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Our Outlook for Industrials Stocks

The current industrial slowdown could persist for several additional quarters, but we think pockets of value exist.

Eric Landry, Associate Director, 09/29/2011

--The industrial slowdown we warned about in our second-quarter outlook continued in the third, with several leading indicators worsening across the world.

--Many industrial companies remain cautiously optimistic as we write, however, highlighting strong order growth, solid backlogs, and healthy balance sheets. Several firms have also turned to major share-buyback programs following the recent market sell-off.

--We think several moat-worthy industrial companies now feature compelling valuations for patient, long-term investors. However, the conditions might remain difficult for some time, and it's anybody's guess as to what share prices do in the short term.

The industrial slowdown continued in full force during the third quarter, but many firms we cover remain cautiously optimistic given their continued orders growth through July and August and solid balance sheets. The market has definitely punished many industrial stocks during the past several weeks, as the Industrial Select Sector SPDR XLI currently resides about 23% lower than its recent highs as opposed to a more modest 16% sell-off for the market as a whole. As a result, we think the sharp sell-off has created discounts for several high-quality companies that could offer better downside protection to those investors who believe the odds might have tilted in favor of a renewed global downturn.

Across the board, we've seen key leading indicators further slide during the quarter. U.S.-focused metrics such as the Philadelphia Fed Index, Empire State Business Survey, and Chicago's PMI posted worse results in the period, leading to a continued decline in the national Institute for Supply Management's purchasing managers' survey. These readings typically lead domestic industrial production, and this quarter was no different; industrial production continued to chug along at a slow 3.3% year-over-year growth through August (though the index was slightly ahead of June's production level). If our continued negative interpretation of the above and other indicators is correct, that 3.3% annual growth will likely not persist into 2012.

Internationally, manufacturing indexes for both Europe and China slipped below 50, indicating expectations of near-term contraction among those regions' manufacturing executives.

That said, although manufacturing companies are seeing a slowdown, we're encouraged that input-cost increases are in the process of abating. The ISM national PMI index gives a pretty good forward look into industrial commodity prices, and here the news is encouraging. The prices-paid component of the index has fallen to 55.5 from a high above 85.0 just a few months ago, which is in line with more-muted price increases seen in China's survey. This silver lining could help to preserve some profitability for manufacturers in the event of further economic slowing (though negative operating leverage would undoubtedly work against the companies in some fashion, as well).

Management teams of many of our largest bellwether firms do not expect the U.S. economy to slip back into recession, but few are calling for robust overall growth either. For instance, at its recent analyst day, United Parcel Service UPS management noted an expectation of further stagnation, but not decline; competitor FedEx FDX maintained a similar cautious tone in its recent quarterly results. Nonetheless, both Emerson Electric EMR and Tyco International TYC have recently posted better order growth than one may have expected (though we caution that these names tend to perform best later in economic cycles), and Caterpillar's CAT dealer deliveries--while slowing--have continued to grow at a healthy rate. Overall, it's hard to argue against a bearish case that has undoubtedly risen in potential probability in recent months. That said, if indeed the current tepid recovery deteriorates into another contraction, we wouldn't expect a deep recession in our base-case assumptions across our coverage universe. Inventories are not bloated, balance sheets are extremely sturdy across the space, and fixed costs are lower now than before the prior recession indicating better trough profitability. In all, we think industrial stocks are well-armed to handle whatever the markets throw at them.

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