3 industrial stocks to watch if the U.S. recovery mimics China

  • By Al Root,
  • Barron's
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As China goes, so will the U.S. And that could lead to a turnaround for hard-hit industrial stocks.

Renewed Covid-19 concerns slammed the stock market—particularly industrials—as the S&P 500 index (.SPX) fell 5.6% this past week and the Industrial Select Sector SPDR exchange-traded fund (XLI) slumped 6.5%. The fear is that the rise in cases will cause economic activity in the U.S. to grind to a halt and depress shares of cyclical companies even further.

For hope, look overseas. China, in particular, looks strong. It’s not just that China is the No. 2 economy in the world and that U.S. industrials generate more than 10% of sales in Asia, but also that China offers a glimpse into what business may look like in North America over the next few months. Industrials like Parker-Hannifin (PH), Littelfuse (LFUS), and TE Connectivity (TEL) could benefit.

China was the first country hit by the coronavirus, and the first to shut down. But China also has been the first to recover from the virus. Car sales tumbled 80% in February but rose 12% year over year by September. China’s gross domestic product fell in the first quarter for the first time since at least 1992 but grew 4.9% year over year in the third quarter.

China’s gains have started to show up in U.S. corporate earnings. Truck-parts maker Cummins (CMI) blew away expectations, mainly because of the Chinese recovery. TE Connectivity sales were 12% above forecasts largely due to China’s strength. “China continues to accelerate,” TE’s CEO, Terrence Curtin, tells Barron’s, while Trane Technologies (TT) CEO Mike Lamach says that from a business perspective, China “looks similar to pre-Covid.” That’s where the U.S. is headed.

Despite recent setbacks, the Dallas Fed Mobility and Engagement Index shows no decline, a sign that Americans haven’t gone back into lockdown mode yet. And the preliminary IHS Markit Flash U.S. Composite PMI for October rose to 55.5, a sign that the recovery was still chugging along in midmonth.

To be sure, China has controlled the virus in a way the U.S. hasn’t, and probably won’t. The U.S. is unlikely to see massive government-mandated contact tracing, but companies are tracking employees. And a vaccine or therapy could give the economy boost, as would another round of fiscal stimulus, something the market has written off for now. Combine those factors with low interest rates, and investors have a recipe for faster-than-expected growth.

As Caterpillar (CAT) CEO James Umpleby put it when his company reported better-than-expected earnings this past week, “While the situation remains fluid, overall we are cautiously optimistic.”

Here are three companies that cautiously optimistic investors should keep an eye on.

Parker-Hannifin

Parker-Hannifin is the quintessential short-cycle industrial company. Short cycle refers to a business that goes up and down over shorter periods, as opposed to one that rises and falls over a longer period. A Boeing jet, which takes years from order to delivery, is a classic long-cycle product; parts for the plane are short cycle.

Parker makes items such as valves, seals, and switches that go into every industrial end market. Its stock is up some 1% this year as earnings fell to $10.79 in fiscal 2020, which ended in June, from $11.85 in 2019. Asian sales are predicted to be flat in fiscal 2021, but that could be conservative.

Wall Street remains optimistic that growth will return. Analysts estimate that Parker will earn $13.12 in fiscal 2022, easily besting prior highs. At a recent $208 a share, Parker stock trades at roughly 18 times 12-month forward earnings. The stock could get a market multiple of 20 times if Covid uncertainty subsides, and with an earnings boost, as well, the shares could trade near $260, up more than 20%.

Littelfuse

Littelfuse is another high-quality, short-cycle industrial company that makes, well, little fuses. Its products end up in electronics used in a host of products, including cars, air conditioners, and telecom equipment.

Sales dropped about 19% year over year in the first half of 2020. But sales growth returned in the third quarter, rising 8% from the year before. Management credited robust electronics demand in China for the rebound, as quarterly sales in the region rose 24%.

The stock is up 3.4% this year, but shares can keep rising, thanks to both economic and company-specific factors. Cyclically, auto and electronics markets are improving, as indicated by global auto sales and Littelfuse’s recent earnings. Secularly, the amount of electronics used in cars and other products is rising, which means that Littelfuse is benefiting from growing markets.

The stock trades at 28 times earnings, above the S&P 500, thanks to its above-market growth, which has averaged about 10% over the past five years, including a rough 2020. Baird analyst Luke Junk rates the shares a Buy with a $218 price target, about 10% higher than recent levels of $198.

TE Connectivity

TE Connectivity supplies components to telecom, automotive, electronics, and industrial sectors. More than half of sales comes from transportation end markets. In addition to automotive improvement, TE enables the fast-growing vehicle-electrification market.

The car business has been a liability, but is improving. In China, sales have grown 12% year over year in the past three months, while the U.S. is back to 97% of pre-Covid levels. And the global production outlook is rising, with China growing again and U.S. dealer inventories far below normal.

As the global auto recovery continues, sales can come in even higher than the $3.2 billion that Wall Street is projecting for 2020’s last quarter. That’s good news for the stock, which trades for 19 times estimated next 12-month earnings, just below the S&P 500 multiple. Goldman Sachs analyst Mark Delaney believes that the shares can hit $120, up more than 20% from recent levels due to cyclical improvement and secular trends such as electric cars.

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