Industrials might not look like an obvious sector within the stock market to hang out right now, given their cyclical nature and the mounting economic threats at home and abroad. But, in a contrarian sort of way, perhaps that’s what makes trains and planes so appealing.
Brian Belski, chief investment strategist at BMO Nesbitt Burns, is a big fan of the sector. He argues that the recent retreat – driven by depressing news out of Europe, weak U.S. economic performance and signs of trouble in China – simply provides another reason to load up in anticipation of better days ahead.
“We recommend that investors focus on higher quality areas with consistent-to-improving operating performance, reasonable valuations and strong cash flow generation,” he said in a note. “Industrials is one area exhibiting all these characteristics and is a main reason for our stance on the sector.”
Big U.S. industrials include the likes of FedEx Corp., General Electric Co, Boeing Co. and Union Pacific Corp. – which are definitely companies that tend to rise and fall with the global economy.
Many observers are growing concerned about this backdrop, which helps explain why industrials have underperformed the S&P 500 since it began to decline from its near-term high at the beginning of April.
Mr. Belski, too, believes that the stock market will remain volatile for the rest of the year, unless there is a pick-up in the pace of job growth.
However, he also believes that industrials are already reflecting pessimism about the global economy, making the downside look relatively limited.
His valuation model – which takes into account factors like trailing and estimated operating earnings, price-to-free cash flow and price-to-book value – shows that the sector is trading at a significant discount to historical norms, using data going back more than two decades. In fact, it was only during the recessions of 1990-91 and 2008-09 that valuations were lower.
“As we have mentioned in prior reports, we believe there is a low likelihood of a severe global economic recession in the coming months, yet it appears that investors have ‘priced this in’ for Industrials,” Mr. Belski said.
“Therefore, discount valuations are likely to provide formidable tailwind for sector performance in the coming months as the global economy continues to grow at a slow but steady pace.”
But the sector has more than cheapness going for it. It also happens to be performing well.
Mr. Belski pointed to the sector’s trailing earnings growth over the past several quarters: It has been solid, beating the historical average. Now, more analysts are upgrading estimates than downgrading them, reversing a recent trend.
“True, growth rates have subsided recently but the fact that they have not collapsed given all the uncertainty and volatility around the world speaks volumes to the fundamental strength of the sector,” he said.
Despite this overall strength, he also drilled into the sector looking for individual stocks that have particularly low valuations (an estimated price-to-earnings ratio below 15), high growth rates (an estimated earnings-per-share growth above 10 per cent in both 2012 and 2013) and strong cash flow (free cash flow yield is greater than the dividend yield).
He also looked for companies with foreign revenue exposure below 60 per cent, given his view that the U.S. economy will outpace global economic growth on a relative basis in the coming years.
Some of his discoveries: Cintas Corp., Danaher Corp., FedEx Corp., General Electric Co., Illinois Tool Works Inc., Southwest Airlines Co., Tyco International Ltd., Union Pacific Corp. and United Parcel Service Inc.
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