The Case for Industrials

The industrials sector, which is made up of large multinational manufacturers, aerospace firms, defense companies and equipment makers, has been buffeted by trade conflicts this year. Those risks aren’t going away, but investors and company managers may have a better handle on what’s at stake.

Now, with trade risks largely factored into stock valuations, many industrials seem attractive. They also have characteristics that could enable them to grow in the coming years, even if the U.S. economy slows.

The industrial sector has been a lagging stock market performer for the past 10 years. In 2015, the sector suffered as oil prices fell, China allowed the yuan to devalue against other major currencies, and industrial activity slowed—before turning around in late 2016. In contrast to the U.S. business cycle, which is aging, if we start the clock in 2016, the current industrial cycle is actually still quite young, and it could last until 2020.

Recently, industrials have outperformed defensive sectors, even as they remain among the worst cyclical sectors (sectors like tech or consumer discretionary, which typically perform well amid robust economic growth). Industrials now trade at a 15.4 price-to-earnings (P/E) ratio, based on consensus 2019 estimated earnings. That’s below the S&P 500 P/E of 15.9 as well as below a P/E of 19.5 for consumer discretionary and 17.4 for technology.

The sector’s P/E has contracted about 20% from 2017’s peak levels. Among cyclical sectors, industrials currently trade at the largest discount to their 2017 peak (excluding energy) and the lowest P/E (excluding financials).

In downgrading the tech sector in July, Morgan Stanley Chief U.S. Equity Strategist Mike Wilson suggested that industrials may have already been repriced by the rolling bear market and now look tactically oversold.

The underperformance (and relatively attractive valuation) of industrials recently is in large part due to investor concerns over current trade disputes. New tariffs have already started to raise materials costs. Plus, these companies often have global supply chains that could be disrupted by trade friction.

Management teams have provided detailed guidance on how trade policy might impact them and how they might respond to additional tariffs through options, such as price increases or supply-chain shifts. They seem well-prepared and have generally explained these plans to investors. In other words, given their significantly contracted P/E multiples, industrial stocks may see the strongest rebound, when macro-trade fears eventually dissipate.

Even with trade tensions, there is an earnings story here. Among cyclical sectors, consensus estimates industrials will have among the highest earnings growth for 2019 at 12.2%. That’s even higher than the technology sector, which consensus forecasts at 11.1% earnings growth for 2019.

Earnings for industrials have beat expectations so far this year, yet the P/E is 11% lower than tech, and 21% lower than consumer discretionary.

Perhaps one explanation for lower P/Es among industrials could be that investors are concerned about a U.S. recession. Yet macro-indicators are not yet raising the alarm.

Surveys show U.S. manufacturing is expanding and consumer sentiment remains high; U.S. unemployment claims are near a 50-year low, and second-quarter gross domestic product, at 4.1%, was the strongest since 2014. True, the yield curve is flattening, but there is reason to question that signal. Plus, contrary to popular belief, some industrials have business models almost as good as some popular technology companies.

Within industrials, some of the better opportunities may be with companies that are undergoing technological transformations. As tech permeates every industry, companies with competitive advantages, economies of scale and leading market share may be well positioned to benefit from technological advances. These industrial companies often offer a cheaper way to invest in tech trends than technology companies. Below are four subsectors to consider focusing on.

• Trucking: Autonomous trucks and routing software could cut costs, which could lead to industry consolidation.
• Hand Tools: Strong brands have pricing power that have enabled them to pass along higher commodity costs while their research and development programs lead to innovations that increase network effects and support further pricing power.
• Defense: The rising defense budget supports top-line growth, and a new focus on space, missiles, and autonomous drones creates opportunities.
• Aerospace: There’s a long order book and a new generation of more efficient turbofan engines, providing ample opportunity for these companies to shine.
  

This article was derived from the August issue of On the Markets. Reach out to your Financial Advisor (or find one using the link below) for a copy of the full report.