Optimistic Outlook

Morningstar equity analyst Daniel Holland sees industrial stocks as a bargain for long-term investors

Image: ThinkStock

Image: ThinkStock

At first glimpse, it’s hard to make up your mind about industrial stocks—companies involved in the manufacturing and services sectors. On one hand the headlines have fixated on the possibility of an economic slowdown and a double dip to the current recession. At the same time a recent survey of 220 industry executives by the consulting firm KPMG found that a majority held a solidly or cautiously optimistic outlook about business prospects in the coming year.

Morningstar analyst Daniel Holland says there may be a long-term investment opportunity in the confusion created by such contradictory information. For one, despite the signs of an economic slowdown in Europe and the U.S., many industrials are still reporting strong order growth. A second positive sign: stock buybacks and merger activity in the sector, which have both been on the upswing. “There are definitely indications that when it comes to the best run industrials, current worries are more headlines than fundamental concerns,” says Holland.

It’s clear that the best managed companies in the group took away some important lessons from the 2008 recession. Many have pared down debt and streamlined operations. Industrials also have a trump card to the effects of the European economic troubles by having some of their business in emerging markets where infrastructure spending is helping to boost revenues. “China and Brazil are particularly compelling stories right now,” says Holland. Finally, stock market volatility has brought down some share prices of the best stocks in the group to bargain levels.

“We look for companies with a wide moat, or in other words, barriers, to keep competitors from encroaching on their markets,” says Holland. “That can include expertise, service, or technology. The bottom line is that in a cyclical industry like this, moats make it possible to maintain operating margins and, in turn, profits.” Holland talked to black enterprise about three of his industrial picks.

—James A. Anderson

1 GENERAL ELECTRIC CO. (GE) It’s a company that ranks as one of our best ideas right now. The stock trades at about 11 times our current-year earnings estimate, which is quite cheap compared with other industrial companies and the historical price-to-earnings ratio that GE has carried in the past. The company is placing more focus on equipment for power generation, which positions it well for emerging market growth. Management currently aims for the GE energy business to grow earnings by more than 10% a year. GE Capital, the company’s finance arm, has bounced back from concerns that clouded its outlook during the 2008 economic crisis. We think GE can reach a fair value of $25 a share.
PRICE AT REC.: $16.48  •  P/E: 12.58

2 PARKER HANNIFIN CORP. (PH) is a maker of engineering and manufacturing equipment—motion and control components as they are called. They include automation and flight control systems, hydraulics, filtration systems, and engines, which are used by companies from McDonald’s to Caterpillar. Parker Hannifin is managed well and has a reputation for engineering expertise. Since the 2008 financial crisis, it has focused on controlling costs and expanding operating margins above 10%. The company also trimmed its debt from roughly 30% of capital on average to a current 20%. It has put 60 years’ worth of effort into setting up a global distribution network. We think fair value for the stock is $97.
PRICE AT REC.: $83.74  •  P/E: 12.39

3 UNITED TECHNOLOGIES CORP. (UTX) United Technologies Corp. has a focus in aerospace and construction. You probably know some of its higher-profile products: Otis elevators, Carrier air conditioners, Sikorsky helicopters, or Pratt & Whitney engines. Like other peers, United Technologies has emphasized cost cutting. Management expects to extract $350 million to $400 million of annual cost reductions. We think the company can attain compound annual earnings growth of 10.9% over the next five years and reach a fair value of $94. One tailwind is its 20% exposure to emerging market growth; another is its recent acquisition of Goodrich Corp., a leading supplier of services and systems to the aerospace and defense industry.
PRICE AT REC.: $78.87  •  P/E: 14.80

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