Time Is Right For Industrials
Subscribers have probably noticed our shift into industrial stocks over the past year. We completed the June quarter with industrials representing 23% of the Focus List, the highest quarter-end percentage since December 2007.
We currently recommend eight industrial stocks for purchase, including four on the Focus List (27% of components), versus just one at the end of June 2013. The Focus List's long-run average for industrial stocks is two.
Some may argue that given the sector's high sensitivity to the economy, our exposure does not make sense for the current position of the business cycle. So why are we making such a bet on the industrials now?
1) We focus on individual stocks, and these picks do not necessarily imply a stance on the broader sector. While we currently recommend a number of industrial stocks, subscribers shouldn't go crazy in the sector, as we see plenty of stinkers as well.
2) Industrial stocks in the S&P 500 Index average Quadrix Overall scores of 70, tied for second-highest among the 10 sectors. The sector also ranks first for Momentum and is tied for first for Earnings Estimates.
3) The industrial sector is diverse, as evident by the industries for our recommended stocks, as displayed in the table below. The S&P 500 industrial sector includes 19 different industries — only the consumer-discretionary sector is more disparate.
Not surprisingly, fundamentals differ widely from industry to industry. Still, the sector follows some general patterns in relation to the business cycle. Recall, we explored the five stages of the business cycle in the March 10 issue.
The first gusts of a recovery tend to propel industrial stocks higher as investors anticipate that economic activity will soon surge. As the upswing matures, the performance of industrials tends to remain strong until the latter stages of expansion. Predictably, the sector's economic sensitivity can work against it during a recession, when industrials tend to rank among the worst performers.
Since industrials can be particularly sensitive to the economy, it's worth considering our current position in the business cycle. Given the severity of the recession that ended in June 2009 and the weakness of the economy's subsequent recovery, it seems reasonable to expect that the current expansionary period to run longer than normal. The following factors suggest the present upswing could continue for several more years.
• With interest rates still historically low, we have yet to see the tighter monetary policy customary at cycle peaks. The Federal Reserve is widely expected to hold off raising interest rates until 2015.
• Inflation is fairly weak, lingering below the Fed's target rate of 2%.
• Wage growth remains modest, helping to keep corporate profit margins elevated.
• Fed Chair Janet Yellen sees room for more progress in the labor market. The unemployment rate stood at 6.2% in July, down from 7.3% a year earlier but still well off the lows of 4.4% experienced in 2006 and 2007, near the end of the last expansionary period.
• With nearly 90% of S&P 500 companies having reported second-quarter profits, the index is on pace to deliver 8.4% higher per-share profits, the second-highest gain for any quarter since the start of 2012. Consensus estimates project double-digit profit growth for both the second half of this year and 2015.
Based on the body of evidence, we are comfortable with our exposure to the industrial sector, and to the eight stocks listed in the table below in particular. Alaska Air Group ($44; ALK), one of the four industrials on the Focus List, is profiled in Analysts' Choice. The other three are reviewed below:
Its shares down 12% for the year, ManpowerGroup ($75; MAN) felt some growing pains as the global markets moved through the early innings of a recovery. Earlier this month, rival Adecco ($36; AHEXY), the world's largest staffing company for temporary workers, reiterated Manpower's July remarks that growth remains sluggish in France. France is Manpower's largest geographic market (26% of sales and 32% of operating profit in the first half of 2014).
Yet Adecco also described a sustainable increase in hiring for employers in the U.S. and Europe. Hiring activity continues to pick up in both regions, particularly with industrial companies. Employers tend to hire temporary workers in the early stages of a recovery, before they gain enough confidence for permanent hires.
Adecco's observations coincide with improving operating momentum for Manpower. Sales rose 6% in the June quarter, Manpower's strongest growth since the September 2011 quarter. Cash from operations jumped 51% to $452 million for the 12 months ended June. At 15 times trailing earnings, shares trade 36% below their five-year average and 25% below the median stock in the S&P 1500 human-resource and employment-services industry. Manpower, earning a Value rank of 87 and Overall rank of 97, is a Focus List Buy and a Long-Term Buy.
Union Pacific ($100; UNP) owes much of its strong operating momentum to improving economic activity in the U.S. From a combination of rising freight volumes and price hikes, revenue advanced 10% for the three months ended June — the railroad's 18th straight quarter of growth and its strongest gain since the March 2012 quarter. Operating profit margins have expanded by at least one percentage point year-over-year for 11 straight quarters. Cash from operations slipped 14% to $1.45 billion for the June quarter, just the second decline in the last 17 quarters.
While reporting June-quarter results, Union Pacific appeared bullish that the U.S. economy will continue to rebound. Indicative of management's optimism, Union Pacific plans to expand its work force and accelerate the addition of new locomotives in the second half of 2014. The consensus expects per-share profits to climb by double digits in the final six months of the year on revenue growth of more than 7%. Union Pacific, with an industry-leading Overall Quadrix score of 91, is a Focus List Buy and a Long-Term Buy.
United Rentals ($110; URI) is well positioned to benefit from a shift toward renting equipment rather than buying it. It is also catching the rebound in commercial construction and has seen broad growth from the energy sector, including power plants, oil and gas, and solar. Management says the September quarter has jumped off to a strong start for rental rates and time utilization — two key indicators of demand within the industry. Rising analyst estimates project 28% higher per-share profits and 15% revenue growth for the quarter.
All six of United Rentals' Quadrix categories exceed 50, and both sector-specific scores top 90. The Momentum score of 93 reflects above-average ranks in all of United Rentals' factors for the category. The stock has surged 41% this year, yet at 17 times estimated 2014 earnings trades 14% below the median for S&P 1500 industrial stocks. United Rentals is a Focus List Buy and a Long-Term Buy.