Our Outlook for Industrials Stocks

• U.S. macro data is sending mixed signals as sentiment indicators remain high, but production and orders remain moderate. Companies have adjusted to the current growth environment and have largely delivered healthy profitability.

• Domestic housing demand is above pre-recession levels, but rising interest rates (increasing the financed cost of homes) and labor shortages have held near-term production below the market's and our near-term expectations.

• The sector's valuations have drifted ahead of our fair value estimates, with an average price/fair value of 1.07. Auto manufacturers continue to trade at a discount to our fair value estimate.

Mixed signals from the global economic environment have provided the backdrop for industrial activity in the third quarter, as has been prevalent for the last several quarters. The purchasing managers' indexes have hugged 50 (any reading over 50 suggests positive growth expectations) for the non-U.S. regions that we track, though, surprisingly, Europe pushed over 50 for two consecutive months, led by the British service sector; this has not happened since July 2011. August PMI in the United States was 55.7, continuing a trend of recent strength. Offsetting the improvement in Europe and the U.S., Chinese growth continued to moderate in the quarter as the country's PMI struggled to break 50.

Mining activity within U.S. industrial production in August continued its upward trend, up 7.5% versus the prior year and month-to-month up 0.3% primarily thanks to higher oil and gas extraction. Based on absolute index values, mining activity remained at a record pace, the highest in 30 years. That said, global manufacturers of mining equipment have grappled with lower demand as worldwide industrial mining activity has adjusted to slowing Chinese consumption levels.

In contrast to some of the sentiment indicators and strength in domestic mining, durable goods orders excluding transportation and defense was down 0.7% following three consecutive monthly increases. The decline was driven by tepid demand from manufacturers as sluggish consumer spending provided little incentive for manufacturers to make incremental investments in operations. In spite of the variety of signals from the economic readings, industrial production is still fairly steady and manufacturers have adapted to a slow, but stable level of production.

Housing Demand Up, but Not as Much as We Thought
Entering the third quarter, interest rates had risen 100 basis points in less than six weeks. This negatively affected the affordability of housing, dampening demand through the summer. In addition to a rising interest rate environment, a labor shortage in new-home construction also lengthened build times. Whereas there was a seemingly endless supply of construction labor during the housing boom, the deep recession forced skilled labor to find other jobs, leaving a gap of capable hands to meet demand. While this crimped demand for 2013, we see this as a near-term factor that simply affects the timing of cash flows for homebuilders. We lowered our fair value estimates for a number of firms in the housing sector to account for the delay in the timing of eventual new home purchases, but our midcycle production annual estimate of 830,000 single-family homes by 2017 is still intact.

We believe the central undercurrent driving the housing recovery, namely, pent-up demand and relative affordability, remain in place. The main barriers to this theme playing out would be an economic recession and a reduction in current government incentives to buy and own a home, and the latter seems highly unlikely. Even though some regions have performed stronger than others, there is still a meaningful gap between current production and what we assume to be normalized demand levels, indicating a sustainable rebound.

After a rocky start to the summer, commercial construction in the United States has found its footing. The architectural billings index remained above 50, indicating growth. Mixed-use buildings were the clear leader of the pack, though commercial/industrial and multifamily units remained strong in the period as well. Surprisingly, the new projects inquiry index gained 6.6% month to month, up to 66.7. Traditionally, the commercial construction cycle lags the housing construction cycle 12-18 months, which points to a more pronounced recovery in 2014.

Diversified Industrial Firms Shore Up Portfolios Through Divestitures
With the broader economy stabilizing, diversified industrial firms have looked to refine existing holdings by divesting businesses. Siemens (SI) successfully spun off its lighting business to shareholders to kick off the quarter, allowing Siemens to direct its attention and capital to core growth platforms. Dover (DOV) also announced the decision to exit a majority of its communications technology business in spite of firm-leading growth prospects and profitability.

The flurry of activity is not over, though, as we expect that General Electric (GE) will also focus on exiting parts of its financial business arm in an effort to emphasize the growing industrial portfolio and return cash to shareholders. The moves across the industry not only relieve management's attention, but also give companies more capital to plow into core operations and acquisitions.

Near-Record Farm Output Yields Strong Cash Receipts for Farmers
In an about-face from last year's drought-filled growing season, farms look to haul in near-record levels of corn and soy in 2013. The extra output was not just isolated to the United States, as production in Argentina and Brazil rebounded from recent weakness. While the strong growing season helped pad farmer pockets, demand for new farm equipment may not follow in lock-step. With lower demand for corn products for ethanol use, the glut of supply may mute farmed commodity prices for the medium term.

Although new equipment demand may be soft in the near future, the moat prospects for our firms under coverage remain healthy, particularly Deere's (DE) narrow economic moat. Major OEMs have maintained pricing discipline during previous volume declines and there is little to suggest a change going forward. Additionally, broad distribution networks support aftermarket equipment sales and strengthen customer relationships.

Market Expectations Outpace Fundamentals in 3-D Printing Sector
In what is becoming a recurring theme, the market's outlook for 3-D printer companies outpaces some of the constraints on the firms, and makes inorganic growth an expensive growth path. Organic growth at 3-D printing firms continues to moderate; while still strong at just under 20%, there is little room for error with lofty valuations exceeding 50 times adjusted earnings. Additionally, competition continues to intensify in lower-priced 3-D printers, making that market less attractive to broad-line printers 3D Systems (DDD) and Stratasys (SSYS).

Acquisitions have been a key focus of the capital allocation strategy for the industry, but elevated valuations make it difficult for new deals to be accretive in the near or medium term without significant growth.

That said, we are surprised by how quickly large industrial manufacturers have begun exploring the technology to see how 3-D printing may be useful to their existing business models. To date, General Electric stands out as the pioneer, embedding 3-D printing in its aerospace business, but we anticipate further penetration in the coming years.

Discounted Stocks Are Tougher to Find
Industrial stock performance, as measured by the Industrial Select Sector SPDR (XLI), outperformed the broader S&P 500 index by 320 basis points over the last three months as weak production numbers were largely already factored into stock prices and corporate results came in generally better than expected in the quarter. The sector enjoyed positive contributions from aerospace and defense, conglomerates, and auto stocks.

After a strong performance in the quarter, we believe the industrial sector is slightly overvalued, with stocks trading 1.07 times our fair value estimate, on average. That said, there are still pockets of opportunities affording an adequate margin of safety within the sector. Third-party-transportation and logistics companies in particular remain at a discount to our fair value estimates as cyclical concerns outweigh otherwise strong business fundamentals. While housing valuations have cooled a bit since our initiation on the sector earlier this month, most homebuilding companies are still trading at significant premiums to our fair value estimates; only NVR offers a suitable margin of safety, in our opinion.

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
CH Robinson Worldwide		$69.00	Wide	Medium	$48.30
Fiat Group SpA		$19.00	None	High	$11.40
General Motors		$52.00	None	High	$31.20
NVR		$1,150.00	None	Medium	$805.00
Data as of 09-20-13

CH Robinson Worldwide (CHRW)
Near-term pressure on gross margins and concerns about net revenue growth have depressed valuations for this wide-moat truck broker. While the market fixates on tighter truck capacity negatively affecting broker margins, we think the firm is capable of posting high-single-digit average net revenue growth over the long run as it continues to take market share from less sophisticated providers and asset-based carriers. Moreover, the firm's newfound scale in global freight forwarding (following the Phoenix acquisition) should support incremental growth once airfreight demand recovers.

Fiat
European automobile manufacturer Fiat is in the middle of a turnaround that has the potential to reshape the firm's profitability profile and has already started bearing fruit. In our opinion, the market irrationally discounts the underlying assets, the high probability that management will dramatically reduce operating break-even, the impact of a reinvigorated model lineup, and the potential for the combined Fiat-Chrysler to generate substantial free cash flow.

General Motors (GM)
GM is also poised to see the upside to a high degree of operating leverage. Many investors are focused on the admittedly large pension/OPEB underfunding and the overhang of government and VEBA ownership. However, the pension will not all be due at once; the December 2012 U.S. Treasury announcement of a share repurchase by GM, a so-far orderly sale of Treasury's remaining 300 million shares, and GM joining the S&P 500 have moved the stock well off its 2012 low of $18.72. Old GM broke even with 25% U.S. share and a U.S. industry sales level of 15.5 million units while new GM breaks even at just 10.5 million units with 18%-19% share.

NVR (NVR)
NVR is our top pick in the housing industry. The firm, currently trading at a discount to our $1,150 fair value estimate, has a strong track record for producing profits in any environment. The firm has less leverage than peers to an improving market, but a differentiated business model hinging on using land options as opposed to outright land acquisition strategies has helped prop up free cash flow and shareholder returns. While we do not assign a moat to any firm in the housing sector, NVR stands out among peers as a firm built for long-term success.

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