Industrials: The New Safe Haven for Investors

The stock market is like a gigantic poker game whereby each player is out for his/her own interests and there’s a tremendous amount of emotions and strategies involved. In addition, there are many mixes of players - the big fish and the small fish, the professional and the newbie, the aggressor and the conservative player, so on and so forth. However, there is one fundamental difference – the stock market offers you better odds because of information, particularly in the digital age. Yet, what many of us keep seeing is that investors often times do not use the information to their advantage to make disciplined buy and sell decisions. After all, it’s hard to take emotion out of the equation, even though many of us deny this fact.

To take the E word out of the picture, I always like to begin with macro fundamentals when making investment decisions. At the 20,000 foot level, I believe the new safe haven for investors is the industrial sector.

Secular market trends can last anywhere from several years to a few decades for different markets depending on the social, economic and political conditions at the time. We’ve experienced three major recessions over the past two decades: 1991-8 months; 2001-8 months; and most recently in 2008. The technology boom took us out of the 1991 recession but lead us into a bust that resulted in the 2001 recession; the housing & real estate boom spawned growth out of the 2001 recession but resulted in a bust that created the 2008 recession; what’s going to take us out of the current recession? I believe the answer is industrials, which involves sectors like aerospace & defense, building products, equipment, machinery, road & rail, transportation infrastructure etc.

Why Invest In Industrials

• Geographically Diversified – Many of large industrial conglomerates have tremendous overseas operations versus domestic-heavy industries such as healthcare, retail, services and utilities. For example, 51% United Technologies’ (UTX) revenues income come from overseas; similarly, 62% of Caterpillar’s (CAT) revenues come from outside of the United States. In 2000, companies in the S&P 500 earned 32% of revenues from overseas; this number is estimated to be 44% in 2007. The ability to diversify lands particularly well when the US economy is struggling, as companies can spread risks over multiple countries and business units.
• Strong International Growth – Despite challenging conditions in the US, the growth experienced by BRICIT and other emerging markets allows industrial companies to keep ahead of their peers. Many of these countries are experiencing tremendous growth in terms of the very basics that countries need - transportation networks, building construction, manufacturing and other related infrastructures. These countries are in dire need of companies that are large enough and advanced enough to support their growth. When was the last time that you saw 1000 cranes in a city’s skyline? Certainly, this is not rare in places like Beijing and Abu Dhabi.
• Declining US Dollar – A week dollar will continue to benefit manufacturers that export their products abroad, as international demand for domestically-produced products rises. It is unlikely that international demand for industrial goods will soften in the future, and countries like China and India will continue to buy more US goods, particularly when everything is relatively inexpensive for them compared to a few years ago. The declining dollar has indeed narrowed the trade deficit; this is good news for companies like Ryder Systems (R), Textron (TXT) and Tyco International (TYC).
• Low Trading Activity – A bull market typically starts off relatively quietly as most investors are still focused on the hot sectors at the moment: currently this involves sectors like financials, agriculture and energy. The following table shows the current average daily volume divided by percent float to give a cross-comparison of the level of activity within the Select Sector SPDRs ETFs. As you can see, the level of activity in Industrials is comparatively low, a good sign for investors to join the pool early.

Companies To Keep An Eye On

• General Electric (GE) – Heavily diversified company (geographically & vertically) that generated organic revenue growth of 9% in 2006 and 2007, more than double the rise in real US GDP; the infrastructure group reported 30% increase in sales last year; earned more than half of its revenues from overseas; the recent fallout of their financial services group only presents a buying opportunity.
• United Technologies (UTX) – A heavy player in the aerospace and infrastructure industry reporting strong YOY revenue and profit growth; has powerful market positions in all of its business segments; has met or exceeded analyst estimates the past three years.
• Caterpillar (CAT) – Reported 18% increase in sales and 13% profit increase in 2007 above analyst expectations; continues to benefit from the construction boom overseas; high commodity prices for metals minerals and energy will likely continue to foster capital investment.
• Deere & Co (DE) – Makers of farm tractors and combines & construction equipment reported 18% rise in revenues in 2007; agriculture will likely to continue to remain strong in coming quarters.
• United Parcel Services (UPS) – Although domestic volumes are down, rising international volumes are keeping this company afloat in an outperforming transportation industry; the company is currently implementing a package flow technology targeted to save $600MM annually.

Other Industrial Companies

This is a list of companies from the Industrials SPDR ETF (XLI):

Disclosure: none

Comments

[businessguy88]

Great analysis Howard. I recently read an article on the WSJ that interviewed a prominent investment guru, I forget his name. Basically his prediction is that industrial mfring and export related industries will pick up steam in the next few years.

[Daniel Jacome]

UTX is the cheapest its been in a long time -- not a screaming buy, but worth looking at. 22% ROE smashes their cost of capital & you have 10% eps grwoth likely through 2010 with 2% yld = 12% rtns in a market that many think will be up 6% per annum going forward. Risk reward is pretty good here...