Industrial Revolution

Charles Darwin might have found something to like about today’s industrials. That’s because the most nimble of these companies–whether in manufacturing, mining, or agriculture–have ways to cope and even thrive under the current economic conditions, says Morningstar analyst Daniel Holland.

Make no mistake; the outlook for the industrial sector isn’t all rosy, observes Holland, who has covered the sector for Morningstar since early 2007. But even as makers of power generators or farm machinery might see factory floors stall in 2009, others in the sector are ramping up production of alternative power sources and renewable energy equipment. And a clever few have found ways to generate income by helping other companies increase efficiency.

That’s a marked break from the past. Traditionally, industrials don’t trend downward until well into an economic slump–and don’t rebound until a recovery is well underway. Their business, after all, requires hefty contractual agreements with utilities, contractors, and other customers who are reluctant to back out of orders when things slow down, and equally hesitant to begin heavy spending at the first sign of an upturn. The upshot: Holland suggests the next 12 months won’t be a banner year for sales and profits. That doesn’t, however, spell doom for all of the companies he follows. In fact, when considering the 2008 stock market retreat, some key industrials are trading at sizable discounts.

Why should investors look at the industrial sector now?
Recently, they’ve been gaining a lot more publicity, particularly as energy efficiency and alternative power sources–wind turbines, solar cells, and solar panels–have been in the limelight.
There’s a lesser theme:  In a tight, low-growth economy, some of the industrials have leveraged their expertise and made a niche for themselves by working with other companies to improve their distribution channels or their overall production efficiency.

When you look at the economy as a whole, it’s safe to say that 2009 is going to be a tough year. Many companies in the group will see revenues go down, but there are glimmers of good news, too. Indications are that there is a lot of money that’s going to go into the nation’s energy production for everything, from nuclear power plants to wind turbines and alternative technologies. In early November, there was news that China is planning to sink another $600 billion into its infrastructure over the next few years, which should help.

In the current environment, what numbers do you look at to gauge a company’s value?
Well, our criteria aren’t markedly different from what we normally use. I keep an eye on return on invested capital, for instance, to see how well a company is using the money it borrows or gets from shareholders in order to boost earnings. Typically, I start to get interested at a 10% return, and I’m very intrigued once we get to 15% and greater. We focus on cash flow. That’s critical at a time when it’s difficult for the best of companies to get financing. It’s also important to determine how much and what type of debt a company has and whether or not management can keep up with principal payments. In most cases, a debt-to-capital ratio of more than 33% means there might be a problem.

Are there any intangible factors that make a company’s shares attractive?
Sure. At Morningstar we like companies with a “moat.” That’s our way of saying that they’re in a business where competition is minimal, and where there are significant barriers potential rivals must cross to vie for market share. In some cases, well-protected companies have spent years developing products and relationships with customers. In other cases, distribution channels are hard to come by and can protect an existing business from encroachers.

A good example is my first pick Watsco (WSO), which currently is the largest heating and air conditioning equipment distributor in the United States. The stock has been beaten down. It’s well below what we think is a fair value of $45 a share. Watsco has developed very significant relationships with big manufacturers and contractors, which should help once the housing construction slowdown comes to an end. In the meantime, a couple of factors bode well for the stock. For one, there’s no way for individual customers to buy air conditioners directly from the factory.

What’s another company you like?
Emerson Electric (EMR) is very interesting. It’s an electric equipment company with very diverse offerings, and has found ways to beat the cyclical nature of some of its markets. One strategy has been to help other companies with process management, helping clients boost efficiency. There’s more: The company has a very strong history of giving money back to shareholders. In the first three quarters of 2008, Emerson earned $2.1 billion–they handed $837 million to shareholders in dividends and then used another $853 million to buy stock back. Even so, the stock trades at a very large discount to a fair value, which we place at $60 a share.

Distribution advantages and process efficiencies are big now. Are there any other names that play on those themes?
My third pick, Thomas & Betts (TNB), an electrical equipment manufacturer, has landed on an interesting variation of that theme. The company makes electrical parts of all sizes, covering the whole spectrum from the high to low end. They make everything from outlet boxes to switches and more. Its product line is broad, something you don’t really see in the commercial or residential market. What’s more, Thomas & Betts has launched an initiative through its distribution networks. The company promises to ship every component a big customer (such as a contractor) buys, in one complete and very efficient order. We place the stock’s fair value at $42 a share, well above its current market price.

This article originally appeared in the January 2009 issue of Black Enterprise magazine.