Investing In Industrials With Limited Risk

Includes: BA, CAT, CMI, GE, HAL, ITW, SLB
by: The Independent Investor

Markets are interesting creatures. Over the longer term, it is easy to look at the respective charts of various individuals companies and see wide divergences in the company's stock performance versus others. Still, in the short term, especially with macro events like the European debt crisis moving the markets fairly consistently, stocks and sectors in the S&P 500 are often trading as an asset class. Often times over the last couple of years, correlations have gone to one. It is very easy in this environment to think that all stocks in a given sector are created equally.

The idea that sectors carry with them certain general economic or regulatory risks is often true. However, while sectors often trade as one in the short-term, long-term, valuations tend to be based more on factors like earnings and growth. Given that long-term valuations are likely to be based more on hard numbers rather than short-term sentiment, I think it's interesting to see which of the traditionally more cyclical stocks in the industrial sector are outperforming.

Also, I think its interesting to see what kind of multiple the market is assigning to companies in an uncertain uncertain economic environment. In short, how cyclical the market thinks the company's business is, or how risky these investments are for retail investors if the global economy was to endure a prolonged period of moderate to weak growth. The two kinds of industrial companies that seem to be doing quite well despite the uncertainties that exist in the U.S. and global economy are cost-cutters and companies on multi-year cycles.

One of the top-performing stocks in the industrial sector over the last couple months has been Boeing (NYSE:BA). A company that has had cost-overrun issues and other problems in the past, Boeing has finally seemed to be able to put some of its biggest issues that have plagued the company in the past behind it. Now, to be sure, the last several months of volatility have affected Boeing as well. The stock was in the $70s just a year ago prior to selling off into the high $50s before the recent rebound back to today's close of around $72 a share. What is interesting to me about Boeing is that its business model has really not been anywhere near as cyclical as the stock's price movement would have a causal investor believe.

Another well-run and fairly conservatively managed company that is seeing longer-term strength in their underlying products and end markets is Cummins (NYSE:CMI). Again, Cummins, a company that offers substantial fuel savings to companies and government around the world with a specialty in diesel equipment that is doing very well in Asia where the fuel is one of their biggest imports.

Cummins is designing engines for trucks and other transports that are going to be carrying products no matter how strong the economy is. Also, with fuel prices and high and interest rates low it's a great time for cash rich companies to continue to spend in the areas where they know products or services will add directly to the bottom line today. Cummins is not multiyear business cycles like Boeing, but the company is in the cost reduction business, and recent earnings reports by a multitude of U.S. trucking companies like Navistar show that this industry is doing well.

However, not all industrial companies have seen their business models hold up as well during periods of weakness. While industrial equipment makers like Caterpillar or oil service and other commodity linked stocks like Halliburton (NYSE:HAL) and Schlumberger (NYSE:SLB) have seen large moves up an down in their earnings estimates, Boeing and Cummins have been able to steadily increase their business without any huge droppoffs during period of economic weakness like we saw last spring.

I think this is for two primary reasons. First, Boeing's business model is on intermediate to longer-term cycles of 3-5 years and longer, rather than the short-term building trends that industrial equipment makers and infrastructure companies are often tied to. Also, Boeing is in the cost cutting business rather than really being tied to increasing economic growth. Since Boeing's new planes are made of plastic fiber rather than the traditional aluminum, the company's products offer significant cost-savings that will benefit airline companies in good times or bad. The fact that fuel prices have stayed fairly high with Brent prices still over a 100 dollars a barrel has probably not hurt their business too much either.

The industrial companies that have been seeing weakness in the last several quarters also have several factors in common. These companies tend to be on shorter business cycles, and their business models tend to be tied more to near-term economic activity. While industrial equipment makers like Caterpillar (NYSE:CAT) have been hit hard by the slowdown in China's construction market, even oil service companies like Halliburton and Schlumberger were affected by the short-term drop in oil prices. Industrial companies tied to consumer spending like GE (NYSE:GE) and Illinois Tool Works (NYSE:ITW) also disappointed on earnings too.

To conclude, investing always involves risks, and allocating capital to any sector that is not traditionally counter-cyclical, will always depend at least somewhat on macroeconomic factors. However, now that a new recession has been averted yet again, I think it is worth looking at which companies businesses are appearing to be more steady.

Since the U.S. and other economies around the world seem likely to sustain at least some growth, strong corporate balance sheets and low borrowing rates will likely keep capital spending at fairly healthy levels. With companies on multiyear contracts and other sthat are in the cost-cutting business doing very well, it's time to look at investing not just in cyclical companies, but the right kind companies with more stable business models.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.