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Prices Are Right for Industrials

Long-term opportunities now abound in the sector, but defense prime contractors are particularly smart plays right now.

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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 Many of the industrials we cover have shuttered manufacturing facilities and withdrawn 2020 guidance, which likely added to investors' angst.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.

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Brian Bernard has a position in the following securities mentioned above: MMM. Find out about Morningstar’s editorial policies.