U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios

This article originally appeared in the April/May 2012 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000.

As the current investment environment seems more uncertain than ever, given the day-to-day status of the European Union, we think that investors should focus their attention on the ground-up recovery occurring domestically. Specifically, the U.S. industrials sector contains numerous examples of long-term value stocks at opportunistic valuations. According to the latest industrial production report, the U.S. is actually outpacing China and Europe on the manufacturing side, and there are higher production-growth expectations from the purchasing managers survey. Coupled with strong balance sheets, we believe that industrial companies with 4- and 5-star Morningstar Ratings should do well versus other sector competition. This screen can be used to pick out the best of that bunch.

Sector = Industrials

In light of the positive production news, filtering down to the industrials sector level is a must. After this portion of the screen alone, the stock universe is cut from 14,000 to a little less than 2,500. Although the butterfly effect felt by companies directly related to production won’t be included, there are still plenty of firms to prune.

And Morningstar Rating >= 4 Stars

With the company’s fair value being one of the primary focuses of investors, the Morningstar Rating lets us figure out just how good of a discount we are getting on the potential purchase. Depending the uncertainty rating, stocks with 5-star Morningstar Ratings are trading with discounts of at least 20% for low-uncertainty companies, and very-high-uncertainty companies require discounts of at least 50% from Morningstar’s fair value estimate.

And Credit Rating >= BBB+

If you’re trying to find out whether the companies you’re looking for are in good financial health but don’t want to screen for all the specific metrics on debt and free cash flow, using the credit rating is somewhat of a shortcut to a similar result.

We like using the credit rating as a general safety kind of filter; our credit analysts work closely with our equity analysts to make sure the ratings are as current and realistic as possible.

And Current P/E <= 15

Our last criterion focuses on how much investors are willing to pay for a dollar of earnings, relative to where the stock has traded in the past. Because we are comparing industrial stocks with industrial stocks, we aren’t breaking any P/E analysis rules by comparing unrelated sectors. If users prefer, they can screen by sector and industry to get an even more in-depth look at where P/Es are trading.

As of Feb. 21, 2012, this screen returned five results:

3M MMM
Over its long history, 3M has invented some of the world’s greatest products. We think the firm’s innovative culture, bottom-line focus, and low-cost manufacturing have carved a wide moat around its business that will enable the company to reap outsized rewards over the long run. That said, the company tends to feel the pinch of economic slowdowns relatively early, and near-term headwinds could crimp the firm’s results for several quarters.

Although 3M sells thousands of products to disparate end markets, the firm cites only a few dozen technological pillars that support its wide array of offerings. The company’s ability to innovate new pillars and leverage the technology across multiple industries forms the backbone of its historical success. As a result, the firm has enjoyed returns on invested capital well above its estimated cost of capital during the past 10 years, while annual free cash flow averaged an impressive 15% of sales. Recent economic headwinds challenged this profitability because of the firm’s inherent operating leverage, but we think 3M handled the 2008–09 recession admirably, reducing working capital to increase free cash flow while remaining economically profitable.

Dover Corporation DOV
Instead of concentrating investment bets in any particular brand or end market, Dover spreads its exposure across several niche end markets. Collectively, the competitive advantages of each of these businesses lead to a narrow economic moat for the enterprise. More than 40 separate businesses and even more products within those businesses make up Dover’s business mix, but the underlying current that glues the pieces together is a focus on product innovation and sticky customer relationships. For example, in what otherwise would be considered a highly contested market, Dover has been able to build a dominant market share in the cell-phone-microphone end market through its Knowles business. Even though there are other firms that would want to break into the industry, high costs of failure and the threat of execution errors keep customers from switching away from Knowles.

ITT Corp. ITT
We believe the new ITT is a solidly run company with high-quality businesses. It sells its highly engineered products into platforms that exhibit multiyear life cycles across a diverse set of industries and geographies. We believe ITT’s well-established brands, entrenched customer relationships, and material switching costs have helped the firm carve a narrow economic moat. Indeed, we think midteens returns on invested capital are here to stay and should result in long-run creation of shareholder value.

Parker Hannifin PH
Parker Hannifin’s motion and control products are integral components in global manufacturing. With its strong balance between engineering prescience and a 60-year-old distribution network, we think this narrow-moat company can continue to return value to shareholders. Parker Hannifin specializes in engineering subsystems for machines and aircraft. The company tends to focus on niche products and the more value-added parts of the final product, permitting it to charge a premium for its products. While there are a number of companies in this market, very few have the same breadth and the clout with original-equipment manufacturers as Parker. From customers like Caterpillar CAT using Parker products in its heavy-duty equipment to McDonald’s MCD relying on Parker in the development of its new smoothie machines, the firm has proved itself on a number of levels and across a variety of end markets.

United Technologies UTX
Durability and balance are trademarks of the portfolio of United Technologies. While the company may not boast the flashy growth prospects found in some of its diversified industrial peers, we think that management’s consistency and commitment to shareholders separate this wide-moat franchise from the cohort. Each of the businesses within United Technologies is heavily entrenched within its respective end market, helping to solidify profitability not just for today but for future years. As with typical durable goods manufacturers, the revenue stream from higher margin aftermarket sales counterbalances equipment sales.