I appreciated the positive responses to my first article on Gardner Denver (GDI). A few people have asked me how I found this company, so I thought it might be instructive to describe my process. As part of my portfolio management course, I was responsible for the Industrials sector and charged with identifying potential new holdings. The first step was to develop an understanding of the firms in this sector and their characteristics. From there, I constructed a thesis for the type of companies I thought would outperform given the current economic conditions and a financial screen to model this thesis.
Characteristics of Target Firms
My research focused on the Aerospace and Defense segments, however the firms of the Industrials sector share many common characteristics. Industrial firms produce equipment and components used by other manufacturers or end consumers. Demand for these products depends highly on overall economic growth and the successful execution of competitive strategies, such as differentiation or cost leadership. The high cost of fixed assets creates a barrier to entry and hinders the firm’s ability to scale down during recessions. Net income has a higher sensitivity to economic conditions because of this, particularly for leveraged firms. As the economy improves, increased production should yield improved results for this sector. Margins tend to be low, particularly for more regulated segments, such as defense, but ROE can be high as a result of leverage or high asset turnover.
In the current environment of slow growth, high commodity (input) costs, and projected government budget cuts, desirable industrial firms have the ability to weather these challenging economic conditions and to offer future growth opportunities. Firms offering diverse product lines targeted at both government and commercial customers have the security of large government contracts, as well as the potential for volume and pricing gains in the commercial segment. Firms with premium products, especially those in heavy demand (e.g. energy-related), will have better pricing power. In addition, companies with low debt levels will be less impacted by the current recession and have a better opportunity to issue debt to fund future expansion.
I developed two screens using Finviz
to identify firms with the previously mentioned characteristics: a growth-oriented screen and a low-debt screen. These yielded more results than I wanted, so I combined them to produce a final list of about 10-15 companies. These screens focus on U.S. Industrial sector firms with over $300M market cap. The screenshots show the final screen filters.
(Click charts to enlarge)
The Growth screen (above) focused on firms that had positive EPS growth this year and projected EPS growth of at least 10% for next year and the next 5 years. This correlated with the desired trait of growth during the recession. In addition, the screen required net profit margins of at least 10%, ROA of over 5%, and ROE of over 15%. Industrial profit margins tend to be low, thus a floor was set to find firms with at least a minimum level of profitability. This also provided a cushion in case margins shrank due to higher input costs and pricing competition. The high ROE identified firms that increased value to equity holders either through leverage or high asset turnover. Given the high fixed asset costs, a high asset turnover was more desirable than high debt, but this screen allowed for both.
Low Debt Screen
The Low Debt Screen (above) sought to find industrial firms with a low debt level and high ROE, which suggested higher profit margins and/or higher asset turnover. The recession impacts low-debt firms less, as they have lower interest costs and repayment obligations. In an effort to seek potential value plays, there was no requirement for positive EPS or profit margin this year, however a 5%+ EPS growth rate was required for the next 5 years. This could reveal companies that are struggling now, but with the potential to recover. Their low debt level also gives them the opportunity to issue bonds in the future to fund growth and raise ROE. A LT-debt level of 0.3 was selected, as it narrowed the screen results to 15 companies.
Combining these two screens (above), with slight modifications to net profit margin (>5%, instead of >10%), resulted in a list of around 10-15 stocks that exhibited positive current and 10%+ projected EPS, 15%+ ROE, and LT-debt levels below 30%. These stocks satisfied the thesis of growth potential with low debt, and provided a starting point for further research. Most were industrial machinery firms with different specialties.
Selecting a Firm
Since the larger firms tend to be well-covered by analysts and investors, I focused on a smaller firm, though above $1B market cap due to the requirements of my class investment policy. I figured that the market may not be fully aware of a smaller company’s story, hence the potential to achieve some alpha. After previewing the annual reports and other research for DCI
, and GDI
, I went with Gardner Denver (GDI
) because it had the most compelling story (growth and improving margins), it was benefitting from the boom in oil production, and its recent financials supported the firm’s stated goals. If time allows, I hope to go back and research some of the other firms on this screen list. Donaldson (DCI
) focuses on filtration systems, Cummins (CMI
) on engines and power systems, and Fastenal (FAST
) on construction supplies. All have performed well during the last 2-5 years and with an improving economy, they should see continued growth.
I hope this article is helpful to investors who may not have tried developing more complex screens. There are many metrics and theories, and I’m not judging the validity or value of any particular one. I’m merely advocating that investors formulate a thesis that they believe in, create a screen that matches that thesis to help them identify the appropriate stocks, and then perform additional research before making their final investment decisions.
Disclosures: I am long GDI and VIS (Industrials ETF) and have no intention of selling either position in the next 72 hours. I do not own direct positions in any of the other stocks mentioned in this article or the screens, nor do I plan to initiate positions in them in the next 72 hours.