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For after the correction, think industrial stocks: Market history says this is their time
01/26/2010 8:30 am EST
Solid data stretching back to 1945 argues that certain industries and sectors outperform during specific stages of any economic recovery. (The best work on this subject comes from Sam Stovall, the chief investment strategist for Standard & Poor's Equity Research Services. His 1996 book Sector Investing is still the best resource on the subject to my mind.)
My first rule of investing is “Put every trend you can on your side.” Neglecting what we know about what sectors thrive when is in my opinion wasting an asset that could help you make bigger profits.
Stovall divides the economic cycle into four stages.
- Full recession: GDP is tumbling, interest rates are falling, and unemployment is rising. Sectors that do best during this stage, historically, have been cyclical and transports (at the beginning of the stage), technology, and industrials (near the end of the stage.)
- Early recovery: Consumer sentiment is improving, industrial production has turned up, interest rates have bottomed, and unemployment has peaked and is starting to move lower. Sectors that do best have been industrials (near the beginning as they continue their starring economic performance from the end of the recession stage), basic materials, and energy (near the end).
- Late recovery: Interest rates are rising as the central bank tries to control inflation, consumer sentiment heads into a downturn, and industrial production is flat. Sectors that do well in this stage have been energy (continuing its out performance from the previous stage), consumer staples, and services (near the end of the stage.)
- Early recession: You should remember this stage vividly. Consumer sentiment ranges from fear to terror, industrial production plunges, interest rates peak and then start to fall, unemployment begins to rise rapidly. Sectors that have done well (relatively at least) during this stage include services (near the beginning), utilities, and cyclical and transports (near the end.)
I think it’s pretty clear that we’re in the early recovery stage. (And I hope that we stay there. No backsliding, Mr. Economy.)
To confirm that opinion I took a look at the performance of the sectors in S&P 500 for the first three weeks of January as of January 20. (I didn’t include last week’s correction in the data because in a correction pretty much everything falls and often the best performers fall hardest. I’m interested in out performance in a market that isn’t either lifting or sinking all boats.) Healthcare led the bunch with a 5.03% gain since the beginning of the year. Much of that I’d argue wasn’t related to the economic cycle at all but was a result of a rally in the sector based on the declining prospects for the Obama administration’s healthcare plan. The financial sector was in second place at 4.95%. (How that’s changed in the last week.) That I think was a result of the origins of this recession in the near collapse of the financial system. I wouldn’t discount this when planning portfolio allocations right now. But that’s the topic for another column.
Then came the sectors that I’d expect to see in the early recovery stage: Industrials at 4.29%, energy at 2.52%, and materials at 2.12%.
Trailing sectors included consumer staples (0.75%), consumer discretionary (0.6%), information technology (-0.11%), utilities (-0.35%), and telecommunications services (-6.42%).
To see why industrial stocks historically do so well during the early stages of a recovery take a look at Precision Castparts (PCP), a company that makes jet engine and industrial gas turbine components.
After managing to hold revenue almost constant in fiscal 2008, the last half of fiscal 2009 and the first two quarters of fiscal 2010 turned increasingly grim. Revenue fell to $1.62 billion in the third quarter of fiscal 2009, slid to $1.6 billion in the fourth quarter, plunged to $1.38 billion in the first quarter of fiscal 2010, and then trickled lower to $1.3 billion in the second quarter.
Not unexpected when Boeing (BA) and General Electric (GE) are two of your biggest customers.
The company announced third quarter results for fiscal 2010 on January 21. Revenue hit $1.37 billion. That’s not a huge increase from the second quarter’s $1.3 billion but it’s a move in the right direction.
Earnings per share showed a stronger rebound to $1.61 a share, up from $1.54 in the prior quarter as the company cut costs and saw margins increase to 25.8% from 23.3% in fiscal 2009. (For more on why companies see rising profit margins in the early stages of a recovery—even as unemployment stays high—see my http://jubakpicks.com/2010/01/22/2010-well-the-first-half-anyway-looks-good-for-stocks-despite-the-current-correction/ )
In its earnings conference call management said that in the quarters ahead it expects unit sales to pick up as the airline and utility industry speed up capital spending. Sales of replacement parts should also rise as airlines fly more miles and need to do more maintenance. And finally Boeing’s troubled 787 Dreamliner made its first test flight on December 15, 2009. At that point Boeing had 840 orders for planes.
All of this leads Standard & Poor’s to project 11% sales growth for fiscal 2011. (The company’s fiscal 2010 year ends on March 31, 2010.) Operating margin will climb to 26.4% for fiscal 2010 as a whole and then to 27% in fiscal 2011. Projected earnings of $7.75 in fiscal 2011 will be 12.5% higher than they were in fiscal 2008 before the bottom fell out of the economy.
My only hesitation with Precision Castparts right now is that the stock has roughly doubled from the March 2009 bottom. Maybe it will pull back enough in what is shaping up as a decent correction for me to find a buy compelling.
But in the meantime let me give you the names of three other industrial stocks (in alphabetical order) that you can use to put sector timing to work for your portfolio. (And that are closer to an attractive buying price.)
Honeywell International (HON). The world’s largest maker of small jet engines, cockpit controls, and climate control equipment also operates business units in specialty materials and automotive products such as turbo chargers. Those latter two units provide some of the company’s most promising near-term growth with S&P projecting revenue growth in the automotive unit at 9% in 2010 and at 5% for the specialty materials business. A big charge for the company’s pension plans will depress earnings in 2010. Absent that one time charge, earnings will grow 11% in 2010. As of the January 21 close, the shares traded at 12.9 times adjusted 2010 earnings per share.
Johnson Controls (JCI). Not only a very diversified industrial but one with the diversity in the right places to take advantage of the early recovery stage of the economic cycle. About 42% of revenue comes from the company’s automotive interiors business. In September the company announced a new joint venture with China’s Beijing Automotive Industry that will use an existing 420,000-square-foot plant in Beijing to operate Johnson Controls’ first automotive seating and interior operation in China with customers that include Chrysler, Isuzu, and Peugeot. In August a new joint venture in India Tata Johnson Controls Automotive began manufacturing seats and related components for Ford Motor (F). Another 44% of revenue comes from a building efficiency business which sells heating and cooling equipment and services. The company also has a huge lead auto battery business and a promising joint venture to build batteries for hybrids. (For more on why you want battery stocks in your portfolio see my post http://jubakpicks.com/2009/09/08/batteries-yep-good-old-batteries-are-the-technology-of-tomorrow-heres-how-to-invest/ ) The company is projected to show earnings of $1.53 a share for the 2010 fiscal year that ends in September. That would be a big improvement on fiscal 2009’s loss of 31 cents a share. At the January 21 closing price the stock traded at 18.9 times projected fiscal 2010 earnings. The stock is a member of both my Jubak’s Picks 12-18 month portfolio and my Jubak Picks 50 long-term portfolio.
Nucor (NUE). Talk about a turnaround. After a sales decline of 50% in 2009, S&P is projecting a 29% increase for 2010 on higher growth for the economy as a whole, a slowing rate of decline in non-residential construction spending, and inventory rebuilding at steel distributors who have spent most of 2009 selling down inventory. Thanks to a rigorous culture of cost control, the company was able to remain cash flow positive even during the 2009 downturn and should see margins increase with a return of sales volume in 2010. S&P projects 2010 earnings of $3.39 a share for 2010, quite a recovery from the $1.12 loss projected for 2009. At the January 21 closing price, the shares traded for 13.5 times projected 2010 earnings per share.
I can’t resist mentioning one other industrial stock, Polypore International (PPO), although I have almost no hope of catching a good price for it in any of my portfolios. The stock has moved up like a rocket on news that this maker of microporous membranes used in filtration and (this is the part that interests me) in batteries had renewed its contract with Exide Technologies (XIDE). Exide is Polypore’s biggest battery membrane customer and fears that the agreement would not be renewed had punished Polypore’s stock. But I missed shares on the bounce because this stock moves so fast. Maybe you’ll have better luck in timing a buy. At a closing price of $13.21 on January 21, the stock was closing in fast on its 52-week high of $14.10. The 52-week low is at $2.38. For more on why you want to own battery stocks, se my post http://jubakpicks.com/2009/09/08/batteries-yep-good-old-batteries-are-the-technology-of-tomorrow-heres-how-to-invest/
Full disclosure: I own shares of Johnson Controls in my personal portfolio.
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