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Stock Strategist

Five Industrial Stocks to Keep on Your Radar Screen

These firms are less cyclical than you might think.

When presented with the opportunity to invest in an industrial firm, many investors think of the dreaded "cycle" and run screaming for the door. Well, maybe their reaction isn't that dramatic, but the cyclicality that plagues a large swath of industrial companies is often enough of a concern to keep investors from considering most industrial firms for long-term investment. It shouldn't be.

Sure, some investors are able to profit from cyclicality by buying when the cycle is at a trough and selling when the cycle peaks, without regard to firm quality. That approach requires some luck, though, given the market-timing necessary to predict an inherently unpredictable cycle, and most investors are less successful at it than they'd lead you to believe. As long-term investors, we tend to shy away from that strategy, since it gets away from the idea of buying a piece of a business and moves closer to gambling. We think there is a better way to invest in industrials.

Some industrial firms are more cycle-resistant than they initially appear, and not surprisingly they typically have an economic moat. We believe this can occur in three ways:

1. They have a more variable cost structure.
The second thing--after cyclicality--many investors think of when contemplating industrial firms is asset intensity. When the cycle turns downward, firms loaded with hard assets get crushed as their assets become underutilized. There are several "asset-light" firms, however, that are able to flex up and down fluidly with demand. Trucking firm  Forward Air (FWRD), for example, doesn't own any trucks, instead opting to hire owner-operators. When the economy goes south, it simply uses fewer owner-operators. Similarly, truck brokerage firm  C.H. Robinson Worldwide (CHRW) works with thousands of trucking companies, but, like Forward Air, it can trim down its "supplier base" at any time without taking a bite out of its profits or endangering future business.

2. Their profits are less cyclical than their revenues.
The dealership business model, in particular, results in profits that are less cyclical than revenues. Why? An investor might think, "New car/truck sales are going to be depressed for a while, so I bet XYZ automotive dealership is going to have a rough couple of quarters." What these investors miss is, for dealerships like  Sonic Automotive (SAH) and  Rush Enterprises (RUSHA), the lion's share of profits stem not from new car or truck sales, but sales of parts and service (had your car fixed lately?). Parts and service may take a hit when gas prices spike for an extended period, but are otherwise generally not considered cyclical. Though dealerships are part industrial firms and part retail firms, they often erroneously trade in step with the cycle of the industrial product they sell--until the market realizes its mistake.

3. They are geographically diversified.
Some firms have become substantially more geographically diversified over the years, but the market stubbornly refuses to give them much credit for having done so. Truck manufacturer  PACCAR (PCAR) is a good example. The firm now generates more than half its sales outside the U.S., yet still trades as though it were beholden to the North American Class 8 truck cycle, which isn't necessarily correlated to the European Class 8 cycle. The primary reason for the misunderstanding: The N.A. Class 8 cycle is the most visible one to investors, interpreted by many as a proxy for overall truck sales. The firm isn't as strong when Class 8 truck sales are down, but not as weak as the market would lead one to believe.

Despite these companies' resistance to the cycle, the market often misprices them. As a result, their stock prices typically get whacked in disproportion to their decrease in profitability, creating excellent buying opportunities for the savvy investors who understand this dynamic. Here's a recap of the five stocks with one of the above attributes that we believe should be on every investor's watch list:

Forward Air (FWRD)
Analyst: Peter Smith
Fair Value Estimate: $40
Consider Buy: $30.80
From the  Analyst Report: Forward Air is the market leader in a niche within the freight transportation industry that its competitors can't seem to crack. This has translated into impressive profitability and boatloads of free cash flow, making it the kind of company we'd want to buy and hold.

C.H. Robinson Worldwide (CHRW)
Analyst: Nicolas Owens
Fair Value Estimate: $54
Consider Buy: $41.60
From the  Analyst Report: Don't confuse C.H. Robinson with a trucking company that owns trucks. It owns none. Instead, it works with thousands of trucking companies across the country using a mixture of on-the-spot transactions, short- and long-term contracts, and long-standing relationships. Firms that own trucks covet repeat cargo shipments along predictable routes and scramble to fill their trucks with something (anything!) on the way home. Some truckers rely entirely on Robinson to fill their trucking capacity as efficiently as possible.

Sonic Automotive (SAH)
Analyst: John Novak
Fair Value Estimate: $31
Consider Buy: $23.90
From the  Analyst Report: While many auto manufacturers and parts suppliers struggle to earn their cost of capital in the best of times, auto dealerships have proved they can be good businesses. Franchise agreements with auto manufacturers fetter competition, and vehicles serve as collateral for low-cost inventory financing, which reduces working capital needs. In addition, dealers' profits can grow despite the vagaries of new car sales, since we estimate post-sale services and parts sales generate about 50% of operating income.

Rush Enterprises (RUSHA)
Analyst: Peter Smith
Fair Value Estimate: $15
Consider Buy: $11.60
From the  Analyst Report: The fixed costs of a truck dealership are lower than those of a manufacturer, making profits less volatile when truck sales swing. Also, selling parts and service is both more profitable than selling vehicles and more stable--Rush's profits won't take as much of a hit when truck sales are soft because the existing trucking fleet will still need maintenance and parts. Rush is rapidly approaching the point where it would still be profitable even if it didn't sell a single truck.

PACCAR (PCAR)
Analyst: Peter Smith
Fair Value Estimate: $82
Consider Buy: $63.20
From the  Analyst Report: The firm aggressively manages production rates and operating costs, which allows it to adjust its production volume without adding fixed costs. It makes up for its higher variable costs by leveraging its premium reputation to raise prices. Also, end-market diversity (less than 50% of revenue comes from the United States) and steady part revenue helps reduce profit volatility.

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