Diversified Industrials, Two Years After the Trough

This week--Wednesday, March 9, to be precise--marks the two-year anniversary of the infamous 2009 bottom, when the S&P 500 closed at 676.53. We thought it would be fun to look back to see which diversified industrials have fared the best. Not surprisingly, the entire group has outperformed the market since then, with the Industrial Select SPDR ETF (XLI) up a whopping 156%, or about 50% more than the S&P. The reason for this outperformance is fairly straightforward: Industrial stocks are inherently more volatile. The group, which is made up mostly of manufacturers, is influenced by the inventory cycle in addition to final demand. As such, manufacturers suffer the effects of shrinking inventories throughout the value chain during declines in end-user demand, thereby magnifying revenue declines. During upturns, the dynamic is reversed, making the snapback more pronounced than in many other sectors. In addition, the added earnings volatility makes investors less intent on holding the names through hard times, making share prices gyrate even more wildly than the underlying fundamentals.

Mispricing Trumps Everything
We put together a list of 20 of our highest-profile diversified industrial names, then sorted them according to performance since the market bottomed. As far as business quality goes, the list contains many we'd consider best in class in the industrial space, including 3M  (MMM),  Illinois Tool Works (ITW),  Emerson Electric Co.  (EMR),  United Technologies (UTX),  Danaher (DHR), and  Parker Hannifin (PH), to name a few. Though these names have fared well since that fateful day two years ago, only Parker is among the leaders, and even it is only the fifth-best performer. As the table below shows, the results are likely not what most would have imagined.

And the winner is: Ingersoll Rand, with a 306% gain over the past two years. Yet the company is definitely not a standout among the group as far as financial performance is concerned. The company hasn't earned its cost of capital since 2007, and likely won't do so this year, or next. It isn't currently growing nearly as fast as several others on the list, and doesn't enjoy as strong a balance sheet as many. What's more, it isn't likely overvalued today. Nonetheless it's enjoyed returns nearly double those of Emerson Electric, a company virtually everybody regards as supremely run, and almost two and one half times those of Illinois Tools Works, one of the best-run companies in the group.

So what did Ingersoll Rand have going for it that allowed its stock to run circles around many of fundamentally higher-performing names over the past two years? Mainly, it enjoyed the all-powerful advantage of low expectations. As can be seen in the second column, only  Crane Company (CR), the second-best performing name on the diversified list, traded at a lower multiple of 2010 earnings back then. In fact, only three names on the entire list (the above two, and  Eaton (ETN)) traded below 5.5 times 2010 earnings on that fateful day in 2009, and only two traded below 35% of their Morningstar fair value estimates. Not incidentally, these have generally been the best performers since. By contrast, a look at some of the names whose stock prices that didn't do nearly as well indicates the burden of relatively high expectations.  Ametek (AME), Danaher, and  SPX Corp (SPW) all traded at double the earnings multiple of Ingersoll Rand that day, resulting in significantly poorer stock performance, even though financial performance has been equal or better in most cases. Bottom line, it's better to enjoy the fruits of mispricing engendered by low expectations than to rely solely on improving fundamentals to drive stock prices. Improvement helps, but mispricing is like rocket fuel for your portfolio.

Of course buying the down and out often entails increased risk. Back in 2009, there was some question about whether or not Ingersoll would be able to roll over some debt, making any purchase more dicey than say buying ITW, which maintained a solid balance sheet throughout the crisis.

Now is Not the Time to Buy Industrial Stocks
Which leads us to today, and the question of whether or not there are still any bargains in diversified industrials. In a word, there are few. Only  ITT Corp (ITT) and Crane trade at anything resembling bargain prices, based upon forward P/E multiples, with both stocks residing at about 12.5 times 2011 earnings. The only problem is that our analyst thinks both names are about fairly valued. Both  General Electric (GE) and Illinois Tool likely have some room to run, based upon Morningstar ratings, with each trading at about a 15% discount to intrinsic value. The latter could see better earnings growth than most believe in the years ahead if there's any good news in the housing market. But overall, the group offers investors little margin of safety, meaning today's buyers will have to rely on some pretty heady financial performance in order to beat the market with most industrial names�not the best odds for outstanding returns.

But Probably Not the Time to Sell, Either
However, by and large, the market is far from assigning frothy multiples today, with most names trading at a mid-to-high teens multiple of what are likely to be growing earnings. In addition, many industrial names stand a decent chance to outperform today's expectations. Specifically, those companies that sell into capital spending markets like, for instance, Emerson, General Electric, and  ABB Ltd. (ABB) to name a few, may enjoy a very solid next few years. Capital spending on everything from factory equipment to buses and construction equipment fell to a generational low during the Great Recession. Typically, when this happens, the bounce is more impressive in its magnitude and its persistence than most think. In fact, we wouldn't be surprised to see several years of very rapid growth in some of these late-cycle businesses, as customers spend on plant and equipment to ensure competitiveness.

It's been a heck of a run for those skilled or lucky enough to invest in the most mispriced diversified industrial names two years ago. While the returns from here will undoubtedly be muted in comparison for the entire group, there may still be some gains left in the tank.