With the S&P Industrial sector down 38.5% for 2008, investors have for the most part steered clear of this manufacturing-driven area of the market. With housing companies relying on things like transportation, volume, government spending and fresh construction projects, it’s hard to imagine that there is high confidence in the the air.
Many made the mistake of overweighting industrial companies on a valuation basis in the fall of 2008, and major losses were incurred as a result. Now, in the new year, is the global picture really as bad as it has been made out to be? I believe the answer is “probably not,” and encourage you to consider industrial companies in 2009.
What strengths are present in industrial companies for the coming year? As we continue to receive downcast readings from economic indicators like the ISM Manufacturing Index, Construction Spending reports and Durable Goods orders, it becomes difficult to trust much of anything. However, as international governments begin to accelerate programs encouraging projects in infrastructure spending and energy efficiency… the direct beneficiaries are industrial companies.
When investors stick to companies with strong cash flows and resilient order backlogs, I believe that there are major profits to be made from historically low P/E ranges across nearly every industry within the sector. Accounting for additional federal stimulus and re-initiated spending plans, we believe that several major investment themes will exist in the industrial arena; for 2009, we see strength in defense, engineering and construction, logistics and energy efficiency.
Northrop Grumman (NOC)
One of my favorite investment themes for 2009 is in the defense sphere. As opposed to aerospace, which is still largely cyclical and volatile, the defense thesis follows a global arms race that is without a doubt taking place. One thing to remember is that as the global economy worsens, we typically see more geopolitical tensions arise.
Sure, it may not be the most “socially responsible” play in the book, but when we see events like Russia supplying Iran with surface-to-air missiles, increasing tensions in the Gaza strip and China & North Korea moving into contracts with Cuba and Venezuela to control Latin America… one has to start thinking defensively. The direct beneficiary in all of this is the defense contractors… and with already healthy balance sheets they are well positioned to continue to outpace the benchmark.
Also, let’s not forget about the pre-election Barack Obama sell-off, something that happened in spite of the fact that the defense industry typically outperforms more under a Democrat leader, which has increased the relative attractiveness in valuation.
Why Northrop Grumman? To me, it’s all about expectations. When you look at a company like Raytheon (RTN) or Lockheed Martin (LMT), you see high expectations and high P/E ratios relative to peers. However, Northrop Grumman (NOC) is in a great position, as they really only need to perform as “average” to deserve a higher stock price appreciation. As the worst performing of the “big” defense contractors in 2008, I believe that it is the year for a turnaround at Northrop.
One of the primary fears in the defense industry concerns the defense budget spending under newly elected U.S. President Barack Obama. Confronted with a massive series of bailouts from the government, we really need to cut money from somewhere, and it will most likely be in these so-called “big-ticket” spending projects offered under more “premium” names. Northrop Grumman, on the other hand, remains diversified into products that make practical sense for things like reconnaissance and surveillance. In other words, Northrop is keeping our soldiers safe. This is an area of spending that likely won’t see cuts under Barack Obama and re-elected Defense Secretary Gates from the Department of Defense.
Northrop has a safe dividend yield of 3.40% at the time of this writing, and trades at a massive discount to the other defense names with a P/E at just 9.4 times earnings. Additionally, they have a strong balance sheet and a FCF per share of $6.22.
With enough cash to make their presence felt, Northrop seems strategically positioned to outperform in 2009. Not only have they recently consolidated their business units to make things easier to manage, but they are starting to form targeted performance numbers in slower units (such as Ship Systems) to increase the overall efficiency of the company in the long run.
While trading at a significant discount to their peers, Northrop has become an attractive target for investors looking to place bets on mean reversion in 2009. With many of the same drivers as other more “popular” names, and none of the aerospace exposure or susceptible budgeting, Northrop Grumman is truly a play for the turnaround.
The rest of this article is included in Bullish Bankers’ newsletter “The Best Stocks of 2009″ that can be downloaded here.
- Jim Regan