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Our Outlook for Industrials Stocks

Cautious optimism continues to pervade the industrials universe.

Eric Landry, 12/29/2011

--The worldwide industrial sector's slowdown continued in the fourth quarter, with challenging conditions in key geographies such as Europe and Asia mitigating surprising strength in the United States.

--With the benefit of hindsight, the third quarter's summer swoon seems to have presented wonderful buying opportunities for high-quality industrial companies. After a sharp rebound, many valuations now look full, in our opinion.

--Even with a more fairly valued sector, we still believe some industries within the sector offer pockets of opportunity, including automotive, transportation, and truck manufacturing.

Cautious optimism continues to pervade the industrial universe. Although it's hard to ignore the weakening manufacturing signs stemming from key geographies such as Europe and China (both of which have seen their Purchasing Managers' Indexes fall below 50), most management teams that we follow do not expect the world to tumble into a renewed recession in 2012. In fact, the U.S. has proved surprisingly resilient, with the ISM U.S manufacturing PMI climbing to 52.7 in November from a low of 50.6 in the third quarter, indicating low-single-digit top-line industrial growth in 2012.

Still, we think some worrying signs lie on the horizon. For instance, several other leading indicators, such as 3M's MMM consumer-electronics business lines (easily one of the earliest-cycle businesses in the industrial space) and semiconductor order rates, have weakened materially in recent months, perhaps signaling lower end-market demand to come for the rest of the industrials market. Semiconductors often are good indicators because of their relatively early position in the value chain. Moreover, we need to be cognizant of the fact that some of the positive order rates we've seen from companies tied to the capital spending cycle, such as Rockwell Automation ROK, might be currently aided by a prebuy effect ahead of changing depreciation rules. Next year, customers can depreciate just 50% of an asset's purchase rather than the current 100% rate currently allowed by The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

The Industrial Select Sector SPDR XLI exchange-traded fund has climbed about 37% from the end of the third quarter, and even though still about 11% off its highs for the year, the index now sits at levels nearly double its 2009 lows. Although we think there are pockets of opportunities for investors, the aforementioned weakening in some of the leading indicators and runup in the shares generally temper our enthusiasm. Our overall sector price/fair value ratio rose to 0.85 in the quarter from 0.78 at the end of the third quarter, suggesting a much slimmer margin of safety among our coverage space today.

Strength Still Evident in Automotive
Some areas of the industrial economy are enjoying healthy rebounds that we think could continue for some time. For example, automakers reported that November's new U.S. light-vehicle sales had the best seasonally adjusted annualized selling rate, or SAAR, this year, the best SAAR since the Cash for Clunkers program's 13.69 million in August 2009, and the biggest year-over-year volume increase since April. It was also the best November since 2007 and the third consecutive month of an SAAR of more than 13 million units, which suggests to us that consumers are finally starting to release pent-up demand.

We have long argued the several years of sales at or below replacement levels was not sustainable, and we think that, barring another major supply shock, we will see our thesis continue to play out next year. Importantly, we expect higher incentive activity in December relative to November, but we also expect solid average selling prices as there is no need for any automaker to drastically overproduce anymore. In short, 14 million units sold in the U.S. isn't out of the question for 2012.

Eric Landry is a director with Morningstar.

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