Our Outlook for Industrial Stocks
Domestic capital spending is set for a long period of growth.
Quarter-End Insights
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- It appears industrial activity may be emerging from its late summer/early fall funk.
- If the magnitude of the upturn is a function of the size of the downturn, investors are in for a period of very impressive year-over-year growth in capital spending.
- The market has already priced in most of the positive good news we're seeing, but a handful of businesses facing unique situations could offer long-term potential gains for investors.
In the industrial space, all one needs to do is attend any analyst day, listen to any earnings conference call, or talk to any management team to figure out that investment in emerging markets is top of mind for every single multinational player.
Indeed, recent presentations from Illinois Tool Works (ITW), 3M (MMM), General Electric (GE), and many others have highlighted strategies to capture their share of growth in public infrastructure investment, emerging consumer durable and nondurable consumption, and health-care infrastructure upgrades--just to name a few areas of focus in these regions. These strategies, of course, are not new, as every forward-thinking management team has had emerging markets in its sights for decades. And in fact, most of these growth initiatives are well understood by the investment community by now, as most investors know the developed world will grow much more slowly than the scrappy upstart developing nations in Asia, India, and South America. As a result, we think many industrial valuations reflect significant expectations of emerging-markets growth in the years ahead.
Capital Spending Set to Increase
Yet a burgeoning trend closer to home warrants close attention as well. Regular readers will remember that in last quarter's outlook, we mentioned that a sustained period of high investment rates in the United States was a distinct possibility after what we thought may be a short period of sluggish industrial activity. Fortunately our prediction of a short period may turn out to be very short indeed and likely very shallow, as it appears industrial activity may be emerging from its late summer/early fall funk. And even better, it now appears as if a capital spending boom is materializing before our eyes.
In this outlook we'll explain exactly what we mean by examining real gross fixed investment in industrial, transportation, and construction equipment as a percentage of real GDP. These three categories include things like engines and turbines, electrical transmission equipment, material handling equipment, metalworking machinery, trucks, buses, airplanes, railroad equipment, office furniture and fixtures, as well as agricultural, construction, and mining machinery.
In essence, by taking these three categories, we're isolating the non-structure-, non-technology-based sectors of the economy that eventually wear out. As such, prolonged periods of under investment beget periods of high investment once the trend turns. Such a turn is afoot, meaning investors can look forward to a prolonged period of above-average growth in these sectors here in the states.
Over the past three decades or so, real gross fixed investment in industrial, transportation, and construction equipment has averaged about 4% of annual real GDP in the United States. In the roughly 25 years before that, aggregate investment in these categories averaged 5.2%. In the period of 1964 through the early 2000s (we'll get to the latest contraction later), spending in this area has suffered three significant contractions, all coinciding with recessions. The first was from 1979 through 1982, the second from 1990 through 1992, and the last was 2000 through 2004. As seen on the chart below, the declines ranged from more than 1.5 points relative to GDP to roughly one half of a point relative to GDP.
Importantly, the periods immediately after the above-mentioned three contractions enjoyed sustained high growth as companies restart investing in their businesses again. The table below shows that the ranges span from 7 to 29 quarters of nominal growth above 5% in year-over-year investment, and 4 to 12 above 10%.
| Expansionary Periods in Capital Spending | ||
 | | |
| No. of Quarters with Ann. Growth of: | ||
| ||
| 5% | 10% | |
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| After 1982 bottom | 7 | 4 |
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| After 1992 bottom | 29 | 12 |
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| After 2004 bottom | 11 | 6 |
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| After 2009 bottom | 2 | 2 |
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Fast forward to the great recession this country recently endured, and you'll see what amounts to the largest downturn in capital spending in several decades, as aggregate real GFI in the above three mentioned categories hit an unprecedented low of 2.6% in mid-2009. This dismal performance dwarfs anything in recent history, so if indeed the magnitude of the upturn is a function of the size of the downturn, investors are in for a period of very impressive year-over-year growth in capital spending. What's more, the booms that generally follow busts seem to get prolonged as the goods-producing sector furthers its mechanization over the decades.
Indeed, this uptick in capital spending is already happening, as companies such as Emerson Electric (EMR) are enjoying very firm order books, with orders in segments like industrial automation and process control growing at more than 20% for several months now. Similarly, Caterpillar's (CAT) retail sales to end-market users have climbed steadily throughout the year, and mining equipment manufacturer Joy Global saw its backlog climb 20% year-over-year in the fiscal year finished in October. We expect these trends to continue, though possibly with a bit of moderation, for several more quarters.
Other Areas of Interest
2011 promises to be a pivotal year not just in capital spending, but in other areas of durable consumption as well. Specifically in automotive, we expect the domestic recovery that started last year to continue its momentum. 2010 saw roughly 11.6 million vehicles sold, up from 10.4 million in 2009. This year we expect somewhere in the 13 million-unit range, with 2012 and 2013 approaching midteens.
If we're right, investors can make some money in companies exhibiting high operating leverage, which today is most of the industry. Specifically, both Ford (F) and GM (GM) have remade their cost structures such that they can break even at the 10 million to 11 million sales range. The companies become highly profitable in the low-teens range. Both names currently rate 4 stars, so investors should be alert for buying opportunities.
Though no longer screamingly cheap, there are also some opportunities in the dealer space. Lastly, third-party logistics operator Pacer is somewhat levered to auto production, as a large chunk of its business is centered on shipping auto parts to and from Mexican plants.
Probably the least expected positive event in the industrial space in 2011 would be a rebound in housing. Officially, we're not expecting material improvement from this sector until 2012, but that doesn't mean there isn't opportunity today. For example, not much is expected of companies like Masco (MAS) that sell cabinets, paint, and faucets. Yet much like the abovementioned industrial, transportation, and construction equipment, gross fixed investment in residential structures has been severely constricted for the past several years. This sector, too, will rebound, and when it does, it may be at a pace faster than many expect. As a result, the risk/reward proposition of owning companies levered to this sector is compelling today.
The longer the doldrums continue, the stronger the eventual rebound becomes, as today's pace of construction is roughly a third of normal demand. In addition, the amount of empty new homes currently sitting on the market is the lowest in 40 years, and many of the companies related to this space have been restructuring for more than three years. If and when employment and consumer confidence pick up, a strong rebound in housing won't be far behind. In addition to Masco, investors who don't mind going down the business-quality spectrum may want to look at a select group of homebuilders. We think KB Home (KBH) is cheap, and Lennar (LEN) remains a good bet, though not quite as inexpensive at today's levels.
Aerospace & Defense Facing Headwinds
In the defense sector, concerns over a declining defense budget will continue dictating sector valuation, at least over the short term. As the newly minted Congress and the Senate mull over ways to meaningfully reduce the federal budget deficit, defense spending should come under the knife. Meanwhile the Department of Defense is on record aiming to achieve $100 billion in "cost efficiencies" over the next five years. Forced to perform similar obligations, though under a restrained budget, the DoD will look to squeeze more out of its contractors. Thus, profitability of defense contractors is likely to suffer in the coming quarters.
Weak revenue growth and limited margin upside bodes poorly for valuation, and the market has factored in the decline to some extent. Many defense stocks are now trading for nearly 10 times their forward earnings, signifying that little future growth is expected. Defense contractors have to also contend with historically low interest rates that force pension expense sharply higher. With reported earnings trending lower, and the macro environment showing no catalyst for growth, stock prices of many in the group are unlikely to appreciate in the short run. Nonetheless, we still believe stellar names such as United Technologies (UTX) and Lockheed Martin (LMT) are cheap.
Many Industrial Names Look Fully Valued
Today, many names associated with capital spending don't currently offer investors a suitable margin of safety due to their stellar performance over the past year. However, a couple of industries we currently see as substantially undervalued are automotive services (with a price/fair value estimate average of 0.78) and automotive manufacturing (0.82 price/fair value estimate). As mentioned above, we think the current run rate of car sales is far below a natural replacement rate, and several dealership operators, suppliers, and OEMs are slated to benefit as volumes rebound.
We view aerospace and defense as overvalued, on average, due to the above-mentioned Department of Defense budget cuts, and we think the market is pricing in an optimistic scenario for farm and construction machinery stocks.
| Top Industrials Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/FVE | |
| |||||
| General Motors |  | $46.00 | None | High | 0.74 |
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| Pacer International | | $8.50 | None | High | 0.77 |
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| St. Joe |  | $40.00 | Wide | High | 0.53 |
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| UTi Worldwide | | $24.00 | Narrow | Medium | 0.86 |
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| Data as of 12-17-10. |
General Motors (GM)
Although the "Government Motors" stigma is likely to hang over General Motors Company for several years, we think GM's car models have their best quality and design in decades. New GM is a dramatically different company than old GM, especially in the United States. We think normative demand for U.S. light-vehicle sales is about 16 million-17 million vehicles, and GM has said its North American operating profit breaks even at U.S. industry sales of 10.5 million-11 million. We believe the industry's volumes are slated for recovery, and GM's high degree of operating leverage means the firm will be printing money when sales rebound.
Pacer International
Pacer International is one of largest intermodal operators in North America, but the company is in the midst of a big transformation. The firm plans a major technology upgrade by implementing a more comprehensive SAP system that will save the company $20 million per year. Peer Hub Group (HUBG) was able to develop sophisticated information systems, integrate widespread operations, and double margins; while we're unsure of Pacer's ultimate level of improvement, we think investors willing to remain patient could see the firm eventually enjoy substantially better results.
St. Joe (JOE)
St. Joe owns vast tracts of land adjacent to the brand new Florida Beaches International Airport in Bay County, Fla. Though not much is happening currently to excite investors, we anticipate a much more eventful 2011. St. Joe is the sole owner of all developable acreage for miles around a facility that promises to be a driver of above-average economic activity for decades to come, offering unique potential. As such, it shouldn't take long for investors to catch on that the company's holdings are worth much more than the current stock price implies.
UTi Worldwide
Uti operates in the attractive freight-forwarding business, but we think the company needs some housecleaning before it reaches its full potential. New CEO Eric Kirchner accomplished part of what UTi needs to do when he integrated acquired logistics firms into a unified information platform at previous employer UPS (UPS). UTi already produces attractive ROICs of more than 20%, on average (excluding restructuring charges), but we think the company could have some capacity for additional profitability improvement as operations are transitioned to a single IT platform.
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