The interim reporting season for the first quarter has revealed relatively strong performance, with engineering companies included. Two of Catella Fonder's portfolio managers, Sven Thorén who shares the management of Catella Hedgefond and Henrik Gripenvik who is involved in managing Catella Sverige Aktiv Hållbarhet, believe the reports show that many companies still have a lot to offer in the current business cycle.
However, there are a number of interesting disparities in the current valuations of industrial heavyweights.
Both managers feel that the first-quarter reports were generally good. They make the point that knowing what the buy side expects is always a challenge, but there was an overall expectation of strong results and this is exactly what companies delivered, although the reactions of stock prices were even less predictable.
The range of share price movements in the engineering sector was mostly a few percent up or down, with Electrolux's slide of 11 percent on the day of its report being one of the exceptions. But real expectations can be tough to identify in terms of consensus. As a whole, engineering shares have fallen a few percent since the reporting season began, while valuation multiples are shrinking due to upwardly revised full-year forecasts.
"There were clearly very high expectations for engineering, and this sector did well. Sandvik and SKF averaged perhaps 8-9 percent negative growth in early 2016, and now they are back at around a positive 7 to 9 percent. What worries the market are the forward-looking factors like the Purchasing Managers Index in the United States and the OECD's leading indicators; that there is a slowdown ahead, and this is what is causing these companies to run out of fuel. The question is, how long is a cycle?" says Sven Thorén.
"Viewed as an upturn from the low point, I do not think that we have progressed very far. I think there is still upside from the forecasts," says Henrik Gripenvik.
Sven: You highlighted the PMI (Purchasing Managers Index) and the valuations in engineering that have fallen slightly.
"The engineering sector has previously traded at a premium to the Swedish stock market as a whole. It started expanding sometime in January 2016, continued into 2017 and today there is around a one-percent premium for engineering compared to the market in general. So, engineering is trading at perhaps 15-16 times forward-looking earnings and the market is just below that at almost 15," says Sven Thorén.
A valuation of around 15 times earnings could be said to be close to the long-term historical average of the Stockholm stock exchange. A more short-term view reveals that the factors having a downside impact during the first quarter included a number in engineering. These included the timing of Easter, with fewer working days, exchange rates and tougher comparisons from the first quarter of 2017. Sven Thorén says these factors can be expected to improve going forward. The impact of exchange rates will gradually shift towards the positive, comparisons will remain tough but perhaps not quite as bad, and the timing of Easter will be positive. This makes it possible to envisage a scenario of further tailwind in the short term.
"Despite the tougher comparative figures in the first quarter, the sector as a whole has shown acceleration. Some companies, such as Sandvik, are talking about exiting the quarter with greater strength than when they entered it. So, there will probably be a continued good growth rate into the second quarter and onwards," says Henrik Gripenvik.
What if we look at the practical outcome for some interesting companies?
"We were previously downbeat about Hexpol, a group that produces advanced polymers for applications such as gaskets for plate heat exchangers and wheels made of plastic and rubber materials, but we now believe that the price pressure from slow growth appears to have eased. Oil and gas, which is a factor in Hexpol's demand, look better. The mining industry is looking better and overall demand in the engineering sector looks improved. The company has done incredibly well since the report, so the question is how much more fuel is left in the short term," says Sven Thorén, adding that there are also interesting valuation issues among the major industrial companies.
"Looking at the larger companies, I think that Atlas Copco has a fairly stretched premium in relation to its peers. The valuation is over 20 times earnings, compared to Sandvik's 15 times – it is rare to see such a large gap between these two."
Both fund managers agree that Sandvik produced a good report, but the market had traded up the stock to old highs in advance. Henrik Gripenvik says this contributed to the lacklustre stock on the day of the report. "But there was nothing to indicate any kind of weakness in the report. It was very strong."
Sven Thorén says that increased capital investment will eventually be needed in the mining sector. The shares that his fund has chosen to short currently include Atlas Copco, due to the already-mentioned valuation gap between Atlas and its competitors.
"We are short in Atlas Copco right now due to the valuation premium against the rest of the sector and because forecast revisions are somewhat negative – that's not a great combination. Combined with the outlook for its vacuum arm, half of which is driven by semiconductor capital investments that seem to have had their peak year, it is reasonable to expect a tougher time moving forward."
What is the impact of the reported trade war and China's closure of steel capacity?
"Commodity prices have risen and cost inflation is evident in many companies. But this is very volatile. Aluminium has yo-yoed in recent weeks on expected tariffs and sanctions against Russians who own the production resources," says Sven Thorén.
China also accounts for a large proportion of global business demand. What is the expectation there, and what does the Chinese market look like?
"If we just look at what the companies said in the first quarter, China was very strong. However, if we consider more forward-looking factors and indexes set to reflect economic activity in China, these show some slowing. This can also be seen in credit growth. It seems that China's leadership is also aware of this because it lowered the capital requirements for banks to provide more liquidity," says Sven Thorén.
SKF and Volvo are interesting at the present time, according to Henrik Gripenvik. SKF has increasingly proven itself, he believes, following a fairly protracted period in which there was scepticism of the company and its ability to offset higher input costs with higher prices.
"I think they're always showing that they can manage it. The margin is expanding alongside volumes. So that still looks good. Even Volvo, which has had problems with bottlenecks for a while, has at least convinced itself of a turnaround and that things will be better in the second quarter, and very much better in the second half. I still think the forecasts look low," he says.
Leaving the engineering sector and looking to banking, the first-quarter outcomes were mixed, but with a strong report from Swedbank. Mortgage lending was good for all banks, with good lending growth and stable margins.
In addition to Swedbank, the bank stocks preferred by Henrik Gripenvik include Nordic neighbours Danske Bank and DNB. The debated initiatives to address home lending margins are still too early to assess, he believes.
"But they have received a lot of media attention, and just being on the radar could be enough for them to continue to put pressure on margins."
When it comes to construction companies, Henrik Gripenvik considers that it may be worth waiting a little in case the sector has not yet bottomed out. The telecom operators had excellent reports, with good numbers from both Tele2 and Telia – although the positive contribution for Telia came largely from the buyback programme.
Forest products companies are enjoying price rises for much of their range, notes Sven Thorén.
"They are upping prices on everything, from regular newsprint and right across the board. This is being driven by the price of pulp," he says.
Sven Thorén says that many analysts were sceptical about pulp prices due to the capacity expected to come online in 2017. But there was not as much as expected, and looking into 2019 and beyond not a huge amount of pulp capacity is predicted. That said, pulp prices are close to their peak and it is worth being cautious," believes Sven Thorén.
We haven't really talked about exchange rates
"This is very different for different companies. However, exchange rates for engineering companies overall are swinging from having been sharply adverse, with something around a 4 percent negative impact in the first quarter, to something close to neutral in the second quarter and sharply positive in the second half," says Sven Thorén.