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Industrial Stocks Tied to Housing Unfairly Punished

Logistics and trucking shares should rebound through the rest of this year and next.

The Morningstar US Industrials Index outperformed the Morningstar US Market Index by approximately 450 basis points during second quarter, yet the industrials index still underperformed the broader market index by about 160 basis points over the trailing 12 months as of June 27. Over the trailing 12 months, the aerospace and defense industry was a clear winner, while the construction, transportation and logistics, and industrial products industries were notable laggards.

TTM Industrials Underperformance Continued Despite Q2 Outperformance

- Source: U.S. Census Bureau, DAT Freight & Analytics, Morningstar Equity Research. Data as of June 24

Defense contractors were responsible for the aerospace and defense industry's stock outperformance. Northrop Grumman and Lockheed Martin outperformed, with both stocks appreciating by a double-digit percentage year to date. U.S. defense contractors would benefit from increased Department of Defense funding. President Joe Biden requested a 4.1% increase in Defense Department funding over the enacted fiscal 2022 budget, and our industry sources suggest there is bipartisan support for increasing the defense budget significantly above the request.

Half of Industrials Are Undervalued

- Source: U.S. Census Bureau, DAT Freight & Analytics, Morningstar Equity Research. Data as of June 24

Many stocks with U.S. housing exposure have significantly underperformed the market index this year as the market became increasingly fearful that surging mortgage rates and heightened economic uncertainty would derail the housing market. While we forecast a near-term residential construction slowdown, with starts falling to 1.3 million units by 2024, we expect a rebound to 1.55 million units by 2023 as affordability improves. We see starts averaging 1.4 million-1.5 million units through 2031, which is modestly above the long-run average despite slower population growth.

Housing Starts Should Rebound After Near-Term Slowdown

- Source: U.S. Census Bureau, DAT Freight & Analytics, Morningstar Equity Research. Data as of June 24

We think the selloff of many housing-related stocks, such as Carrier and Masco, has been too punitive. Johnson Controls is particularly interesting, given that it has little residential exposure.

The trucking and logistics industry enjoyed strong stock performance in 2021 amid exceptional pricing power stemming from robust durable spending and tight truckload and less-than-truckload capacity. However, we expect industry fundamentals will return to normal in the second half of 2022 and throughout 2023. With the looming correction in the operating backdrop, shares have come down accordingly, and the once-overvalued industry now offers attractive investment opportunities, such as XPO Logistics.

Freight Spot Rates Have Tumbled From Early 2022 High

- Source: U.S. Census Bureau, DAT Freight & Analytics, Morningstar Equity Research. Data as of June 24

Top Picks

Rockwell Automation ROK Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $290 Fair Value Uncertainty: Medium

We view Rockwell as the highest quality pure-play automation competitor on the west side of the Atlantic based on quality, breadth of offerings, and shrewd strategic partnerships. Supply chain disruptions and inflationary pressures continue to act as headwinds for Rockwell, but demand remains strong and Rockwell’s secular growth trends remain intact. Over the long run, we think Rockwell's future is bright, particularly in the area of analytics closer to the plant floor, where it is more likely to see recurring, subscription-type revenue. We expect Rockwell will continue as a leader in the convergence of information technology and operational technology.

Johnson Controls International JCI Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $68 Fair Value Uncertainty: High

As a pure-play building technologies and solutions business, Johnson Controls stands to benefit from secular trends in global urbanization and increased demand for energy-efficient and smart building products and solutions. Also, in our view, Johnson Controls is better positioned in the building automation systems market than its close HVAC competitors. We also like that Johnson Controls has limited exposure to the weakening North American residential HVAC market (4% of revenue). More importantly, we maintain our positive outlook for global commercial HVAC demand, which accounts for more than 40% of the firm’s revenue.

XPO Logistics XPO Star Rating: ★★★★ Economic Moat Rating: None Fair Value Estimate: $70 Fair Value Uncertainty: High

Unusually robust consumer goods spending and heavy retailer restocking drove incredibly strong freight demand, tight trucking market capacity, and very favorable pricing conditions for XPO in 2021. Growth tailwinds are likely to remain in play through first-half 2022, but we expect XPO’s less-than-truckload yields and truck brokerage sell rates (to shippers) to begin easing by early 2023 as demand normalizes off unusually robust levels (especially retailer restocking). While we expect flattish organic revenue trends on average in 2023, over the long term, we think XPO can post steady-state annual organic revenue growth near 5% on average.

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