Magna warning threatens industrials’ success story

I'm really hoping Magna's disappointing earnings guidance doesn't become a trend in the industrials sector, not least because it's a direct affront to my market outlook for 2014.

If domestic industrial companies' exports rise as much as expected, on the back of an accelerating U.S. economy, stocks like Magna's ought to perform strongly.

So it's somewhat reassuring that Magna's issues appear limited to European operations. At the same time, management's global production growth forecast of 3.7 per cent is uninspiring.

High expectations are another, arguably more worrying factor. Despite the 35 per cent appreciation of the S&P/TSX Industrials index last year, there were few hints that profit growth was on the upswing. Earnings grew at an anemic 1.6 per cent pace for the year.

Yet expectations for 2014 are extremely optimisitc – analysts estimate 34.5 per cent profit growth. The fact that industrials' strong equity price performance in 2013 was not backed up by earnings growth suggests that much of the projected growth for 2014 is already reflected in stock prices.

Worse yet is the risk of not just failing to surpass those lofty expectations, but actually falling short of them. If Magna is a precedent, and more industrial companies start guiding lower, the odds of hitting the 35 per cent profit growth target decrease. Stock value declines become a distinct possibility.

The distressing recent trend of weak U.S. economic data casts further suspicion on a pro-industrials stance. Reports on consumer credit and job creation came in well below consensus estimates, threatening optimistic economic growth forecasts and U.S. demand for Canadian exports.

Admittedly, the news for domestic industrial companies is not uniformly bad. The ongoing slide in the Canadian dollar is steadily increasing the competitiveness of companies looking to sell goods and services across the border.

I'm not ready to give up on the industrials investment idea yet, but there does seem good reason to be selective. There are a wide variety of subsectors represented in the S&P/TSX Industrials and, while the average valuation levels are high, not all of them are trading at SNC-Lavalin's stratospheric 40 times forward earnings estimates.

The table below lists both trailing and forward P/Es for all members of the industrials index. It's the beginning of a process of winnowing down investment opportunities to those with the most reasonable growth expectations and that best fit the theme. I'll be taking a closer look at the most logical candidates in the weeks ahead.