Prices Are Right for Industrials

Brian Bernard: The Morningstar US Industrials Index underperformed the broader U.S. equity market by over 600 basis points during the first quarter due to investor concerns about how a COVID-19-driven economic slowdown would affect the sector. Many of the industrials we cover have shuttered manufacturing facilities and withdrawn 2020 guidance, which likely added to investors' angst. While many industrial firms will be adversely affected over the short run, we think many of these companies' stocks are priced as if the current economic environment is normal. In fact, most of our sector coverage currently trades in 4- or 5-star territory, with a median price/fair value ratio of 0.8.

Industrial conglomerates, construction, and aerospace and defense are the most undervalued industries. We see many attractive long-term opportunities across the sector that should bear fruit as the virus abates and business conditions normalize. Industrial conglomerates, like General Electric GE and 3M MMM, have substantial healthcare exposure, which tends to be stable compared to more cyclical industrial counterparts, and stability is an attractive quality given current market volatility. Now, 3M and Honeywell HON, they also have sizable personal protection segments, which should see revenue growth as global demand for face masks and respirators exceeds supply. Farm equipment firms, such as Deere DE, may be more resilient during the COVID-19 outbreak because, in our view, it's hard to see how U.S. agricultural commodity production will be affected by the virus. U.S. acres planted remains relatively constant over time, as demand for agricultural commodities varies less than discretionary goods.

We think defense prime contractors are a smart play for investors right now, because these firms are less exposed to the business cycle since sales are largely generated from the government and governments across the world have been focused more on military modernization. Customers also fund research and development, so these firms can return free cash flow to shareholders. With second-quarter earnings right around the corner, we'll be listening for insights on the 2020 outlook. However, given how much uncertainty there is right now, executives may shelve these types of discussions until the next quarter.