Orders for durable goods are reported at 8:30am EST on Tuesday following a mixed report last month that renewed fears of a fiscal cliff-induced postponement in business investment.
Headline growth of 9.9% in September orders was welcomed by the market after a sharp 13.1% contraction in August. Closer inspection, however, found that the gain was almost entirely on an increase of 2,640% in aircraft orders. A separate report by Boeing (NYSE:BA) showed that orders for the company's aircraft increased from one in August to 143 in September. Orders for non-defense capital goods ex-aircraft, the proxy used for nonresidential business investment, were flat last month after a gain of 0.2% in August and following two months of significant losses.
In fact, the weakness in business investment led many economists to reduce their estimates for third-quarter GDP from 1.8% to 1.7%.
Tuesday's report could be a rude awakening for the market if, as many suspect, businesses have decided to put off capital spending until road blocks to economic growth are worked through in Washington. The S&P 500 has moved 4% off its post-election lows on hope for a European debt deal and strength in Chinese economic data but is still off by 2.4% from the beginning of the quarter. Weakness in business investment, approximately 15% of the GDP, could send the market down further as investors rush to safety.
Shares of industrials will most likely feel the most pain from a weak durable goods report. Investors may want to position their portfolios for relative safety in names with stronger margins and lower betas. Additionally, while dividends seem to be the buzzword lately, investors need to understand that a high payout ratio may inhibit future growth.
Growth and Dividends at a Discount
As the third largest military weapons maker, Boeing has come under pressure to address weakness in military spending next year. While the conclusion of the wars and sequestration cuts to defense could mean lower spending over the foreseeable future, military spending continues to enjoy strong support on Capitol Hill. The company's large commercial segment, accounting for half of revenue, should help to support the shares until government spending returns.
The shares trade for a relatively cheap 12.9 times trailing earnings and pay a 2.4% dividend yield with a 31% payout ratio. The stock's beta of 1.2 means it could be slightly more volatile with market swings. The company's operating margin of 7.9% is average for the industry. The company recently announced a 20% increase in its production rate for its 777 jets. This drive for efficiency and a backlog of 335 planes should help to moderate any effects of a slowdown in defense spending.
United Technologies (NYSE:UTX) reported a strong third quarter with an adjusted profit of $1.37 per share against expectations for $1.19 per share. Management has had the foresight to divest weaker segments like rocket engines, wind turbines and industrial pumps to grow total sales by 5.7% over the same period last year. The company's operating margin of 13.9% is above 85% of its peers in the Aerospace & Defense industry. Trading at 13.4 times trailing earnings, the shares pay a 2.8% dividend yield with a 32.5% payout ratio. The stock trades with a beta of 1.0, meaning it will tend to rise and fall about the same amount as the general market.
Shares of 3M Company (NYSE:MMM) dropped sharply last month when the company cut its full-year earnings forecast against continued weakness in Europe and Asia. Management cut guidance almost two percent to a range of between $6.27 to $6.35 per share. Sales for the third quarter declined by 0.5% to $7.5 billion while the company managed to meet expectations for a net gain of $1.65 per share. Recent weakness has brought the stock down to a relatively cheap 14.2 times trailing earnings, and the company's operating margin of 21.6% is above 94% of industry peers. The shares trade with a beta of 0.9 and pay a 2.7% dividend yield. The payout ratio of 36.6% means the company keeps nearly two-thirds of earnings to finance future growth.
Volatility and Weaker Margins
General Electric (NYSE:GE) is a market darling for its 3.3% dividend yield, but the 50% payout ratio severely limits growth for the company. The stock's beta of 1.6 means that it is significantly more volatile than the general market and could drop sharply with negative headline risk. The company's operating margin of 11.4% is average for peers in its industry. Besides weakness in the industrial space, GE could also see hurdles to its financing unit under a stricter environment of financial regulation and narrowing interest spreads.
Emerson Electric (NYSE:EMR) also pays an attractive 3.4% dividend yield but limits growth with a 60% payout ratio. While the company's operating margin of 12.8% is above 83% of peers in its industry, the shares trade for a relatively expensive 18.1 times trailing earnings. The stock's beta of 1.2 is just slightly higher than others in the industry. To focus on its global strategy, the company is shrinking its most profitable unit and building out other divisions with lower profit margins. The commercial and residential unit, with a profit margin of 21% and accounting for 7.6% of sales, has languished over the last decade. Other units, like industrial automation with margins of only 17%, have grown as the company tries to make itself a global brand.
No cover, but concealment
I remember learning in the Marine Corp about the difference between cover and concealment. Concealment may offer protection from sight but will not stop the bullets, while cover will protect from both. A drop in business investment could take the market down sharply and cover from losses could be hard to find in any investment. Stocks with lower betas and strong fundamentals could offer some concealment from market losses among names in the industrial space. Additionally, once growth returns, it will be those companies that retain some of their earnings that will have the capital to deploy for higher stock prices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.