One of the things investors keep hearing now from the talking heads on TV is that the investing game has changed; stocks that attractive for the last few years and paid big dividends are no longer the place to be. Instead, investors are told they should be focusing on stocks that will benefit from rising rates and an improving economy.
I beg to differ with this advice though… I think investors can look for both yield/income and stocks that will benefit from a slowly improving economy. This article is about stocks in a sector that should fulfill both objectives for investors, and the best play in that sector.
(Note: For those who are interested in a more general discussion about the effects of rising rates and what strategies investors can benefit from; read the article here, while those looking for opportunity in beaten down assets, should read the article here.)
One industry that is likely to benefit from rising rates is the industrials sector (XLI), and in particular, makers of capital goods stand to pick up more profits as businesses loosen their purse strings and invest in the future. To that end, the following chart includes seven major industrial capital goods firms, all of which have historically had revenues that were highly correlated with GDP growth and unemployment levels.
Vs. S&P 500 (52 Wks)
The chart shows various valuation metrics for each firm; Price-to-Earnings, Price-to-Book, and Price-to-Cash Flow Ratios, as well as stock price performance vs. the S&P 500 over the last 52 weeks, and dividend yield. While all of these firms have fairly strong businesses and are probably worth investigating as investments for the future, a couple of things stand out here.
First, looking at P/E ratios, most of the firms are fairly richly priced right now. Pall Corp (PLL), for example, at 25.5x ttm EPS and 21.6x ttm 2012 cash flows looks priced for perfection. The maker of filtration products in undergoing a restructuring, so it is likely that 2013 and future EPS will come in much higher than current EPS levels, but nonetheless, the firm is still priced as those these cost savings are a sure thing. Similar accusations of rich valuations would not be unreasonable for Flowserve (FLS), Xylem (XYL), and certainly Pentair (PNR). All of these capital goods makers are well positioned for the future, but are trading at P/Es which are above their historical norms.
In contrast though, General Electric (GE), Cummins (CMI), and to a lesser extent Ingersoll Rand (IR), all stand out as better value opportunities on the basis of P/E and P/CF ratios. Engine maker Cummins and conglomerate Ingersoll Rand should both benefit from on-going improvements in the economy, and either would probably be a reasonable choice as an investment going forward.
But of all the companies on this list, GE is the most interesting in my view. The industrial giant is the closest thing to a "safe stock" given its massively diversified product base, unparalleled access to debt and equity markets, and unimpeachable market position. Yet for all these advantages, and despite the likely acceleration in revenue growth from an improving economy, GE is trading at just 16.6x ttm EPS, 9x cash flow, and less than 2x book value. Further despite paying a very reasonable, and generally increasing dividend, the stock has lagged the S&P over the last year by a non-trivial amount.
As such, I think investors looking for income and a stock that will benefit greatly from rising rates and an improving economy should consider GE a top pick.
Consensus fair value estimates for the firm's stock price are at $27, 15% ahead of the current stock price, but even this undervalues the company in my opinion. After meeting with GE management recently, analysts have reiterated their views that revenues for the firm will grow meaningfully over the next several years with segments like commercial aircraft and healthcare poised to do particularly well.
Meanwhile, the firm's GE Capital unit is being trimmed down and made more efficient by the company despite being labeled "too big to fail". GE stands to make significant profits from GE Capital going forward, and it is even conceivable that the unit (or part of it) could be spun-off in an IPO going forward, though CEO Jeff Immelt has made it clear that any divestment would "not come at the expense of EPS growth." This portfolio restructuring for GE capital is expected to be largely completed by the end of the current calendar year, and it should set the stage for improved profits next year.
Rising interest rates will benefit GE Capital enormously. Given the firm's diversified and stable business, GE can borrow money at very close to the same levels as the U.S. Treasury giving the company one of the lowest cost of capital rates of any company in the world. As such, increases in long-term rates and risk premiums will have huge benefits for GE, and could easily lead to $1.00/share in annual EPS accretion or more over the next five years depending on how quickly and how high rates rise.
Further, the firm is targeting margin expansion in many of its industrial segments including overall expansion of 70bps in operating margin (vs. previous analyst expectations of 30 bps). This margin expansion is very meaningful for the firm given that last year the company had operating margins of 15.5%. Thus a 70bps margin increase translates into a permanent 5% increase in EPS.
GE also is looking to cut its share count to 9-9.5B from 10.4B now via buybacks between now and 2015. This action alone should increase EPS levels by 10%, total EBITDA will grow another 10% between now and 2015. Given these profitability levels, along with expanding margins, and increased cost efficiencies, GE should see profits of ~$2/share by FY 2015, a 33% improvement over today's levels.
The firm's dividend also is likely to continue to increase 10% or more each year for the foreseeable future. With dividends only at $0.74 a share over the last 12 months (payout ratio of ~50%), it's likely the dividend will increase to $1.00/share by 2015 as the firm's EPS ramps up. Between dividends and buybacks, the company is looking to return $20B+ to shareholders going forward.
Between this increase in EPS and the relatively low current P/E for GE vs. its historical average of 19.6x, GE looks like it could have significant opportunity to appreciate going forward.
The one major headwind facing GE is the situation in Europe. This situation should be temporary and Europe is already showing signs of improving, but for now, the situation remains difficult. Over the longer run though, analysts think that GE is well positioned on the continent and indeed its outperforming U.S. operations should help the company to fund aggressive growth strategies that competitors based in Europe can't afford to pursue because of the short-term challenges they face.
Analysts seem confident that GE will be able to outperform over the short and long run given that 14 of the 21 analysts covering the firm rate it a Strong Buy (9) or a Buy (5), while rest rate the stock a Hold.
Despite all these advantages and the company's apparently bright future, so far the market isn't buying it. GE's stock has underperformed all of the other firms listed in the table above and the S&P 500 over the last year. This will ultimately have to change though once the market sees GE's improving profit levels and when it does, patient investors in the company should benefit.
The chart below shows GE's stock (BLUE), along with the S&P 500 (red), Xylem (purple), Pentair (brown), Flowserve (black), Ingersoll Rand (green), Pall Corp (orange), and Cummins (yellow).
For more ideas on individual high-yield stocks that will benefit from an improving economy and rising rates, read this article.