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Quarter-End Insights

Our Outlook for Industrial Stocks

The largest decline in industrial production may finally have ended.

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Our outlook for U.S. industrial activity has brightened for the rest of 2009 and into 2010, as several indicators that looked as if they might be bottoming earlier this year may have finally turned the corner in the just-ended three-month period.

In prior outlooks we outlined that some of the leading indicators, such as the ISM purchasing managers survey and the architectural billings index, were starting to trend positive, and that certain subsets of the ISM report, such as new orders, were even stronger than the headline numbers. At that point, we thought a bottom in industrial production was likely in the not-so-distant future, but we couldn't pin down exactly when. Fortunately, the just-finished quarter may have provided the data we needed to declare an end to what's sure to go down as one of the worst periods in modern manufacturing history.

The widely followed industrial production index published by the Federal Reserve put in two consecutive gains in July and August for the first time since the recession began in December 2007. So, indeed, a bottom may be forming as we write. Yet if the bottom in U.S. manufacturing activity has actually occurred (as we believe), it happened after the sector suffered its worst decline in more than 60 years. In short, industrial production hasn't suffered a worse decline since World War II came to a close in the mid-1940s. This is important, as some economists argue that the strength of a recovery is almost always a function of the depth of the corresponding downturn. If this is the case, the industrial economy is in for a much more impressive upturn than either of the past two recoveries.

There's additional evidence to back this optimism. In the above-mentioned ISM report, the ratio of new orders to inventories indicates that industrial production will be materially higher 12 months hence as businesses work to rebuild significantly depleted inventories. The ratio hasn't been this extreme for 30 years (high orders divided by low inventories), and has only sat at this level or higher in 10 months out of the 740 months measured. Each time, industrial production has been at least 8% higher one year later. We're not implying an 8% expansion in industrial production is in the bag, but we're not ruling it out, either. In short, investors shouldn't be surprised if industrial output stages an impressive recovery over the next several quarters, as it's generally a normal occurrence after a steep decline such as the one just suffered. The Economic Cycle Research Institute seems to agree, as it has been on record saying that a double-dip recession is out of the question, and that its indicators haven't been this positive in more than 20 years.

Valuations by Industry
Current prices across the sector are discounting a pretty optimistic outlook, however, as industrial stocks, represented by the  Industrial Select Sector SPDR (XLI) ETF, have rallied by more than 77% from their March lows. Names tied to the auto sector have led the pack, but this is due in large part to an overly pessimistic (even more so than the average stock) view by investors last spring. Residential construction-related names have also fared well as the residential production outlook improved from dismal in the early summer to merely pretty bad currently. These names also had extreme pessimism priced into them back in March.

 Industrials Industry Valuations
   Star Rating Price/Fair
P/FV Three
Months Prior
Change (%) Industry FV
Aerospace & Defense - Maj Diversified 2.72 1.01 0.99 2 87
Auto Dealerships 3.00 0.98 0.88 11 46
Airlines 2.70 1.31 0.97 35 69
Auto & Truck Manufacturing 3.49 0.82 0.82 0 60
Auto Parts Manufacturing  2.97 1.03 0.97 6 88
Diversified 3.61 0.78 0.71 10 17
Electronic Equipment 2.70 1.19 1.37 -13 99
Farm & Construction Machinery 3.27 0.94 0.89 6 42
Homebuilding & Construction Products 3.03 0.83 0.69 20 24
Industrial Distribution 3.00 1.01 0.90 12 73
Industrial Products 2.78 1.05 0.92 14 53
Logistics 3.61 0.86 0.77 12 26
Railroads 2.62 1.02 0.92 11 50
Trucking 3.03 1.20 0.94 28 63

Data as of 09-14-09.
*Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

The lowest rated industry in aggregate is currently railroads, while the highest is our diversified manufacturers. The latter group is highly affected by GE, which remains one of our cheapest names, even after a 180% run from its March low. Unfortunately, no groups offer outstanding value at today's levels, as margins of safety remain slim.

Our Top Industrials Picks
That said, we believe investors can still earn above-average returns in a few names.

 Top Industrials Sector Picks
   Star Rating Fair Value
Fair Value
Mohawk  $79.00 Narrow Medium 0.6
Spirit Aerosystems  $27.00 None Medium 0.6
UTI Worldwide $24.00 Narrow Medium 0.4
General Electric  $25.00 Wide High 1.1
Data as of 09-25-09.

 Mohawk Industries (MHK)
Mohawk Industries has posted an impressive triple-digit recovery off the depressed prices it reached back in March, but we still think the stock has plenty of room to run. With control over roughly one quarter of the total U.S. flooring market, Mohawk stands to be a prime beneficiary of an even modest recovery in the housing and renovation market. While the company is currently operating at significantly depressed profitability levels, we believe it has the ability to maintain earnings of $5-$6 per share in a more normalized economic environment. At current market prices, Mohawk still appears deeply undervalued relative to its sustainable earning power and offers investors an indirect way to profit from a housing recovery.

 Spirit Aerosystems (SPR)
Formerly a division of  Boeing (BA), Spirit builds fuselages, wings, and engine components for its former parent, Airbus, and other commercial-aircraft manufacturers. Its revenue is heavily levered to these firms' delivery schedules, and can swing dramatically in the face of altered dynamics. In late 2008, for instance, Spirit halved its Boeing-related production levels in response to the customer's machinist strike. Nonetheless, thawing credit markets and recent capital-raising activity by airlines suggest that aircraft backlogs may be more solid than originally expected, and high-dollar content on the upcoming Boeing 787 and Airbus A350 should drive substantial long-term growth for the supplier.

 UTI Worldwide 
Not as profitable as its more well-known competitor  Expeditors International (EXPD), UTI Worldwide has nonetheless knit together an impressive freight-forwarding and logistics web capable of serving as its clients' single-source international shipping solution. The difficulty of establishing such a network establishes a narrow economic moat guarding the firm's profits from potential competitors. We believe the logistics market is attractive and consider UTI to be well-positioned to continue to generate returns in excess of its cost of capital. Current conditions combined with some internal issues are currently weighing on the name, but we don't expect this to last forever.

 General Electric (GE)
General Electric is well-positioned in the areas where governments are targeting spending, and it will therefore enjoy tailwinds in businesses such as energy and health care. Moreover, as emerging markets continue to develop, GE's products and services are vital to their growth. Increased demand in these regions provides new end markets and a bigger installed base from which to generate high-margin service revenue. Doomsday scenarios around GE Capital are now probably off the table, and the likelihood of material external capital raises have diminished. The company has managed to hit all stated targets with regards to shrinking GE Capital and shifting its funding model, indicating GE likely will be able to successfully complete this transformation. And though we're not happy the company had to cut its dividend, the move freed up an additional $9 billion of cash flow per year that it can invest back into its businesses. With heavy global investment in energy infrastructure on the way, there are plenty of avenues for the company to grow.

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Eric Landry does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.