Industrials: Macroeconomic Tailwinds Lift Market Valuations

• As a whole, our industrials coverage universe appears fairly valued on average, with many subsectors lingering in overvalued territory. Nonetheless, the space is not without pockets of opportunity.
• Industrials have enjoyed tailwinds from generally healthy macroeconomic conditions, particularly in the United States, and investors seem to be extrapolating those trends out over the long run.
• Global trade has seen healthy expansion since the middle of 2013, providing a boost to many industrials stocks, especially those in transportation.

Continuing the theme of recent quarters, we find few bargains throughout our industrials coverage. Only about 19 stocks (out of roughly 160) trade in 4-star territory, and we currently have no firms in the 5-star range. That said, this dynamic doesn't deviate too far from the broader market. At the time of writing, industrials stocks carried a market price/Morningstar fair value estimate ratio near 1.07 (7% overvalued compared with our discounted cash flow derived fair value estimates), while all stocks that Morningstar covers hovered near 1.02.

Among the most expensive subsectors are trucking, airlines, truck manufacturing, and auto dealers, ranging from 16% to 43% overvalued--the asset-based truckload and less-than-truckload carriers hover at the high end of that range. Other subsectors such as third-party logistics, the railroads, and business services also carry healthy market valuations, but aren't quite as lofty.

Despite generally rich valuations across the industrials space, however, some pockets of value still exist. As highlighted in the top picks section below, our best ideas include

), automaker

Naturally, idiosyncratic influences vary by company, but broadly speaking, we suspect rich industrials-sector valuations reflect healthy macroeconomic conditions and related optimism. Economic tailwinds have supported decent demand and pricing in most industries. Firms have also become leaner and more efficient since the 2008-09 downturn, providing fertile ground for incremental operating leverage and margin gains. In many cases, we suspect investors are extrapolating these positive operating trends out over the long run.

Overall, U.S. real GDP grew at an annual rate of 5.0% in the third quarter of 2014, beating the solid 4.6% growth rate of the second quarter, which saw an incremental boost from pent-up demand carrying over from early 2014 weather disruptions. Industrial production has also been quite favorable this year, increasing an average of 4% (year over year) through October, and about 4.5% in the third quarter. Manufacturing output rose more than 3% over that time, including 4% in the third quarter. The U.S. PMI came in at 58.7 in November, also signaling solid growth, particularly in new orders and production. Recall that this metric hit 59.0 in August, the highest reading since early 2011.

In terms of other key indicators, the architecture billings index, which came in at 53.7 in October, continues to point to healthy construction activity, driven in part by multifamily and institutional-related projects. A showing above 50 indicates increased billing activity. Although the index declined sequentially from September (55.2), we remain optimistic about U.S. nonresidential construction, which is well below midcycle levels.

In the auto sector, light-vehicle volume was up 4.6% year over year in November, with the seasonally adjusted annualized selling rate at 17.22 million, according to Automotive News. This was the second-highest showing of the year after August's 17.53 million. Behind the strength are solid consumer confidence, relatively easy credit, and an old vehicle fleet; we anticipate continued growth in 2015.

In transportation, freight demand remains solid for the trucking industry, with the ATA truck tonnage index up more than 3% through October year over year, and carrier commentary points to a solid peak season this year. Further, highway brokers and carriers are both seeing robust pricing power thanks to secular truckload-capacity constraints, which should persist in 2015. Rail carload volume remains positive, increasing roughly 4% year to date (through November), supported in part by strong grain and crude oil shipments; coal shipments have been flat this year. Despite ongoing rail service issues, intermodal activity continues to expand as well (up about 5%), with help from shippers' heightened focus on multimodal planning (truck to rail conversions).

Beyond the United States, the Markit Eurozone Composite PMI has signaled expansion (above 50) all year. That said, the reading peaked at 54.0 in April and has gradually declined, coming in at 51.1 for November. Thus, unlike trends in the United States, there are hints of moderation in eurozone manufacturing (particularly in Germany, France, and Spain), which originally started recovering in the middle of last year.

International trade flows on key Asia-U.S. and Asia-Europe freight lanes have been improving since the middle of 2013, and industry commentary suggests fourth-quarter trends remain healthy. These factors are providing a boost to firms across the transportation space. Of note, underlying macroeconomic conditions in the United States (in particular) and Europe have proved generally favorable for import trends. Import activity increased an average of 3.6% and 2.3% (year over year) for the U.S. and the eurozone, respectively, during the first nine months of 2014, according to the CPB World Trade Monitor. Along those lines, international air cargo tonnage expanded 5% over that period, with global containerized ocean volume growing just shy of 4%.

After two years in the doldrums--between mid-2011 through mid-2013--recovering airfreight demand is reviving the asset-light global forwarding space, benefiting providers such as

) has seen meaningful operational improvement over the past year as well, as decent container demand on core European trade lanes helped mitigate the unfavorable impact of chronic industry overcapacity and rate volatility.

Additionally, global integrators such as

(

) have posted solid intercontinental express-parcel activity. In fact, UPS expects a healthy 3%-4% volume uptick in the fourth quarter in its international package business. On the domestic front, favorable import trends have also contributed to intermodal growth, which in turn profits the Class I rails, as well as intermodal marketing companies such as

AGCO

AGCO

We see an upside opportunity in out-of-favor agricultural equipment manufacturer AGCO. Approximately 25% of revenue comes from the high-profile North American agricultural market, which is suffering from a steep drop in crop prices. While North American tractor sales will decline in 2014 and 2015, AGCO's grain storage and animal feed business, GSI, should do well as farmers buy grain silos to store crops for a more robust market. Additionally, 2014 was good for livestock farmers, who are spending profits on GSI's feed equipment.

The South American business should also do better in 2015. A 2014 delay in renewing Brazil's equipment financing subsidy program caused a 20% decline in AGCO's South American farm equipment sales, but with that program renewed for 2015, this should improve the outlook in a region responsible for 18% of sales.

While AGCO has no moat, during the last decade, the company has transformed itself from a barely profitable portfolio of farm equipment brands into a fairly profitable company with attractive global diversification and some countercyclical sales characteristics. Profitability should continue to improve over the long term. In mid-2015, it will begin to consolidate its small-tractor manufacturing, an initiative we expect to add 70 to 100 basis points to AGCO's 7% operating margin over the next several years.

Management shares our positive sentiment and purchased 7% of shares outstanding over the first nine months of 2014. Additionally, an AGCO affiliate and board member has purchased 3% of outstanding shares over the September through November time span and has expressed intentions to acquire more stock in the company.

Fiat Chrysler

FCAU

We believe no-moat Fiat Chrysler has long been overly discounted and misunderstood by the market. However, we think this 4-star-rated stock is appropriate only for investors who are willing to accept the risks of a turnaround situation with a leveraged balance sheet in a cyclical, capital-intensive, highly competitive industry.

Our $15 fair value estimate includes the expectation that Italian demand will remain in a protracted recovery well into the second half of this decade; that Fiat retains its top market share in Brazil, albeit on an 18% slump in Fiat Latin American revenue for 2014; and estimated revenue and EBITDA that is roughly 20% below management's five-year plan.

At the beginning of 2014, the company purchased the remaining 41.5% stake in Chrysler that it did not already own. Fiat's ownership in Chrysler will enhance margin and returns as the two companies integrate common vehicle architectures and parts while making more efficient use of capacity, engineering, and corporate functions.

As of Oct. 13, the new entity incorporated in the Netherlands, and its corporate address is now in the U.K. Fiat Chrysler Automobile NV exchanged 1:1 new common for old shares of Fiat SpA. New shares are trading on the New York Stock Exchange under the ticker FCAU, with a secondary listing on the Milan exchange under the ticker FCA. The company has announced financing transactions that should take place during fourth-quarter 2014 and in 2015, including a secondary 100 million share offering of Fiat Chrysler treasury stock, up to $2.875 billion in mandatory convertible bonds, an IPO of 10% of Ferrari with Fiat's remaining 80% (10% held by Ferrari family) spun out to shareholders, and early payoff of Chrysler's credit facility and bonds.

General Motors

GM

GM is poised to see the upside to high operating leverage thanks to rising volume and smarter manufacturing than in the past, including a reduction in its vehicle platforms. We believe many investors are focused on the large pension/OPEB underfunding and the overhang of government and VEBA ownership. However, the pension will not be due all at once and is closed to new participants. Global pension underfunding at the end of 2013 fell by $7.9 billion, or 29%, compared with year-end 2012 because of a rise in interest rates. The U.S. Treasury exited GM in late 2013, and we expect the Canadian government to exit soon. GM also has a cash hoard that it could use for share buybacks or discretionary pension funding, and we like the announcement of a significant initial dividend in January 2014 of $0.30 a quarter, equivalent to about a 3.5% yield.

The GM Europe and GM International Operations segments will likely remain challenged in 2015, but Europe is improving rapidly while key holes in the U.S. product lineup (full-size sedan, full-size trucks, and SUVs) are now filled. We would not be shocked if Europe even made a profit in 2015 instead of 2016 as management has guided.

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, depending on mix, at just 18%-19% share of 10.5 million to 11 million U.S. industry units.

The ignition switch recall increases headline risk and litigation risk, but we think GM can pay any fines or judgments that come its way thanks to $36.6 billion of automotive liquidity, including over $26 billion of cash.

In early June, we reduced our fair value estimate by $4 per share for a $7 billion reserve estimate for fines, lawsuits, and the compensation program related to the ignition switch recall. We think this accrual will likely prove too high, but we factor a conservative penalty into our valuation. GM said in July that the compensation program could cost it as much as $600 million, but many uncertainties on this fund and government fines remain.

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• Credit Market Outlook: Tailwind From Declining Interest Rates Has Likely Run Its Course
• Basic Materials: Iron Prices Swoon on Weaker China--Copper Is Next
• Consumer Cyclical: 4 New Realities for Retailers
• Consumer Defensive: Only a Handful of Values Left
• Energy: Oil Price Collapse Takes Center Stage
• Financial Services: Bargains Still Hard to Find
• Health Care: A Strong Run, but Some Stocks Still Look Undervalued
• REITs: Tread Carefully in This Low Interest Rate Environment
• Tech and Communication Services: Gravitate Toward the Moats
• Utilities: Repeating a Stellar 2014 Performance Will Be Tough