Let us assume for a moment that a new global economic cycle is about to start. What could be next for the Diversified Industrials sector from a valuation multiple perspective assuming a return to a traditional macro-economic cycle? To answer this question our team first went back to the 2002–09 period, and then sought to interpret what has happened since then.
Four stages of the market and economic cycle are identifiable (see picture below)
Stage I: Growth expectations increase on the back of soft (survey) data, with valuation multiples reaching elevated levels to compensate for low earnings in the short term (2003–04)
Stage II: Earnings catch up, putting valuation multiples under pressure as the macro-economic conditions normalize (2004–06)
Stage III: During a euphoric period seeing global capex finally rise and sending book-to-bill ratios significantly above 1x, both multiples and earnings expectations reach new highs, sending equity values to new peaks (2007)
Stage IV: Oh no! There is no super-duper cycle, no magic in new technologies, no super heroes. After a period of equity market over-shooting (high multiples associated with high earnings), earnings decline alongside risk appetite and thus valuation multiples, leading to some under-shooting (low multiples coupled with low earnings)(2008–09)
During Stage I, companies with early (e.g. residential construction) and mid (industrial production) cycle exposure tend to beat expectations and outperform late or long (capex) cycle driven companies. Demand for their products and services increase comparatively faster, allowing them to exert some pricing power at a time when cost inflation (commodities, wages) bites. By definition, late cycle companies tend to gain some momentum rather late in the cycle, at which point they trade at a premium multiple versus the broader sector, driven by a fast increasing book-to-bill ratio. That period does not last very long, as Stage IV kicks in, sending all multiples to the ground. For a brief moment, though, late cycles companies enjoy some protection as they rely on some presumed visibility provided by a large order backlog… until everyone realizes that the order book is melting fast through deliveries, postponements and cancellations as the downturn persists (often driving up working capital at a critical juncture through declining advance payments). By that time, late cycle companies – undeniably the toughest businesses to manage – revert to a sector valuation discount.
Here is an interpretation of what has happened since that last cycle, as illustrated below: Stage I took place in 2010, followed by Stage II in 2011–12 until the market realized that it was a false start, with Stage II being closer to a premature Stage IV. A new Stage I started after Mr. Draghi’s “Whatever it takes” moment over 2012–13, followed by another period of multiples compression during the 2014–16 period. Again a false start, this time caused inter alia by a natural resources downturn. After multiple misses, a new Stage I is finally taking place alongside a “reflation trade”, paving the way for a new global economic cycle. In that context, early (or short) cycle companies should outperform in Q1 and in the coming quarters, until capex get deployed, at last!
Of course, any pessimist would be quick to argue that the global cycle is too messed up or much more advanced than assumed above (led by the US); and that the current stage – with its nose-bleeding multiples of 12x EBITDA and 15x EBIT on a 2017 basis – is much more symptomatic of a Stage III set to be rapidly followed an economic downturn. It is of course possible – but capex has been a missing ingredient of the economic cycle for years as discussed in “Immediacy” in January. The world has now substantially de-levered and stands ready to afford a new wave of investments (see “Extreme Divergence” two weeks ago). Let’s continue to watch book-to-bill ratios in the coming quarters for signs of it.