Outside of Aerospace and Defense, Few Undervalued Industrials Stocks

The Morningstar US Industrials Index rebounded sharply during the fourth quarter, led by construction, industrial distribution, and farm and heavy construction machinery, as investors bet that COVID-19 vaccines and the incoming Biden administration would usher in increased infrastructure spending and a sustained economic recovery. Furthermore, U.S. industrial production continued to rebound, which buoyed investor confidence in the sector. Still, the industrials index has underperformed year to date, primarily due to aerospace and defense laggards. The market has punished stocks with exposure to commercial aerospace, which is still struggling mightily amid the pandemic.

Despite sharp rally, industrials have underperformed year to date - Morningstar

Stock prices for most of the industrials companies we cover have recovered since the late March equity market trough, and few industrials stocks look undervalued to us currently. However, we still see some attractive aerospace and defense investment opportunities, including Airbus EADSY (which has ADRs) and defense primes Lockheed Martin LMT, Northrop Grumman NOC, and General Dynamics GD. U.S. air travel is still subdued, but we don't think there are structural barriers to travel beyond the virus, and we’re anticipating that consumers will be comfortable flying after broad distribution of COVID-19 vaccines. While a new U.S. administration introduces defense budget uncertainty, we still expect elevated spending on missiles, missile defense, and space militarization as the U.S. defends against great powers conflict.

Few industrials stocks are undervalued - Morningstar

With the recent U.S. authorization of Pfizer's PFE and Moderna's MRNA COVID-19 vaccines, investors have turned their attention to likely beneficiaries of the wide-scale distribution effort. Companies such as Emerson Electric EMR, Carrier CARR, and Trane Technologies TT, which manufacture refrigeration products, along with shippers United Parcel Service UPS and FedEx FDX, will play integral roles in the cold chain. However, we believe future incremental cash flows related to this opportunity are already embedded in the stock prices for these firms.

U.S. industrial production has rebounded from April trough - Morningstar

The American Society of Civil Engineers estimates that over $1 trillion in funding will be needed to address the aging U.S. infrastructure by 2025. President-elect Joe Biden has promised a sweeping infrastructure plan aimed at rebuilding crumbling infrastructure, which would be a boon for construction-oriented industrials companies, such as Caterpillar CAT.

More funding is needed for U.S. infrastructure - Morningstar

Top Picks

Lockheed Martin LMT Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $433 Fair Value Uncertainty: Medium

Wide-moat Lockheed Martin is the largest defense contractor globally and has dominated the Western market for high-end fighter aircraft since being awarded the F-35 program in 2001. In our view, medium-term defense budget uncertainty has weighed on the stock. While we expect a flattening defense budget, we don't expect spending contraction. We think Lockheed Martin's $150 billion backlog, roughly 2.5 times 2019 sales, will allow it to grow despite the macro environment. We think Lockheed’s recently announced acquisition of Aerojet Rocketdyne, a propulsion technologies supplier, is a sensible play on the growing missiles and space market.

Wesco International WCC Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $100 Fair Value Uncertainty: High

At over $17 billion in pro forma sales after acquiring Anixter International in June 2020, Wesco will dwarf W.W. Grainger as the largest U.S.-based industrial distributor. Wesco's $200 million cost synergy target seems like an achievable goal, and we also see opportunities to achieve sales synergies (from cross-selling and enhanced pricing power) and improved capital efficiency as digitalization efforts promote a shorter cash conversion cycle. While the market has started to appreciate the growth, earnings power, and free cash flow generation potential of the combined entity, we still see plenty of upside at current prices.

Roper Technologies ROP Star Rating: ★★★ Economic Moat Rating: Wide Fair Value Estimate: $453 Fair Value Uncertainty: Medium

Over the years, Roper's exemplary management team has transformed the firm into a wide-moat diversified technology company with a business model that focuses on acquiring asset-light businesses in mature, niche markets and then reinvesting excess cash in businesses that yield incrementally higher rates of return. We expect Roper will benefit from increased adoption of its software-as-a-service and cloud-based solutions, which has accelerated during the pandemic. Roper is a high-quality cash compounder that is rarely cheap, but it's currently trading at a modest discount to our fair value estimate.