Industrials: Healthy Demand, But Few Values

• We consider the industrials sector to be slightly overvalued at a market-capitalization-weighted price/fair value estimate ratio of 1.06. In our view, investors need to select undervalued stocks, given that we rate most individual industrial stocks as roughly fairly valued.
• Demand for industrial products is healthy, and most industrial firms are executing well. We still expect improvement in the U.S. housing market, and note that aircraft manufacturing backlogs are particularly robust.
• U.S. corporate tax law changes will benefit many industrial firms both directly from lower cash tax outflows, and also via stronger capital purchases for customers.

Overall we consider the industrials sector slightly overvalued, given its market-cap-weighted price/fair value ratio of 1.06 as of the end of February. That said, we rate a number of stocks as undervalued, and highlight several below:

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Demand for industrial products is healthy and most industrial firms are executing well operationally. Related indicators like U.S. gross domestic product, industrial production, purchasing managers' indexes, and consumer confidence are strong. Broadly speaking, many indicators in Europe and China are also healthy, even if not currently at peak values. We see much of this translating into generally strong demand for most industries. We believe there is still room for the U.S. housing market to improve and note that global aircraft backlogs, especially in narrow-body models, are particularly robust. On the flip side, North American light-vehicle demand has plateaued and is in slow decline, but we expect global auto demand to trend upward at about 1%-3% during each of the next few years, and many of the global original equipment manufacturers have structured their costs to remain much more profitable than during prior demand cycles.

We believe U.S. corporate tax law changes will benefit many industrial firms, both directly from lower cash tax outflows, and also via stronger capital budgets for customers. We expect the tax-rate-catalyzed incremental capital investments that several firms announced when reporting earnings will roll out throughout 2018. Because some industrials (such as truckers, homebuilders, waste haulers, and some railroads) have near-complete exposure to U.S. pretax earnings, many will reap the full benefit of the statutory federal tax rate reduction.

U.S. President Donald Trump shook up global financial markets in March by announcing plans to enact import tariffs of 25% on steel and 10% on aluminum. The exact form these tariffs will take remains unclear, and already several of the largest supplier nations have been exempted from these tariffs. While we expect steel and aluminum prices in the U.S. to increase, the previous steel tariffs, under President George W. Bush, lasted less than two years. Looking forward, we expect no manufacturing firms to be directly affected by the tariffs sufficiently to change our fair value estimates, but second-order effects could have a greater impact than the raw material price increase alone.

U.S. automakers use almost entirely domestic steel and aluminum for their U.S. plants, and their suppliers also source in the U.S., based on our talks with

The direct impact on U.S. aerospace giant

Top Picks

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: EUR 47.00

Fair Value Uncertainty: Medium

5-Star Price: EUR 32.90

Wide-moat GEA supplies food and dairy processing equipment specializing in decanters and separators that determine a product’s texture and consistency, which is essential to brand creation for food companies; along with food safety standards, this creates high switching costs for its customers. Some of its equipment is used in food processing to make products such as edible oils, instant coffee, and baked goods. As GEA is a leading global supplier and number-one or -two player in nearly all its markets, it will benefit over the long term from increasing food production demand to feed the world's growing population, as well as urbanization increasing demand for convenience food.

We believe management's clumsy handling of its restructuring program has clouded the market's view of the firm's long-term value. At issue is disappointing profitability relative to the company's previous medium-term guidance of 13%-16% adjusted EBIT margins, starting with a profit warning at the end of 2016. Dairy-related orders started to rebound in 2017 from a low in 2016, with new dairy farming equipment orders coming through in the first half. We also expect to see EBIT margin expansion in the near term, helped by a volume recovery.

Anixter International

AXE

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $107

Fair Value Uncertainty: Medium

5-Star Price: $74.90

Narrow-moat Anixter International has recently transformed itself, and we think shareholders will be rewarded with consistent earnings growth and occasional outsize dividends over at least the next few years.

Over the past three years, Anixter has completed three transactions that have bolstered its market presence, growth potential, and operating flexibility. After acquiring Tri-Ed, selling its capital-intensive OEM supply fastener business, and purchasing

With the addition of Tri-Ed, Anixter's network and security solutions segment is set to gain share with midsize system integrators and in residential end markets. This segment should also benefit from cross-selling security products to utilities customers as they invest in security solutions to comply with regulatory standards. Growth in wireless and cloud-related products should augment network and security growth. Anixter's electrical and electronic solutions business has suffered from industrial end market weakness and has been generating depressed margins. As industrial markets recover, we expect this segment to return to growth and normalized profitability. After the acquisition of HD Supply’s power solutions business, the utility power solutions segment was created, which has industry-leading scale and should benefit from market share gains and improving utility capital spending.

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: GBX 337

Fair Value Uncertainty: Medium

5-Star Price: GBX 235.90

Global security leader G4S has fallen more than 25% from its 2017 peak on the back of concerns about its India and Middle East business and resultant cuts to full-year revenue growth guidance. However, this division generates just 11% of group revenue and 15% of EBITA, and we believe many of the issues highlighted by investors in this business are short-term in nature and do not pose a significant structural risk. In the longer term, we believe the ongoing restructuring program can further simplify the business and remove costs, and structural improvements, as the largest players in the industry shift toward higher-value activities, should go some way to improving revenue growth and operating margins for G4S. We see material upside to our fair value estimate.

Quarter-End Insights

Stock Market Outlook: Stocks Look Slightly Overvalued Today 4- and 5-star stocks are harder to come by in today's market, but a few values are still out there.

Credit Market Insights: A Decidedly Negative Quarter for Fixed-Income Markets Rising rates and widening credit spreads took their tool in the first quarter of 2018.

Basic Materials: Still Overvalued Despite Protective Tariffs Our bearish view on the mining and metals sector means the basic materials coverage universe trades at a market-cap-weighted 30% premium to our fair value estimates.

Communication Services: The Most Undervalued Sector We Cover We see value in several firms as consumers migrate away from traditional TV bundles and Europe invests in fiber and 4G.

Consumer Cyclical: Confidence, Demographics Support Consumption Gains E-commerce market share gains present challenges for some, but trends continue to support healthy profitability for many companies.

Consumer Defensive: Looking to M&A, Online Sales for Growth We see a few values for long-term investors amid intense competition.

Energy: Looming U.S. Shale Supply Should Temper Optimism Huge output decline boosts near-term fundamentals, but lofty prices likely to trigger dangerous shale growth later.

Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018 We see financial services stocks across the globe as fairly valued today.

Healthcare: Values Among Drug, Biotech, and Supply Chain Firms Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first- quarter.

Real Estate: Rising Rates Won't Derail Strong Fundamentals REITs have focused on strengthening their portfolios, deleveraging, and capital recycling in the face of higher bond yields and new construction.

Technology: Shift to Cloud Computing Most Important Story The sector looks modestly overvalued as a whole, but there are some attractive firms in enterprise software and IT services.

Utilities: Under Pressure in Early 2018 Utilities sell-off presents opportunities for long-term investors.

Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows As dealmakers look to innovate their origination process, we anticipate a continued rise in take-privates and corporate divestitures.