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Transportation, Construction Optimism Lifts Industrials

We expect the U.S. to increase spending on missiles, missile defense, and space militarization.

The Morningstar US Industrials Index outperformed the broader market over the trailing 12 months after a strong first-quarter performance. Farm and heavy construction machinery and construction stocks were the top performers during the quarter amid growing optimism over a U.S. infrastructure spending plan. Strong performance from transportation and logistics stocks (including airlines) boosted the index’s performance as well. Industrial distribution, waste management, and business-services stocks were laggards during the quarter.

Industrials have outperformed overall U.S. equities - source: Morningstar

Industrials stocks remain overvalued, in our view. About 97% of industrials firms we cover have ratings of 3 stars or less. We see some upside with defense primes, including Lockheed Martin and Northrop Grumman, as demand for military products remains strong. We expect increased spending on missiles, missile defense, and space militarization as the U.S. military shifts its focus toward defense against great powers conflict. We believe the increase in the U.S. deficit, usually indicative of decreased military investment, will be offset by the military’s intent to modernize certain operations. We expect demand for U.S. air travel to return to normal once enough people are vaccinated against COVID-19. U.S.-based airlines have outperformed the broader market this year, and we aren’t seeing compelling value in any of these stocks, but Delta and Southwest remain our favorite companies and we think Delta offers the best relative valuation.

Most industrials stocks are overvalued - source: Morningstar

U.S. air travel remains around the same level as the second half of 2020, but year-over-year declines continue to abate. According to the Transportation Security Administration, March 21 was the busiest travel day since mid-March 2020, with over 1.5 million travelers. The recent uptick is likely due to spring breakers heading to vacation destinations, but we expect domestic travel will continue to recover in the second half of 2021, especially as vaccine distributions expand.

Severe winter weather impeded industrial production growth - source: Morningstar

The U.S. Industrial Production Index pulled back slightly this quarter as severe winter weather hindered manufacturing output and mining output. Underlying demand remains strong, and barring any significant obstacles, we expect continued growth in the second quarter.

Recent travel volume at its highest since March 2020 lockdown - source: Morningstar

Top Picks

Lockheed Martin LMT Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $433 Fair Value Uncertainty: Medium

Wide-moat Lockheed Martin is the largest defense contractor globally and has dominated the Western market for high-end fighter aircraft since being awarded the F-35 program in 2001. Lockheed’s recent acquisition of Aerojet Rocketdyne is an opportunity to carve out share in the burgeoning hypersonics market. The U.S. National Defense Strategy prioritizes great powers conflict, requiring modernization in areas where the military possesses asymmetric weaknesses (like hypersonics). We believe demand for military modernization will offset contractionary effects stemming from the nation’s increased deficit.

Wesco International WCC Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $107 Fair Value Uncertainty: High

Wesco’s acquisition of Anixter International created a powerhouse in the electrical, communications and security, and utility distribution market. The combined entity is already benefiting from cross-selling opportunities, and we think its 2023 target of $250 million in cost synergies is achievable, if not conservative. We believe Wesco and Anixter’s history of solid cash flow generation throughout the business cycle coupled with a strong backlog will aid in a return to a more normal capital structure as the firm pays off its outstanding debt.

Roper Technologies ROP Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $452 Fair Value Uncertainty: Medium

Roper has significant exposure to technology software in mature, niche markets with large quantities of deferred revenue. These tend to be asset-light, cash-generating investments, which allow Roper to reinvest its excess cash in businesses that yield incrementally higher rates of return. Since Roper mostly funds its acquisitions with its own free cash flow, we believe the firm will benefit from rising interest rates, as it can purchase businesses at more favorable prices than its more highly leveraged competitors. We expect 2020 project delays will increase sales in 2021, a growth opportunity not currently acknowledged by investors.

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