Anyone who has heard the investing maxim "buy on the rumor, and sell on the news" will appreciate the contrarian logic behind "buy on the bad news, sell on the good." That's the idea behind picking up stocks in the paint and coatings industry right now. It's no secret that there are currently significant supply chain difficulties in the industry. Therefore, stocks like PPG Industries (PPG -0.68%), Axalta Coating Systems (AXTA -2.25%), and Sherwin-Williams (SHW -1.23%) have fallen in the last three months. Is now the time to take advantage of the dip?
Why the sector has sold off
After outperforming the S&P 500 index in the first half of the year, the paint and coatings sector has underperformed the index in the last few months.
The reason for the underperformance? It comes down to a combination of factors. First, there are well-documented shortages in 2021 for certain materials -- semiconductors, plastics, steel, and lumber -- which have put pressure on production schedules in specific key industries such as vehicle production.
Second, issues around the reopening of the economy and renewed COVID-19 cases have created more supply chain and logistics issues.
Third, the impact of Hurricane Ida has negatively impacted the supply chain in the industry, due to production shutdowns at factories in the hurricane's path.
On a broader scale, these impacts are reflected by looking at the data from the Institute for Supply Management (ISM) purchasing managers index (PMI). The new orders and production have remained in solid growth mode over the summer, but the manufacturing supplier index has seen its growth rate slow in the last three months.
Quoting from the ISM chair, Timothy Fiore, on the latest PMI report, the supplier deliveries index "continues to reflect suppliers' difficulties in meeting customer demand, including (1) ongoing hiring challenges, (2) extended raw-materials lead times at lower tiers and stubbornly high prices, and (3) inconsistent transportation availability."
It's getting worse
The data above runs through August, and company updates suggest the situation got worse in September. The leading paint and coatings companies have alluded to higher than expected raw material price inflation and supply chain and logistics issues.
On Sep. 7, PPG Industries told investors that its sales volumes in the third quarter would be lower by $225 million to $275 million compared to previous guidance. In addition, raw material inflation will be $60 million to $70 million higher than anticipated, and "The coatings commodity supply disruptions have further deteriorated..." Full-year guidance was withdrawn due to the uncertainty.
On Sep. 20, Axalta Coating Systems, a company focused on automotive coatings (original equipment and refinish markets), issued a similar release saying net sales in the third quarter will be $40 million lower compared to previous guidance. Volumes "have continued to be impacted by customer supply chain disruptions, most notably in the Light Vehicle end-market, where semiconductor chip and other supply shortages have continued largely unabated." Again, full-year guidance was withdrawn.
Sherwin-Williams' press release on Sep. 28 told investors that "We now expect raw material availability issues to negatively impact our consolidated sales by a high-single-digit percentage in the fourth quarter" and "we are increasing our full-year raw material inflation outlook to be up a high-teens percentage compared to last year."
Newsflash: The third-quarter earnings reporting season for the industrial sector isn't going to be pretty.
The paint and coatings sector in 2022
That said, provided you think the COVID-19 pandemic won't resurface, the bad news should provide a good buying opportunity with these stocks.
First, going back to the ISM data, it's clear that customers' inventories are too low while new orders remain strong. This typically happens out of a recession as supply catches up with resurgent demand. The extremely low levels reported in the PMI suggest orders will remain strong as customers still need to rebuild inventory.
Second, all three companies gave anecdotal commentary supporting this argument. For example, PPG management said, "global economic demand remains robust," and Sherwin-Williams management remains "confident the majority of sales delayed by these conditions will be recovered over future quarters." Meanwhile, Axalta's management said, "inventory on hand in customer channels remains below normal levels," which will support a "continued recovery in both Net Sales and profit during 2022 and beyond."
Third, valuations --measured in terms of enterprise value (EV) to EBITDA -- are now looking a good value on a historical basis.
All told, investors should keep a close eye on the sector to buy in on any significant weakness in these companies' stock prices caused by negative near-term sentiment. Conditions remain tough for now, but everything is in place for a strong recovery in 2022.