Capital Goods Stocks Lookin' Good

Includes: AGCO, CMI, GD, NOC, PRIM
by: John P. Reese

Last summer, with the U.S. debt ceiling debate turning into a debacle, the European debt crisis lingering, and growth slowing, many believed the U.S. economy was headed for a big tumble.

But just when things looked so bleak, the economy staged an impressive turnaround. Numerous reports -- from unemployment claims numbers to manufacturing data to retail sales -- have shown that the economy hasn't just weathered last summer's storm; it has actually made some of the most significant improvement we've seen in quite some time. Businesses are indicating we'll see continued growth. New orders for capital goods -- machinery and other equipment companies buy to make the products consumers buy -- jumped 5.1% in December after having risen 8.0% in November, according to Commerce Department data. They fell 5.0% in January, but a big reason for that seems to be the expiration of a tax credit that promoted capital spending. Many economists say the underlying trend remains strong, the Associated Press reported.

The fact that companies are willing to invest in expensive equipment (and the fact that hiring has picked up significantly in recent months) is a sign that they are seeing the sort of demand in the marketplace that many pundits thought just wasn't going to be there. And that's been a good thing for the Capital Goods portfolio I run on my Validea Pro website, which is up 18.4% so far in 2012, making it the best of any of the industry portfolios I track. If the economic outlook continues to improve, capital goods stocks should continue their solid performance. Here are some that my Guru Strategies, which are based on the published approaches of investing greats like Warren Buffett and Peter Lynch, like right now.

Cummins Inc. (NYSE:CMI): Indiana-based Cummins makes engines and related products such as fuel systems, controls, air handling, filtration, emission solutions and electrical power generation systems. Its products are used in a variety of commercial trucks and vehicles, as well as boats, and the $23.5-billion-market-cap firm has customers in about 190 countries and territories.

Cummins was hit by the global economic troubles in 2009, but has bounced back quite strong since then. It has grown earnings per share at a 27.9% clip over the long term (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term figure). That makes it a "fast-grower" according to the model I base on the writings of mutual fund legend Peter Lynch -- Lynch's favorite type of investment. Lynch famously used the P/E/Growth ratio to find bargain-priced growth stocks, and when we divide Cummins' 12.8 price/earnings ratio by its long-term growth rate, we get a P/E/G of 0.46. That falls into this model's best-case category (below 0.5).

The Lynch approach also likes that Cummins has a very reasonable 12.5% debt/equity ratio, and that its inventory/sales ratio declined in the most recent year, falling from 15.0% to 11.9% -- that's a sign its products are in demand.

General Dynamics (NYSE:GD): This Virginia-based firm is one of the U.S.'s largest aerospace & defense firms, making battle tanks and assault vehicles, armaments and munitions, battleships and nuclear submarines, and military information technology systems. The $26-billion-market-cap firm has taken in more than $32 billion in sales over the past 12 months.

Defense contractors have had the cloud of potentially significant budget cuts hanging over them. And while that could well impact them, my Joel Greenblatt-inspired strategy thinks General Dynamics ($26 billion market cap) is cheap enough that it's worth a long, hard look. In his Little Book that Beats the Market, Greenblatt detailed a remarkably simple, remarkably successful approach that used just two variables: earnings yield and return on capital. With a 14.1% earnings yield and 45.8% return on total capital, General Dynamics makes the grade.

AGCO Corporation (NYSE:AGCO): Based in Deluth, Ga., AGCO makes tractors, combines, hay tools, sprayers, and forage and tillage equipment. Its products are sold through 2,600 independent dealers and distributors across more than 140 countries.

AGCO ($5.1 billion market cap) has taken in $8.8 billion in sales over the past 12 months, and gets approval from my Lynch-inspired strategy. The Lynch approach likes its 19.9% long-term EPS growth rate, 8.9 P/E ratio, and stellar 0.44 P/E/G ratio. It also likes that the firm's inventory/sales ratio declined slightly in the most recent year, and that AGCO has a reasonable 49% debt/equity ratio.

Northrop Grumman Corporation (NYSE:NOC): Another company from the fear-filled defense industry, Grumman is one of the highest-rated stocks in the market according to my contrarian-minded strategies, getting approval from three different models.

My Lynch-based model considers the stock a "stalwart" -- the kind of large, steady firm that Lynch found offered protection during downturns or recessions -- because of its size ($26.4 billion in annual sales) and moderate 18.6% long-term growth rate. For stalwarts, Lynch adjusted the "growth" part of the P/E/G equation to include dividend yield, and Grumman's 3.4% yield helps give it a stellar 0.37 yield-adjusted P/E/G. It also likes Grumman's reasonable 38.2% debt/equity ratio.

My Greenblatt-based model, meanwhile, likes Grumman's 20.4% earnings yield and 48.6% return on capital. And my Kenneth Fisher-inspired model likes that the stock trades for just 0.57 times sales, is producing $3.85 in free cash per share, and has 7.1% three-year average net profit margins.

Primoris Services Corp. (NASDAQ:PRIM): This 66-year-old Dallas-based firm provides construction, fabrication, maintenance, replacement, water and wastewater, and engineering services to major public utilities, petrochemical companies, energy companies, municipalities, and other customers.

Primoris ($845 million market cap) is another favorite of my Fisher-inspired model. Its price/sales ratio is 0.6, which comes in under the model's 0.75 upper limit. The approach also likes that Primoris' debt/equity ratio is a reasonable 30%, and that it's producing positive free cash ($1.09 per share).

Disclosure: I am long NOC, GD, PRIM.