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Craving Industrials: A Beginner's Guide And Top 6 Picks

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Includes: ALK, BA, DAL, DE, ETN, FB, FDX, GOOG, GOOGL, HON, ITW, LMT, MMM, NFLX, NOC, PLD, PLDGP, PTON, ROP, RTX, SPG, T, TDG, TDY, TEVA, UNH, UNP, UPS, WM, XLI, XLK, XLV, XLY
by: The Long-winded
The Long-winded
Growth, long-term horizon, portfolio strategy, large-cap
Summary

Industrials is essential for any well-diversified portfolio and 13% compounding over the last decade is not something to scoff at.

Among the Industrial subsectors, Aerospace & Defense has led the charge and may continue to do so with its ability to compound revenue and earnings.

Capital Goods and Transportation also sport some solid long-term compounders that may write the future of the sector as a whole.

Identifying potential winners in the space can generate significant alpha for your portfolio over the next decade.

Come on, long-winded! Who craves industrials today? Aren't you the one, who keeps talking about Technology & Healthcare? So why are we discussing Industrials today?

Okay. Hear me out. I must admit that I am a big fan of Technology and Healthcare as they are enjoying long-term secular tailwinds and they command close to 50% of my portfolio. But it also means that almost half of my portfolio is spread across Industrials, Financial Services, Energy & Materials, and Consumer. There are three prime reasons for adding Industrials -

  1. In each sector, there are strong companies that continue to allocate capital efficiently, resulting in market share, revenue, and profit growth.
  2. The future of Industrials will be written by leaders in the space rather than someone from the outside.
  3. This provides me the much-needed diversification as all these sectors don't move in lock-step and allow me to rebalance if needed.

Before I get started, I want to let you know that this is my third article in the 'Craving' series. In these write-ups, I hope to provide a high-level overview of a sector and discuss key sub-sectors and investment themes within it. My first article was on Healthcare and the second was on Technology - both of them have handily beaten the S&P 500 over the last decade. So, if you haven't yet, you should definitely check those out. So today my hope is to demystify the Industrials, show what drives its different sub-sectors, and how to invest in the sector with high conviction.

I also want to clarify that I am looking at Industrials from a 5-year view and not looking to debate how the sector would trade in the short term, especially if there is a sharp reversal in investor sentiment. I did share my perspective on the recent correction here.

Now, coming back to the topic of the day. The table below (last updated August 31, 2020) neatly summarizes the performance of all the key sectors within the S&P 500 over different periods. Industrials (XLI) has underperformed the S&P a bit, though we are seeing a bit of a reversal over the last 1-month (+1.5% compared to SPY) and 3-month (+0.3% compared to SPY) periods. Also note that over a longer period (5-year or 10-year), it has outperformed every sector except Technology (XLK), Healthcare (XLV), and Consumer Discretionary (XLY) - almost 24% of which is Amazon (NASDAQ:AMZN). So, in my mind, Industrials has done a better job than the credit it receives for.

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So, let's do the famous $10,000 test. If 10 years ago you had invested $10,000 in XLI, it would have grown to ~$34,000 - not something to scoff at, while the same in SPY would have resulted in ~$40,600. S&P wins by almost $6,600 (~16%) more. So, agreed that investing in this broad index may not have been as rewarding, but the objective of today is to go slightly deeper and understand sub-sectors / industries within it and identify winning themes.

Background

Before I get into the details, let me share my investment beliefs. You can skip this section if you have read my prior articles.

  1. Conviction - I don't invest unless I am convinced about the story. This lets me stick with a stock whether it's sunshine or rain, and it has served me well in the past.
  2. Growth - I believe a lot of people misunderstand growth. It's as simple as the power of compounding. Considering my focus on total returns, I always value companies that show their ability to grow revenues profitably.
  3. Flexibility - I don't think as a retail investor, we need to marry ourselves to a single investing style (e.g., dividend growth). Even if you prefer dividend growth, it shouldn't stop you from picking Google (GOOGL) or Facebook (FB), if you believe in their story.

My own portfolio is spread across ~40-45 securities, and I divide them into 3 buckets -

  1. Consistent Compounders - proven business models, above-average growth rate (Medium Risk, Medium-High Return) - Think of GOOGL, UnitedHealth Group (UNH), Honeywell (NYSE:HON).
  2. High Flyers - growing at a rapid pace, may have little to no profits (Medium-High Risk, High Return) - Think of AMZN, Netflix (NFLX), Peloton (PTON)
  3. Special Situations - depressed valuations due to short-to-mid-term challenges such as loss of confidence in management, significant debt, or industry overhangs (Medium-High Risk, Medium-High Return) - Teva (NYSE:TEVA), Simon Property Group (SPG), AT&T (NYSE:T). This is sort of my gamble money.

You can read more about my journey, investment beliefs, and allocations to these buckets here. Now it would become easier for me to take a deeper dive into Industrials and help you in developing a strategy that can outperform broad indices.

What makes up Industrials?

Here is how State Street breaks down the Industrials sector. Are you thinking, what I am thinking? There are a lot of moving pieces here.

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Here is how Fidelity defines it -

The Industrials Sector includes companies whose businesses are dominated by one of the following activities: The manufacture and distribution of capital goods, including aerospace & defense, construction, engineering & building products, electrical equipment and industrial machinery. The provision of commercial services and supplies, including printing, employment, environmental and office services. The provision of transportation services, including airlines, couriers, marine, road & rail and transportation infrastructure.

I personally like to keep things simple. So, I like to break this down into 3 constituents -

  1. Capital Goods - These are the people who make stuff to be used by other industries - the typical definition of Industrials. This is the largest component, ~45% of the sector. Think of Honeywell, 3M (MMM), Deere & Co. (DE)
  2. Transportation - These are the folks who would move things such as railroads, logistics, and airlines. ~25% of the sector. Think of FedEx (FDX), Union Pacific (UNP), United Parcel (UPS). IYT is a good ETF proxy. Here is a snapshot of the top holdings -

Source

  1. Aerospace & Defense - Companies that keep you safe (or the illusion of). These also include large aircraft manufacturers and associated downstream companies. ~20% of the sector. Big names include Lockheed Martin (LMT), Raytheon (RTX), and Boeing (BA). ITA is a good ETF proxy. Here is a snapshot of the top holdings -

Source

The remaining 10% is spread between other smaller players, which I don't think we have to worry about in this broad sector assessment.

I would have loved to look at a straight forward ETF corresponding to each of these sub-sectors to assess the largest holdings and overall performance, but we don't live in a perfect world, and I couldn't find a good proxy to simulate the performance of Capital Goods side of things. So, I took the 10 largest companies from each of the sub-sector, plugged them into a Morningstar portfolio, and started analyzing from there. Makes sense?

Capital Goods

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Not a big fan of this particular group as I burned my hands in GE. That was the classic case of trying to buy something cheap (read falling knife / 52-week lows) rather than time tested and proven strategy of sticking with quality. Anyways putting my biases aside, the overall performance of this group doesn't look so bad. If we focus on the ones with consistent double digit returns, we have 6 names to look at - Honeywell, Illinois Tool Works (ITW), Deere & Co., Waste Management (WM), Roper Technologies (ROP), and Eaton Corp. (ETN). ITW is expensive with valuations 27X FY21 while relatively moderate expected earnings growth (low single digits). Eaton has also been struggling to deliver any meaningful revenue and earnings growth, so I will drop it for now. So, we are left with four for further analysis.

Honeywell - Honeywell is the easiest buy from this sub-sector. It's trading at 20X FY21 earnings with double digit EPS and high single digit sales growth expected. All this while knowing their diversified revenue base with a continued focus on industrial technology such as IoT. Here is a snapshot of their focus areas with a heavy emphasis on industrial transformation.

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Deere & Co. - DE is an iconic brand and has been able to execute very well even in a tough environment. But its low profit margins and lack of diversification have always prevented me from pulling the trigger.

Waste Management - WM is a unique business in itself, and one that is facing a bit of a challenge in the current environment. While the returns have been great over the last decade, the lack of revenue growth while sporting a 25X+ FY21 earnings multiple gives me a pause.

Roper Technologies - As the name implies, Roper is more of a technology business than typical industrials, and its revenue and EPS growth (both double digits - some of that is due to acquisitions) as well as 20%+ CAGR returns over the last decade showcase how well they have performed. The beauty of any pureplay technology business is operating leverage, or in other words, the ability to generate outsized EPS growth even with a slight improvement in revenues. Look at the 14% improvement in gross margins over the last 15 years. Considering it's trading at ~25X FY21 earnings, it definitely deserves a second look.

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Transportation

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I call these the boring bunch. They do a lot of grunt work from picking to warehousing to shipping to delivering. But look at the consistency of returns - every stock is a winner (except of course airlines). You would notice that over the last 5-years and 10-years almost all the holdings produced double-digit CAGR, showcasing this sector is not dependent on a couple of star performers.

But all this without any context may lead to wrong interpretations. All the railroads have made a step change in how they ran their operations and that has led to massive improvements in efficiency and profits. This is reflected in their anemic revenue growth but exceptional EPS increase. Not sure, how much of that can continue.

Time to talk about airlines. Mr. Buffett's favorite investment. But seriously even airlines have performed so well before COVID-19 hit. Though I know they started from a relatively bad shape, so market rewarded them even with slight improvements in the performance. Anyways, we know where they are, and I am truly concerned about business travel in the long term. I know it will come back but when and to what extent is unknown. Plus, I never get excited with low single digit revenue growths. I do hold Delta (DAL) and Alaska Air (ALK), but both are more of a trade - part of my gambling money - than a long-term high conviction investment.

Now my favorite name from this sub-sector is FedEx and Prologis (PLD). I know PLD doesn't belong here as it's a REIT, but it's more correlated to the industrial sector, so I feel this is the better place to talk about them. There are two prime reasons why I like these two - eCommerce and Technology. You can't run eCommerce without someone storing the goods in a warehouse ("PLD") and shipping them to your house ("FDX"). Plus, they both run state-of-the-art operations that are difficult to replicate.

I strongly believe that FDX has done an exceptional job by distancing itself from Amazon, so it can earn the badge of preferred logistics partner of other retailers, a massive bunch. Their Q2 results were incredible, and I see them uniquely positioned to grow its business as well as margins. Here is a slide from FedEx investor presentation showcasing their commitment to growing EPS in double digits while the company is trading at 15X forward earnings. A must buy from my perspective even after the recent run.

Source

Some of us may not have heard about PLD, but they are the leader in the logistics and warehousing side of things. The who and who of the world are their customers, and it's not just a real estate business. It's a technology business. Running an efficient logistics and warehousing setup requires much more than buying a piece of land with a shed. All this is reflected in PLD's exceptional performance over the last decade (16.6% CAGR over the 10-year and 24.8% over the 5-year period). Notice the increase in returns highlighting the exceptional momentum. Here are a couple of snapshots showcasing how diversified they are across geographies and industries, the top 10 customers, and PLD's FFO and dividend growth.

Source

Aerospace & Defense

Source: Morningstar

This is a curious bunch and I would say the best kept secret. The median returns for this group are 20%+ while they trade at median forward P/E of <15. Btw, just to reemphasize the 20% annual return over the last 10 years means, you have multiplied your money 6 times. In other words, $10,000 invested 10 years ago, would have been $60,000+ today. This is even better than some leading technology stocks and ETFs. Don't believe me? Check those out.

Now the most obvious overhang is elections and aftereffects on all the defense companies. I believe the impact of elections is overrated especially over the long term. Returns for both Lockheed Martin and Northrop Grumman (NOC) are better over the 10-year period than the 5-year period meaning they performed quite well during the previous administration. So, in my view, it's not as big of a concern, and the current prices kind of reflect that.

My favorite is definitely LMT followed by NOC. Both are leaders and performed extremely well with solid revenue growth. Plus, trading at not so expensive multiples. I am hoping to add LMT to my portfolio one day.

The other one I like is Teledyne (TDY). It provides various components to the aerospace and defense industry, but its revenue is well diversified. It has continued to show great Revenue and P/E growth, though a bit richly valued at close to 28X forward earnings. Here is a snapshot of its revenue breakdown -

Source

I would also like to mention another exceptional performer here from the group - TransDigm (TDG), an aircraft component maker. It has also performed exceptionally well in the last decade but has been struggling recently thanks to COVID-19. Due to the incredible growth it has demonstrated, the P/E is still not cheap. So, if you really want to go contrarian, look deeper at TDG.

Full disclosures, I do have Boeing in my portfolio but only in small quantity and that too picked at sub-$100 as a short-term trade. I believe that things should get better from here, but I'm not kind of a major turnaround guy.

Final Thoughts

Taking a deeper look into Industrials is a must for anyone trying to build a diversified portfolio. Plus, the performance of the sector has been relatively fine compared to most of the other sectors in S&P 500. Looking within the sector, Aerospace & Defense seems to be uniquely positioned to continue to deliver growth while trading at very reasonable valuations. Though I will advise picking some high-quality buys from each of the three sub-sectors. And my favorites are the following six, in no particular order -

The large / mega well-known names -

1. Honeywell - Capital Goods

2. FedEx - Transportation

3. Lockheed Martin - Aerospace & Defense

Relatively less known mid-large cap ones -

1. Roper Technologies - Capital Goods

2. Prologis - Transportation

3. Teledyne - Aerospace & Defense

All six of them are leaders in what they do. And from my perspective, the future of industrials will be shaped by innovative and nimble companies within the sector rather than from the outside. All six of them understand that and are continuing to stay ahead of the curve. The recent correction (shown in the chart below) has also brought down the prices a bit but not as much as you may see in the tech sector, and that also shows the benefit of diversification.

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Before I close off, I wanted to mention that the objective of the article was to generate some interesting ideas from a sector that is not so much in the limelight but has exceptional companies that may continue to deliver alpha to the portfolio. I would expect you to take a deeper dive into the names you like before buying.

If you like the material and want more, click "Follow" to receive instant notification when I publish the next one. Also, leave a comment with your thoughts on the analysis.

Disclosure: I am/we are long ALK, BA, DAL, FB, GE, FDX. 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.