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State of the sector: industrials

It was a strong first half for industrial stocks. Tailwinds and headwinds abound now.

  • Industrials Sector
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Despite a mixed record of earnings growth at the industry level, the industrials sector overall has generated strong returns during the first half of 2013, slightly outperforming the broader market.1

Companies across a wide variety of industries have participated in the ongoing U.S. recovery. In the near term, improvements in housing are likely to be followed by improvements in nonresidential construction, both of which may benefit several industries in the sector. Longer term, lower domestic energy costs and ongoing wage inflation worldwide continue to lay the foundation for a domestic “manufacturing renaissance,” as companies look to repatriate and expand U.S. manufacturing capacity.

One outperforming industry during the first half of the year was aerospace and defense, which makes up roughly 20% of the sector by market capitalization. Earnings growth greatly exceeded expectations in the second quarter (see chart below, right), despite the fact that the U.S. federal government’s sequester began in March and has continued since then. The sequester will cut approximately $85 billion from federal spending in 2013, about half of it from defense discretionary spending, with more cuts scheduled in the years to come.

However, defense contractors have long-term contracts and multiyear backlogs of projects going forward, and so are at least partially insulated from the immediate effects of budget cuts. Companies in the industry have been aggressive about reducing costs in response to anticipated slower topline growth going forward, which may help to boost earnings in the short term. However, the effects of backlog and of cost cutting may not continue indefinitely, and the U.S. defense budget cuts will likely be visible in the defense industry’s earnings performance before too long.

Aerospace companies also performed well in the first half of the year. The aerospace group splits into “original equipment” (OE) manufacturers (the companies that make airplanes) and aftermarket manufacturers of necessary components. Like defense, OE manufacturers have a long order cycle. As the global economy has improved, orders have remained elevated from recent lows, with 2013 orders likely on track to outpace those for 2012. The aftermarket producers, working on a much shorter order cycle, had been at a lull but have generally begun to show some sequential improvement, and may be able to grow revenues and earnings alongside the OE companies.

The machinery industry, roughly 20% of the sector by market capitalization, had the opposite experience, with both earnings and revenue growth in the second quarter lower than expected, and year-to-date returns trailing those of the sector. The slowdown of growth in China may be one factor, along with a drop in the price of many commodities, particularly those associated with mining. Companies that built up large inventories anticipating vigorous Chinese growth might need to go through a destocking period, lowering inventories and conserving cash. Because machinery companies tend to have high fixed costs and operate on a relatively short sales cycle, changes in revenue growth may have a magnified effect on earnings growth, positive or negative depending on the direction of the shifting conditions.

The last of the largest industries within the sector is industrial conglomerates, at roughly 18% by market capitalization. This industry is composed of seven diversified industrial companies making a variety of products in multiple markets. With their large sizes and wide exposures to the global economy, these companies are often well positioned to take advantage of economic growth in any of their markets, and tend to have steady streams of recurring revenues. In times of slow growth, they are likely to have plenty of internal costs to cut to improve the bottom line, and cash on hand to make acquisitions in preparation for better stages of the economic cycle. Despite earnings growth that was lower than anticipated for the second quarter (see chart, right), industrial conglomerates have made a nice contribution to returns for the sector for the first half of the year.

Of the smaller industries, one notable contributor to the sector’s performance was the road and rail industry, which includes both freight and passenger railroads, trucking transportation, and vehicle rental companies. With trucking and car rental companies adding strong returns to those of railroad operators, the industry returned roughly 24% over the first half of the year.

Assessing valuations

Looking at the ratio of enterprise value to sales (EV/Sales) for the sector, valuations have been increasing over the last year, and are now right around the long-term average (see chart, right). The EV/Sales ratio divides the total value of the companies within the sector by their aggregate revenues over the last year.2 In general, lower ratios signify that the sector is currently inexpensive. The ratio will sometimes rise when investors expect that future sales will grow, because the calculation divides the current market valuation of the company (reflecting future expectations) by the previous year’s revenues.

Although valuations have risen sharply during the past year, the sector is still inexpensive relative to the past decade, and there are likely to be many strong investment opportunities within the sector.

Outlook for industrials stocks

The U.S. housing recovery touches many different parts of the sector, both directly in the form of construction and indirectly by supporting consumer confidence; if housing trends continue to improve, so should the fundamentals of many associated industries and companies. Moreover, a recovery in nonresidential construction, which tends to follow a residential recovery, could have incremental positive effects on many industries in the sector, including machinery and the industrial conglomerates (two of the three largest components), as well as construction and engineering, electrical equipment, and transportation infrastructure. In the past, the recovery phase for construction-related industries has often built momentum over multiple years.

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With ongoing defense budget cuts from government sequestration starting to hit new orders over the quarters to come, the revenues of defense-centered companies may be pressured. Improvements in the global economy may provide tailwinds for the aerospace companies, which could allow them to contribute some offsetting positive performance to the industry. If the defense budget were to return to the high levels of the past few years, the recent cost cutting may lead to marked improvements in the group’s bottom line—but given the current political environment, that improvement may be some time away.

Long-term positive influences on the sector include stabilization in Europe, the manufacturing renaissance in the U.S., and more consistent economic growth expectations for China (even if growth is slower than in the recent past). As usual, it may be prudent to focus on companies with capable management teams, strong balance sheets, and reliable cash flows, because these qualities often allow a company to weather volatility in the macroeconomic environment while “creating growth” through accretive acquisitions.

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1. Sector and industry returns, industry weights, and industry earnings throughout this article refer to returns, weights, and earnings within the MSCI U.S. IM Industrials 25/50 Index, an index designed to be broadly representative of industrials sector companies in the MSCI U.S. IMI 2500. In a 25/50 index, no single issuer exceeds 25% of the index weight, and the sum of all issuers with weights above 5% does not exceed 50% of the index weight. The MSCI U.S. IMI 2500 returned 14.0% year-to-date as of Jun. 30, 2013, while the MSCI U.S. Industrials 25/50 Index returned 14.6% over the same period.
2. Enterprise Value (EV) is the measure of a company’s market capitalization plus its debt, minority interest, and preferred shares, minus the cash and cash equivalents held. It is sometimes summarized as the amount required to acquire the company and pay all obligations. In sectors or industries with a wide variety of levels of debt, EV is often considered a useful way to compare companies.
Sectors and industries defined by Global Industry Classification Standards (GICS®).
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