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America's industrial heartland is flexing its muscles again. U.S. auto production is near a four-year high, the domestic oil-and-gas business is booming and residential construction is heating up.
Industrial stocks in the S&P 500 have powered ahead too, gaining 12% since October, more than twice the return of the S&P 500 (.SPX). Yet some analysts see attractive, long-term potential in the sector, offering investors more than just a rebound due to the economic recovery.
Over the next five years, industrial companies are projected to grow earnings 7.7% a year, on average, beating the S&P 500's five-year projected earnings growth of 7.4%, says John Kozey, a senior analyst with Thomson Reuters.
"If the analysts are right, there's upside in the sector," he says.
Granted, industrial companies may not hit their targets if the global economy weakens. The U.S. economy is forecast to grow about 2% this year, according to the International Monetary Fund, and Europe appears to be in recession with the European Central Bank forecasting a 0.3% decline in economic output this year.
Still, U.S. manufacturing continues to grow, according to surveys by the Institute for Supply Management. Auto sales, residential construction and oil-and-gas production have showed gains.
In addition, many industrial companies have slimmed down since the recession, slashing billions in costs and improving their finances, says Kozey. Their dividend payments are rising: Industrials issued more special dividends in 2012 than any sector except financials, according to S&P.
Another plus: The sector isn't as prone to extreme swings in profitability, according to Tobias Welo, manager of Fidelity Select Industrials Portfolio (FCYIX). In 1979, he says, operating margins for a basket of 18 large industrial stocks peaked at 13.2% and then plunged to 7.6% at the trough of the business cycle in 1983. In the 2008-to-2009 period — including the worst recession since the 1930s — margins fell from 13.7% to 10.6% and have since rebounded to 12.1%. "The cycles are more muted," he says.
Industrial stocks trade around 13.9 times estimated 2013 earnings, a slight premium to the market, according to S&P. Yet Welo and other analysts see some areas with attractive, long-term growth potential. For example, railroad companies such as Union Pacific (UNP) and Kansas City Southern (KSU) are benefiting from rising trade with Mexico, and their stocks look undervalued, according to Morningstar analyst Keith Schoonmaker. For his part, Welo likes companies benefiting from lower U.S. natural gas prices and China's accelerating growth.
Despite all that, industrial companies are still sensitive to swings in the economy. Some businesses, such as those tied to residential construction, make the most money in the early and middle stages of a recovery. Others tend to peak later on, when capital spending and factory output tend to rise, benefiting companies that supply materials and commodities, for example. When a slowdown comes, companies with high fixed costs often see their profits plunge because they can't cut costs fast enough to keep pace with falling demand.
Since they're largely still tied to the economy, some investors view industrial stocks as a trade: They invest when earnings are on the upswing and sell as the wave seems to be peaking.
Timing that trade isn't easy, though: Earnings don't crest at the same time for every company, nor do stock prices. While capital goods companies may be rallying, aerospace and defense stocks could be in a slump, or vice-versa. Many large conglomerates are also more diversified with a mix of early- and late-cycle businesses and steadier revenue streams, which may help smooth out earnings and generate longer-term growth, says Welo. "It's too tricky for most retail investors to time the market right," he adds.
If you own an S&P 500 index fund, you already have exposure to industrials, which make up 10.2% of the index. ETFs and mutual funds can offer more targeted exposure and may be appropriate if you have a long time horizon and can ride out swings in the sector, says Tom Roseen, head of research services for Lipper. One way to lower your risk: Buy shares gradually over time, which can lower your average purchase price.
Here are a few specific ways to invest, based on our research and interviews with analysts. You should do your own research or consult an adviser before investing.
If you're looking for broad, low-cost exposure, the Industrial Select Sector SPDR Fund (XLI) may fit the bill. One of the largest and most liquid industrial ETFs on the market, it tracks an index of large-cap U.S. industrial stocks, with an average market value of $59 billion.
Around 90% of the stocks in the ETF have "economic moats" that help insulate them from competitive pressure, says Morningstar analyst Robert Goldsborough, who recommends the ETF. Top 10 holdings include conglomerates such as General Electric (GE), United Technologies (UTX) and 3M (MMM). And many companies in the ETF generate significant sales outside the U.S., offering exposure to economies around the world.
The downside: General Electric and United Technologies account for about 18% of the ETF and could drag down returns if their stock prices weaken. The ETF's volatility has averaged 19% a year over the last decade, compared to 16.2% for the MSCI World Index, according to Morningstar.
The iShares Global Industrials ETF (EXI) holds about half its assets in U.S.-based giants like General Electric and Caterpillar (CAT). But it tracks a global index of industrial stocks with the rest of its holdings in European, Japanese and other foreign companies, including German conglomerate Siemens (SI) and Swiss power-and-automation firm ABB (ABB).
These foreign stocks yield more than 3% and the ETF's yield exceeds its U.S.-based counterpart. Goldsborough calls it a "solid choice" for investors looking for broader geographic reach.
The downside: The ETF is highly correlated to the SPDR Industrials ETF, offering minimal diversification benefits, according to Morningstar. It's more volatile than the S&P 500 and poses some currency risk due to its foreign stock exposure.
One of the more unusual ETFs on the market, the PowerShares Dynamic Industrials Sector Portfolio (PRN) ETF tracks an index that evaluates companies based on "investment merit" such as earnings and price momentum, according to PowerShares.
The ETF rebalances quarterly and no stock accounts for more than around 3% of the fund. The average market value is $9.7 billion — a fraction of the average for the S&P 500 industrials index. Indeed, the ETF holds more than 70% of its asset in small- and mid-cap stocks, including businesses such as executive recruiter Korn/Ferry International (KFY) and steel services firm TMS International (TMS).
"It's an interesting choice if you're comfortable with the 'enhanced-index' approach," says Goldsborough. While it takes a bit more risk, the ETF's index beat the S&P industrials index over the last three years, according to PowerShares, returning 16.1% a year versus 13.3% for S&P's index, on average.
The downside: The ETF is pricey with an above-average expense ratio, according to Morningstar. Its exposure to small- and mid-cap stocks makes it riskier, and it yields less than large-cap industrial ETFs.
One of the few no-load mutual funds offering pure industrials exposure, Fidelity Select Industrials Portfolio (FCYIX) beat its benchmark over the last three years, returning 18% annualized compared to 16.6% for the MSCI IMI Industrials 25/50 Index. Over the last five years, the fund beat 95% of peers, according to Morningstar, with a 7.3% average annual return.
That kind of performance could make it a solid pick for investors who want to try and beat the index over time, says Lipper's Roseen. Indeed, the fund beat peers over the last year primarily due to stock picking, according to Lipper data.
Fund manager Welo holds the major names in the sector, but he adjusts the mix based on the "fear and euphoria" that often build up around industrial stocks, he says.
For example, he's placing less emphasis on companies benefiting from the residential housing rebound and focusing more on the commercial side, where construction is now ramping up, he says. Holdings along those lines include Johnson Controls (JCI), which makes temperature regulation equipment, and United Technologies, a major supplier of industrial heating and air conditioning units.
The downside: The fund has been slightly more volatile than the S&P 1500 Industrials index, according to Morningstar, and annual returns may fluctuate by 20% in either direction. Given its risks, investors should have a long time horizon if they buy shares, says Roseen.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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