Every day produces a new headline about the risk of recession and at this point, it seems like everyone has an opinion and a number of sectors have benefitted from this while others have suffered.
While most sectors are up year-to-date, this is due to the major market selloff that occurred during the last few weeks of 2018. When we look at the same sectors on a rolling 12 month period, we can see that the performance associated with each sector is significantly lower or worse than the YTD figures.
Industrials are one sector that contains a number of companies that you have to love if you enjoy consistency during uncertain times with many of these stocks serving as the anchor to dividend growth investors' portfolios. Not all industrials are built the same and it really depends on which segment of the industrial realm they focus on that dictates the stability of their earnings and the consistency of their revenues when the economic outlook isn't so positive.
If we take a closer look at the different segments that make up the industrial sector we can see that there are only three segments that have seen positive growth year-over-year (YoY) while the remaining groups demonstrated performance that ranged from flat to down significantly during the same timeframe.
There are five high-quality industrials that look interesting (or have the potential to be interesting) over the next few months and going in 2020, including:
- 3M (MMM) - Industrial Conglomerates
- Eaton (ETN) - Electrical Equipment
- Honeywell (HON) - Industrial Conglomerates
- Illinois Tool Works (ITW) - Machinery
- Parker-Hannifin (PH) - Machinery
Looking at the following companies by sector it becomes easier to see that industrial conglomerates and electrical equipment companies (down YoY -15.4% and -13.3% respectively) have suffered significantly more than the machinery sector (down -8.5% YoY). At this point, the industrial conglomerate sector is the second worst-performing industrial sector although it was barely edged out air freight and logistics (down -15.5% YoY).
The rest of this article focuses on the current valuation of the five stocks mentioned above and provides current price targets that I have for accumulating shares and discusses some of the potential valuations at which I consider the stock to be fully-valued and would be willing to consider selling shares.
3M - Industrial Conglomerate
When I think of the crown jewel of the industrial sector my mind can't help but jump to 3M because few companies (even in other sectors) can even come close in matching its growth record and its 60+ year history of dividend increases.
Even with its track record, 3M's stock price has continued to push new lows as they struggle to maintain earnings in 2019 which resulted in a major guidance adjustment following the release of Q1-2019 earnings. The drop in price has caused the yield to increase beyond its normal range of 2.0-2.50% to 3.71% as of market close on October 3rd. The dividend yield for 3M has not been this high since the Great Recession.
Although 3M has problems, it also remains to be seen whether or not these issues are temporary. Historically, 3M's ability to grow earnings is exceptional and its ability to maintain those earnings during difficult times is also something that should be appreciated by potential investors.
The opportunity for prospective investors is that earnings come out on October 24th which will be a true test of where 3M stands in its restructuring efforts. Q3 is a traditionally strong quarter for 3M earnings and meeting or beating earnings expectations would provide the kind of clarity the market is demanding before the stock price can begin moving in the right direction.
3M currently trades at a P/E ratio of 16.4x but it has an average P/E ratio of 19.7x over the course of the last 10 years. I believe that a P/E ratio of 19.7x is too rich when we take into consideration some of 3M's existing problems, so I would say that shares are fully-valued somewhere between 17x-18x earnings.
Assuming that FastGraphs estimated earnings for 2019 is $9.32/share, we can estimate the fair value somewhere between $158.44 to $167.76. If the earnings announcement in the month of October sees the kind of improvement I am looking for I would be willing to bump my fully-valued P/E ratio to 19x which would correspond to a share price of just over $177/share.
Target Price: $150/share
Eaton - Electrical Equipment
Eaton has strong support at around $72/share and tends to hit ceiling right around $88/share. Currently, these two ends of the spectrum represent the price I'm going to purchase more shares at and also the price which I'm willing to sell shares at, respectively. As shown in the graph below, movement in this range (with the exception of December in 2018) continues to maintain a dividend yield that is between 3.2-3.6%.
ETN has been on a tear since 2009 with a rapidly increasing dividend, EPS, and a reasonable payout ratio that continues to be maintained at around 50%.
When we consider ETN's 10-year track record it hasn't translated to a P/E ratio multiple that really exemplifies how quickly things have improved since the recession in 2009. The 10-year average P/E ratio is 14.3x but the stock currently trades at 13.8x which seems rather low based on near double-digits earnings grow estimated FY-2019.
Although FastGraphs shows ETN is trading in-line with its 10-year average P/E Ratio I believe that it deserves a higher multiple based on the improved and more focused business model. At a P/E ratio of 15x earnings, this would put ETN at just under $88/share (which is right where the stock tends to trade at the top end of its range). Looking to 2020, this has the potential to push up another $5/share to $93/share as the fair value.
Target Price: $75/share
Honeywell - Industrial Conglomerate
HON is currently seeing the opposite trend of 3M because it is sitting at a P/E ratio of 20.3x which is well above its 10-year average P/E ratio of 16.4x. HON's consistent history of beating earnings expectations and raising guidance has definitely added value for investors' which is why a premium at this point in time makes sense. For HON, analysts are predicting a strong close to 2019 (especially following the guidance raise from Q2-2019) and expect solid earnings growth going into 2020.
Source: SeekingAlpha - HON - Earnings
HON looks fairly valued at a P/E ratio of approximately 20.5x which translates into a share price of $166/share based on FY-2019 estimated earnings of $8.10/share. If analyst EPS growth estimates are correct, the real opportunity lies in HON's return to high single-digit or low double-digit EPS growth in 2020, 2021, and 2022. This is especially important considering that 2019 was a transition year that saw very little EPS growth YoY.
- 2020 EPS Estimate $8.90/share = $182.45/share Fair Value.
- 2021 EPS Estimate $9.73/share = $199.47/share Fair Value.
- 2022 EPS Estimate $10.55/share = $216.28/share Fair Value.
If these assumptions hold true, HON shareholders stand to make an average rate of return (capital gains and the dividend) of 11% each year for the next three years.
HON should hold up well around $160/share and I have it marked as a potential BUY opportunity if it were to drop below this level (the last shares were added at around $155/share). HON currently has a cost basis of $138.44/share in our clients' portfolio.
Target Price: $160/share
Illinois Tool Works - Machinery
Rarely do I agree with Goldman Sachs but the headline downgrading ITW to a sell is something that resonates with me as we recently sold more of our client's high-cost ITW shares near the 52-week-high. I typically only sell shares of a high-quality company like ITW when I believe that the shares are too richly valued because it allows us to redistribute funds to purchase more attractively priced stocks. My clients still maintain a modest position in ITW but the stock looks overvalued based on its Q2-2019 miss that led them to cut FY-2019 EPS and reduce revenue guidance.
When ITW is trading at around $145/share there appears to be strong support which corresponds with a P/E ratio of approximately 19x. Meanwhile, strong resistance kicks in at around $158/share or a P/E ratio of 20.6x. Personally, I believe that ITW should be valued at a P/E ratio that is closer to 18.5x because there are no near-term catalysts (a great example of these catalysts is Honeywell's EPS growth) that would justify the kind of premium the stock is currently trading with.
Investors' should also consider that ITW's yield has become range-bound over the last few months with the yield constantly being maintained between 2.50- 2.75%. If ITW dropped into my BUY range of around $140/share it would result in a dividend yield of 3.06% based on the new dividend of $1.07/share per quarter for a total annual dividend of or dollars and $4.28/share.
ITW estimated earnings of $7.65/share for FY-2019 would result in a share price of $141.53/share which means there is a 5.5% downside to the October 4th closing price of $151.50/share. Even if we consider future estimates we can expect an annualized rate of return (capital gains and dividend) of around 6.9% per year.
ITW's organic growth going forward looks limited and there are no mergers & acquisitions in the short-term that would help compensate for the lack of organic growth. Based on this, investors should be patient and wait to purchase shares of ITW only when the share price drops below $145/share and it would be even better if they could pick up shares below $140 (this is my personal buy range).
Target Price: $140/share
Parker-Hannifin - Machinery
I would describe PH's current situation as short-term stagnant growth and long-term opportunity. PH shares currently trade at a P/E ratio 14.7x while the 10-year P/E ratio average sits just under 16x. In my opinion, the current discount in the P/E ratio can be attributed to a challenging business environment that is expected to prevent almost any earnings growth in 2020.
Although PH expects challenges to EPS there have been a number of improvements made to PH that suggests the company is executing well and continues to push efficiencies that should give investors reason to consider adding PH to their portfolio. Here are three major takeaways from the Q4-2019 Earnings Call.
- Q4-2019 - All-time quarterly record for total segment operating margin (17.4%).
- Q4-2019 - All-time quarterly record for net income and EPS.
- FY-2019 - All-time records for sales, total segment operating margin, net income, EPS and operating cash flow.
Free cash flow has improved significantly in the last few years and has more than doubled since 2013. Even better, PH is trading at much more attractive levels than what we saw at the beginning of 2018 where it was trading at almost 22x P/FCF compared with its current P/FCF of 14.6x.
Where PH truly excels is in its ability to consistently increased its dividend for 62 years straight while operating in an industry dominated by cyclicality. Although the dividend yield is just over 2%, it sports a payout ratio of 29.6% which has been conservatively managed during the last 62 years.
Look no further than the last 10-years to see just how tremendous the growth story has been for EPS (nearly tripled during this time) and the dividend (more than tripled) while maintaining an incredibly low payout ratio year-after-year. The decrease in share count is the final piece of the puzzle that really drives home PH's value proposition to shareholders. with the total number of shares decreasing by 30.9 million in 10 years (or a total reduction of 19.2% over the last decade).
I currently have a target price of $160/share which is the equivalent of a P/E ratio of 13.5x based on FY-2019 estimated earnings of $11.85/share. I believe that shares are fully valued at a P/E of 15.5x or around $183.68/share. This led me to sell some of my clients' high-cost position at $184.32/share which dropped the average cost basis of the remaining position down to $164.27/share. We are only looking to add shares at a significant discount to a fully-valued price because of the expectation that EPS will continue to experience pressure that will likely result in minimal price appreciation in 2020.
Target Price: $160/share
Although none of the five stocks mentioned in this article would be considered "cheap" I think it is worth keeping an eye on these companies because we have seen more volatility in their stock price over going into the month of October.
The other reason for focusing on these companies is that I have begun focusing on high-quality investments that will help solidify my clients' portfolio with the goal of adding stocks that consistently increase their dividends even when times are difficult. Given the track record of these five companies, all of them deserve a place in my clients' portfolio.
My Clients' John and Jane are long: MMM, ETN, HON, ITW, PH
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MMM, ETN, HON, ITW, PH over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article reflects my own personal views and is not meant to be taken as investment advice. It is recommended that you do your own research. This article was written on my own and does not reflect the views or opinions of my employer.