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Selloff Leaves Industrial Products Trading at a Discount

U.S. airlines are also worth considering.

The Morningstar US Industrials Sector Index outperformed the Morningstar US Market Index by approximately 200 basis points during first-quarter 2022, yet the industrials index still significantly underperformed the broader market index over the trailing 12 months.

Exhibit 1: Industrials outperformed U.S. equities during the first quarter.

- source: Morningstar

Strong industrials sector first-quarter stock performance was driven by aerospace and defense and farm and heavy construction machinery, while industrial products were notable underperformers.

Exhibit 2: There are quite a few undervalued industrial products stocks.

- source: Morningstar

Defense contractors, such as Lockheed Martin, L3 Harris, Raytheon, Northrop Grumman, and General Dynamics, have seen double-digit percentage increases in their stock prices during the first quarter, likely due to the market pricing in increased global defense spending amid the Russia-Ukraine conflict. Because most U.S.-based defense contractors generate less than 30% of sales from international customers, we think potential changes to the U.S. defense budget are the key consideration. Given heightened geopolitical tension, we think inflation-adjusted growth in the defense budget seems plausible, which would be significant relative to our previous assumption of a flattening U.S. defense budget.

Exhibit 3: The U.S. is the largest customer for many defense contractors.

- source: Morningstar

Agco and Deere were the top performers in the farm and heavy construction machinery industry during the quarter. We expect both firms will continue to benefit from rising farm incomes (due to higher crop prices) and a healthy North American equipment replacement cycle. That said, we maintain our view that the agriculture cycle will likely begin to moderate in the next couple of years.

Exhibit 4: Rising farm income has benefited farm equipment manufacturers.

- source: Morningstar

Industrial products stocks were mostly laggards during the first quarter amid economic uncertainty and continued supply chain and inflationary challenges. However, in our view, these challenges will ease and the selloff has presented long-term investors with a quite a few opportunities, including Honeywell and Pentair. U.S. airlines remain undervalued, in our view, and we consider Delta and Southwest the two highest-quality airlines in the space. We expect both companies to return to 2019 levels of capacity by 2023.

Top Picks

Honeywell HON Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $230 Fair Value Uncertainty: Medium

In our view, Honeywell is one of the strongest multi-industry firms in operation today, and it has successfully pivoted to capture multiple environmental, social, and governance trends, including energy efficiency, emissions reduction, and e-commerce, among others. We believe long-term share gains can be built during downturns, and in contrast to its competitors, Honeywell maintained reinvestment levels throughout the pandemic. We believe these actions will contribute to solid revenue growth and margin expansion over the next five years.

Masco MAS Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $72 Fair Value Uncertainty: Medium

We see a solid growth runway for Masco as the company capitalizes on healthy long-term repair and remodel fundamentals and internal growth initiatives across its plumbing (Delta is its most notable brand) and decorative architectural segments (Behr paint is the most notable brand). Masco's key organic growth initiatives include increasing Behr's professional painter market share and extending the plumbing segment's product portfolio. Masco's wide moat supports durable pricing power, which should help mitigate continued inflationary pressure in 2022.

Pentair PNR Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $70 Fair Value Uncertainty: Medium

Pentair is a pure-play water company manufacturing a wide range of sustainable water solutions, including energy-efficient swimming pool pumps, filtration solutions, and commercial and industrial pumps. The company is focused on three strategic areas: advancing growth in the swimming pool market, accelerating growth in residential and commercial filtration, and penetrating emerging markets, especially China and Southeast Asia. We view this strategy as astute, as management is pursuing opportunities in the more profitable and faster-growing consumer solutions segment, where the company already has a strong competitive position.

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