exceeding the ratio from 1999-2000 when the tech bubble popped. I am not trying to time another tech bubble or declare an end to this bull market. I am merely highlighting the extreme discount and historic low valuations for value and cyclical names as we begin 2022 with increasing inflation and with the market anticipating at least three rate increases.
Since the financial crisis, we have had a low-interest-rate environment that has in part helped push growth vs value outperformance to essentially unprecedented levels as can be seen in the chart above which shows the S&P 500 Growth and Value indices. The consequence of this move has been an ever-increasing amount of AUM shifted to passive funds, ETFs, and quants. Actively managed sectors are overwhelmingly crowded into larger cap growth with many of the companies generating no earnings. Especially crowded have been the mega-caps such as AAPL, (MSFT), AMZN, (TSLA), GOOGL, FB, GOOG, (NVDA), BRK.B, JPM, JNJ, etc. Over the last decade, investors have been continually punished for holding value names, especially professional investors that need to show results on a month-on-month basis. However, as inflation became more apparent and the “transitory” discussion from the Fed dissolved, active managers began selling the newer mega-cap stocks with no earnings. (Hedge Funds Bailing on Expensive Tech at a Breakneck Clip). Also noteworthy, the amount of AUM in these names is staggering. For example, AAPL has a roughly $2.85T market cap at an approximately 31x P/E. If that compresses to 20x P/E from selling that is roughly $1T of market capitalization.
A plunge in dizzily priced software and internet stocks is setting off a quick exodus among professional speculators who were counting on the group to salvage their year.
What Happened Last Time
The last time a tech bubble burst, the sell-off was predictably large when it finally happened—however, perhaps not as obvious, value names performed extremely well.
Dan Suzuki from Richard Bernstein Advisors began sounding the alarm bell late last year in this interesting 8-minute video segment (Not too late to sell as big bubble in tech starts to collapse, says Dan Suzuki). When discussing the massive tech/growth bubble, he described it as “monstrous.” Suzuki argues (at about 4 mins 30 secs into the video) that in 2000-2001 when tech stocks were down around 60% that the S&P was down along with tech by about 20% while small-cap value stocks were UP ~40%.
As we have seen in the past, I would argue new leaders will emerge, and at a minimum, will have little to no downside risk as multiples are already compressed, and have substantial upside potential even when the market sells off. Remember, most funds have to be fully invested and cannot raise more than about 10% cash. Hedge funds have no such restrictions, but not too many investors want to pay fees of 2%/20% for parking their funds in cash. Thus, active managers will have to put money to work and will look for names that are cheap.
Below is a table showing the magnitude of the selloff in selected large names (at the time) last time tech crashed:
SOURCE: Baseline quoted from Fintech Zoom/MONEY
Of note, look at how small the dollar amount is of those large moves compared to today. For example, if AAPL had a 52% selloff today, it would be closer to $1.48 trillion, not just $9 billion. Of course, there are dozens of extremely high multiple shares achieving those valuations on “hope” for a brighter future for shareholders.
Aside from the historically strong performance of value names during the last tech selloff we believe there are other reasons value shares should do well—especially names like Trinseo (TSE) and Dow (DOW). First, higher interest rates penalize long-duration assets and reward shorter duration assets – like companies with very large cash flows now. In other words, if I told you my miracle growth story stock will make billions 100 years from now, but rates are at 5%, what is the PV of those billions compared to if rates are 0.35%? Second, valuations are very low already in both DOW and TSE—more on that later. Finally, these shares are not as nearly widely held by retail. When was the last time you spoke to someone about Dow Chemical or Trinseo at a social gathering?
Why has this taken so long?
We have had a very long period of low rates and a market-friendly Fed. In addition, COVID has not only cranked up the money printing machine but the work/stay at home environment has been especially well suited for tech names. For one, tech companies provide products that have helped us better live our lives at home. Whether that be work in the home office, e-commerce, entertainment, or exercise options. In addition, with all the stimulus and wealth effect of crypto, retail has been a massive participant in the stock market—similar to the last tech bubble. Tech names provide “stories” that are very easy to be excited about, but much harder to perform a valuation on. Retail investors, of course, seem to be more easily excited by the former and often uninterested in the latter—also similar to the last tech bubble I would argue. Finally, the explosion of social media is also likely to play a role in the dumbing down of retail investor information exchange. You may find the following interesting: Fintech Zoom #1 (The Social-Media Stars Who Move Markets) and Fintech Zoom #2 ( Young Investors Flock to Discord and Telegram for Financial Advice).
Where are we now:
Although tumultuous, we have finally gotten to a point where it looks like we will be able to live with COVID. The sugar high of stimulus has resulted in inflation and widespread depletion of inventories leaving both supply shortages as well as unsatisfied demand. In particular, due to the massive shortage of semiconductors, auto sales have been lower than expected and there is large unsatisfied demand evidenced by the MSRP + prices at new car dealers. Of particular note—autos consume 25% of chemical sector output. I believe that we will likely see much higher auto sales going forward well into the next 18 months.
Also noteworthy, the consumer is strong. We know savings are up, perhaps partly due to unsatisfied demand for travel and goods during Covid.
Inflation: De-Globalization and the limits of Tech-Based Productivity Gains
The Fed has made it clear that maybe inflation is not so transitory after all with their most recent minutes. The market has responded by pricing in a significantly larger probability of rate hikes in the near term. Globalization moving to deglobalization, however, is another important factor influencing inflation in the past and going forward. The pandemic has helped illustrate the vulnerabilities that result from having to rely on China, for example, for mission-critical supplies.
Another deflationary pressure that perhaps can’t be relied upon going forward is the massive boost in productivity that has been delivered by new technology. We have seen a massive increase in productivity from technologies that have allowed e-commerce and business to be conducted efficiently online rather than in person. The positive impact of technology has been massive but there is a real question on whether or not these huge productivity gains from tech can keep going forever. What possible tech is on the horizon that could be as game-changing as the internet, smartphones, e-commerce, and the ability to seamlessly work from anywhere?
This brings us to Value/Cyclical companies many of which we believe to have been overlooked in a frenzy to buy tech growth stocks at almost any cost. Here you have not only a favorable environment in terms of unsatisfied demand, potential pricing power, and a healthy consumer finally breaking free from COVID—you also have the aftermath of such an extended period of low multiples. With multiples low for so long, many CEOs have favored share buybacks to increase shareholder value rather than investing in new plants. And while share buybacks are certainly effective in raising the value of shares, we wonder if this has created or is creating a situation that can further inflame supply shortages in favor of these producers.
In summary, we are entering an environment where rates will be higher, supply is low, there are inflationary pressures and demand will likely be high. On top of that, the companies due to benefit most from this have had severe multiple compressions, and many have strong pricing power.
My Best Two Ideas for 2022 – Trinseo and Dow Chemical
- An attractive business environment characterized by high demand, pricing power, and a healthy consumer.
- The current multiple does not reflect the transition of the business from “chemical” to “specialty chemical” company.
- The CEO announced a $200M share repurchase on the back of strong earnings and a reduction in leverage.
- 1Q 21’ catalyst potential with the announcement of the sale of the styrenics business which could substantially increase cash on hand and further solidify the transition from a chemical to specialty chemical business. My view is this could net the company between $1B and $1.8B. A very large amount relative to the current market capitalization of the entire company at around $2.25B.
- We believe Wall Street analysts have been asleep at the wheel not picking up on the share buyback which was telegraphed and underestimating the earnings potential.
- Performance of small-cap value names has been horrible as a group—this has dragged the stock even lower over the last months and helped to create what we think is a unique opportunity to buy a cheap name that can benefit not only from a rerating but also a “bounce” in value and small caps as a group.
I have written extensively on TSE in the past. (Bullet Proof #1). I first started writing about the company after its 2014 IPO. When the stock dipped post-IPO to the low teens, I detailed its compelling business lines and market drivers. (1st Prati article on TSE).
TSE is Cheap! Under 6x P/E? And they are executing! And now, they fall within the Specialty Chemical category.
Above is a table from NYU Stern, where one can see that Basic Chemicals have a Forward P/E of 9.09x while Specialty Chemicals have a 22.19x P/E. As per the point above, the market and indeed NYU Stern has not caught on that TSE is a Specialty Chemical company now as they classify TSE in their data as “Chemical (Basic).” We suspect it will take some time for the changes to filter through to the data—but when it does, we believe the quant funds (and other investors) consuming this data will see TSE as a large outlier and this will feed into their models accordingly.
The acquisition of Aristech with the sale of its synthetic rubber business has been transformational for TSE. And now with the sale of its styrenics business likely (according to the CEO on the last earnings call) to be announced this quarter, TSE will have transitioned the company to a specialty chemical company, deserving a significantly higher multiple. With the rubber sale closed and cash in hand, the final disposition of their commodity styrenics business imminent, the two remaining questions for investors or potential investors are (1) what should we expect for the sale of the styrenics business? and (2) what will the remaining business of TSE look like from a financial perspective?
Whoever buys the styrenics business is likely not buying it for a tactical trade. The buyer would likely acquire the division strategically as a long-term asset. Consequently, they know that a commodity business will not always have negative margins. This is why strategic buyers look at normalized margins and normalized EBITDA. Either PE or strategic players will look at average cycle EBITDA. However, strategic players are likely to pay more because they will want to buy polystyrene due to recycling technology. But to make this work they will value upstream access to styrene which makes the styrene piece strategic to them even if it is at the bottom of the cycle currently. The consensus view is a sale price of between $500 million and $800 million. However, I believe the sale will be between $1.0 billion and $1.8 billion with $1.4 billion as my “best guesstimate.” As we know, the styrenics business is only worth what someone is willing to pay. In either case, the sale price will be large relative to the current market capitalization and it will complete the transformation to a “Specialty Chemicals” business.
TSE recently sold their synthetic rubber company for an accretive number netting over $400 million. It is likely this quarter that TSE will sell their last remaining commodity business (styrenics) for a number likely between 55-75% of the market cap of the company leaving only a specialty chemical business that will generate $600mm in EBITDA annually on a normalized basis.
With the cash from the sale, a decisive transition to specialty chemical company and high earnings power where will the stock go? My view is the stock will re-rate at 3-5X current prices over the next 18 months. Note, if TSE were trading above $100 per share today, I might consider the range of the price obtained for the styrenics business to be a bit more important for the immediate reaction in share price to the news of the sale. At ~$56? I am flummoxed that the stock is not trading higher on the news last quarter that TSE intends to sell styrenics. This remains my most compelling idea and a truly asymmetric setup.
CNBC’s Steve Grasso, who is a regular on “Fast Money” appeared last Thursday on “Power Lunch” and happened to highlight three of my favorite stocks – TSE, DOW, and WRK. It is rare for analysts or pundits to diverge from recommending mega-cap tech. (CNBC – Power Lunch with Steve Grasso – January 6, 2022)
While I am accustomed to finding extraordinary opportunities in small and mid-capitalization materials companies periodically, my enthusiasm and investment in Dow Inc. (“DOW“) are less typical. DOW is a premier global chemicals producer, with leading competitive positioning across its portfolio and a high-quality management team. On top of that, it has a roughly 5% dividend yield.
To find a global bellwether with this asymmetric risk/reward is rare. I believe this opportunity exists because DOW has been public for a limited time, having been formed when the prior Dow Chemical was split into three companies in 2019. Many investors have bad memories of former Dow Chemical CEO Andrew Liveris, who made an ill-timed acquisition of Rohm and Haas, as well as forming the excessively expensive Sadara joint venture with Saudi Aramco. Moreover, I believe that prior poor performance and poor execution for a well-known large-cap company have tainted the stock with a sizeable negative bias, and it will require a bit more time to see “new management” deliver the goods and execute before investors will recognize that this is not the “old DOW.”
At the helm of the new DOW, is Jim Fitterling, a highly regarded and seasoned chemical veteran. Since the new company came public, Fitterling has structurally grown earnings and significantly reduced debt, all while consistently paying a 5% dividend. The Company has three main divisions: specialty plastics (mainly ethylene and polyethylene), industrial chemicals (polyurethanes and construction chemicals); and performance materials and coatings (consumer chemicals). The portfolio is positioned to benefit from secular drivers such as energy-efficient insulation and electric vehicle market share gains. It will also benefit from the ongoing recovery in travel and auto production.
However, since DOW‘s public market introduction, investors have been myopically focused on industry capacity additions, fearing downward pressure on polyethylene profitability. While much of the announced supply additions have already hit the market, there has been no impact on profitability as demand continues to be stronger than expected. The remaining additions are primarily in 2022 in China.
While I agree that these incremental capacity additions could have an impact on pricing (as does management), I think the impact will be much smaller than the market fears. In prior cycles, industry consultants and investors have consistently overestimated supply additions as capacity announcements run many years ahead of construction, while less efficient plants that are ultimately shut down are typically not identified until they close their doors.
In addition, recent changes in the energy markets, as well as more stringent environmental standards, have made the new capacity less competitive. Not only are half of the plants under construction in China unprofitable at current thermal coal prices, but the Chinese government is also intensifying efforts to curb carbon emissions resulting in a drive to shut down less efficient plants. The recent rise in oil prices has rendered European capacity less profitable. Consequently, if the polyethylene prices were to fall even half as much as the market is expecting in 2022, many European producers would shut down until pricing rebounded.
Analysts expect DOW‘s EBITDA to fall from $12.3 billion in 2021 to $9.8 billion in 2022. I estimate the impact from lower polyethylene prices will be much more limited, a $1.2 billion headwind or possibly less. In addition, I believe DOW‘s other divisions will see profitability expand this year. Polyurethanes are likely to remain very tightly supplied. Siloxanes and monoethylene glycol are also likely to benefit from the broader re-opening of the economy.
At its analyst day last October, DOW announced that new organic growth projects will add $500 to $700 million of EBITDA per year in each of the next three to four years! When all of this is assimilated, I believe it is much more likely that earnings probably will remain flattish or perhaps even grow, rather than exhibit the significant decline the market expects.
Regardless of the exact magnitude of earnings compression in polyethylene, it will likely be short-lived. The COVID-19 pandemic pushed the industry to shelve capacity additions and uncertainty around government CO2 policy mandates has also reinforced a pause in new capacity announcements.
DOW trades at 5x current cash EPS, or a 20% free cash flow yield. Cash earnings exceed reported earnings due to several pre-IPO growth initiatives which are paying off now. Adjusting for average cycle commodity spreads, as well as capacity additions, DOW‘s normalized FCF yield is 15%. Using a conservative 12.5x cash EPS multiple on this earnings power, I estimate a fair value of $106 per share.
As the growth projects discussed above unfold, however, fair value would increase to $131 per share. I believe this is very attractive for an industry leader with a clean balance sheet, paying a 5% dividend yield. Even if I am wrong about the limited impact of new supply and DOW‘s earnings fell (consistent with bearish expectations), DOW‘s free cash flow yield would still be 13%. The stock should arguably be significantly higher than today’s level even in this scenario.
Call it intuition, the intonation on the most recent earnings call, or the choice of words, but it appears management is becoming increasingly frustrated with the current share price and the past six months of the stock decline. Were the DOW Board to authorize a leveraged recapitalization, bringing leverage back to its targeted 2.0-2.5x Debt to EBITDA level through share repurchases, DOW could reduce outstanding shares by 40%.
When I first aggressively pushed DOW back in March 2020 (Bullet-Proof Portfolio – Top 10 Ideas; Trough Value, Big Dividends, And Weathering Coronavirus And Oil Tanking), when the stock swung wildly all the way down to the low $20s, I viewed this as more of a trade at the time. When the stock ascended to the low $70s by 1H 2021, it seemed investors had started to figure this one out, and it would be a solid long-term investment. Since last May, DOW has been a very frustrating stock to own, as the company over-delivered on both earnings and deleveraging plans, only to see its valuation multiple compress. With a greater than 20% pullback from the mid-2021 highs, DOW is again at an extremely compelling valuation level and widely disliked by the street. I take comfort in the downside protection afforded by its strong cash flow generation, attractive dividend yield, and deeply discounted valuation.
Indeed, during the worst of the COVID-19 pandemic panic, DOW maintained its dividend in the face of significant earnings pressure while many other companies cut or eliminated their dividends altogether. Even at that trough level of profitability, the company still generated a 10% free cash flow yield. Such fundamental underpinnings paired with growth initiatives and stock buyback optionality, make DOW an extremely compelling investment opportunity that should surprise the myriad market participants betting on long-term profitability erosion.
Trinseo and Dow Chemical remain my top ideas in the chemical space and overall. WestRock (WRK) and Lanxess AG (OTCPK:LNXSF) are my other top picks as names like HUN and OLN have moved so significantly that TSE and DOW are much more attractive. I encourage investors to stay long in this bull market but build a portfolio centered on value names that are likely to far outperform growth and high-flying and expensive tech companies. I certainly cannot say when the bull will end, but in the latter stages, it is much better to own the value names which have much less downside risk than the general market.