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Bargains in U.S. Industrials

There's value to be found in smaller U.S. industrial names, and this screen can help you find it.

Haywood Kelly, 06/03/2009

When considering the likely bankruptcy of General Motors GM, or the incredible shrinking market cap of General Electric GE, it's easy to forget that the United States is still home to some of the best-run, most technologically advanced industrials firms in the world. And right now, many of them trade at levels that sure look compelling to Morningstar's team of analysts. While this issue's Sector Rap focused mainly on large-cap names in the industrials sector, this issue's stock screen turns up some mid- and small-cap industrials that are beaten down to attractive levels.

Price/Sales < 1.0

Price/sales tends to be a good valuation tool for industrials stocks. Sales are less variable than earnings and cash flows because operating and financial leverage magnify changes to profits relative to revenues. So price/sales gives you a smoother, more meaningful number to screen on. It's meaningful even when profits are low or negative (sales are never negative). For a cyclical stock, a low P/E can simply mean earnings have peaked and it's all downhill from here. In fact, there's an old saw that the time to buy cyclicals is when the P/E is astronomical, as that means earnings might be bottoming. For this screen, we require a low price/sales ratio--less than 1.0.

And Dividend Yield > Dividend Yield of the S&P 500

Perhaps I've been spending too much time with Josh Peters, Morningstar's dividend strategist, but I'm paying more attention to dividend yields these days. The typical industrials stock is not in the ramp-up phase of its growth cycle and therefore should be paying out profits to shareholders in the form of dividends. Given the S&P 500 dividend yield of 3.3%, I should demand at least that much from an industrial. Plus, a dividend signals that management thinks the company has the wherewithal to part with cash; other things equal, that's a good sign.

And Financial Health Grade >= B

For an industrial to make us money, it needs to make it through this crisis. So a financial health criterion is essential. We could screen by any number of financial health variables--financial leverage less than three, for example, or debt/equity less than 50%. But the financial health grade tends to be a more reliable screening tool in the sense that you get fewer false positives. Tossing out any company that fails to make an arbitrary cut-off on one of the traditional financial leverage ratios tends to (at least in my experience) eliminate too many solid companies; there's often a financial ratio that a company will look poor on (financial leverage, say, because the company has bought back a lot of shares, depressing its book equity), even if it's actually quite strong on closer inspection.

The financial health grade, in my opinion, does a good job across a variety of different types of firms. It ignores book equity (using market capitalization instead), and only relies on the book value of liabilities from the balance sheet. And even if liabilities are understated on the books, the market capitalization will often reflect the off-balance-sheet liabilities, keeping the financial health grade honest.

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