Investors, Choose the Right Hammer

02/04/2011 10:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

For this stage in the economic cycle, the sector to add to your portfolio is one you may not be familiar with, so start learning. Here are several stocks to choose from.

"I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail."

I don't have the foggiest idea if Abraham Maslow, the psychologist who authored that quote in 1966, knew anything about investing.

But from painful personal experience, I'd propose an investing version that goes like this: "When you know only one group of stocks, it's tempting to see that group as the way to succeed in every market."

In 2011, I think it's going to be hard to make much money in the stock market unless you learn a new stock group, one that you're probably uncomfortable with, and one that's not the commodities or technology stocks you're familiar with from the last two huge rallies.

You're going to have to learn something about industrial and manufacturing stocks. That's the stock group you'll need in 2011—or at least in the first half of 2011.

(My dad told me his own version of Maslow's quote one day. As he handed me a pipe wrench, he said, "When every problem is a nail, you should use just about anything you have as a hammer." But I don't know what the investing wisdom in that might be.)

In 1999, for example, anyone who knew technology stocks hammered the stock market for about a 100% gain—or more. Shares of Cisco Systems (Nasdaq: CSCO) climbed 131% that year.

Try that in 2007, a huge rally year that was similar to 1999 in that it preceded a crash, and you would have been left crying on your router. Shares of Cisco dropped that year by about 1%. Not every technology stock did that badly in 2007. International Business Machines (NYSE: IBM) was up 13%. Microsoft (Nasdsaq: MSFT) advanced 21%. Oracle (Nasdaq: ORCL) nailed 32%; Intel, (Nasdaq: INTC) 34%.

But compare those gains with those delivered by a different stock group. General-purpose mining stock BHP Billiton (NYSE: BHP) was up 79% in 2007—and BHP Billiton was a laggard in its industry that year. Brazil's iron-ore giant Vale (NYSE: VALE) climbed 122%. Potash of Saskatchewan (NYSE: POT) soared 202%.

Yep. In 2007, it sure would have paid to abandon what you know—technology stocks—and learn an unfamiliar group—commodity producers.

In 2011, the group you need to know is industrials. Why?

Three Reasons for Industrials Now

First, because we're in the early recovery stage of the economic cycle. For more on why I think that and why it's important, see my Jan. 28 column. In the early recovery stage, consumer sentiment improves, industrial production turns up, interest rates hit bottom, and unemployment peaks and starts to move lower. Sectors that usually do best are industrials, near the beginning of the stage; basic materials; and, near the end, energy.

Second, the actual economic numbers, as opposed to the economic theory, show that manufacturing is leading the economy at this point in the cycle. For more detail, see my post on Feb. 2. The ISM Manufacturing Index climbed to 60.8 in January from 58.5 in December. The January number was the highest since May 2004. New orders picked up to 67.8 from 62.0 in December. The order backlog index rose for the first time since August 2010, to 58.0 from 47.0 in December.

The US isn't the only country with strong manufacturing activity right now. In the United Kingdom, despite a contracting economy, manufacturing grew at a record rate in January. In China, a purchasing managers index from HSBC and Markit Economics climbed to 54.5 in January.

Third, this outperformance by manufacturing makes sense. During a recession, especially during a deep recession, companies put off any spending they can—especially any spending that's linked to increased production capacity. Why invest in a new plant or equipment when the old stuff is running at only 60% of capacity, or less?

When the turn in the economy comes—or at least when companies are convinced that the turn is real—they start buying. And they buy not just for their current needs, but also to make up for all the buying they postponed during the recession.

So, for example, sales of Class 8 trucks—the big rigs—fell well below the long-term replacement rate during the Great Recession. No operator or owner wanted to sink money into a new truck when nobody knew if there would be freight to haul tomorrow. The result was that by spring 2010, the age of the US fleet had reached a two-decade high. The orders that started to flow in to Cummins (NYSE: CMI), Paccar (Nasdaq: PCAR), and other truck makers and suppliers in the second half of 2010 included a huge dose of pent-up demand.

You can see the same thing in radically different industries. Mining companies have announced huge increases in capital spending as they run to catch up with demand. Rio Tinto (NYSE: RIO), for example, has announced that its capital spending will climb to $11 billion in 2011 from $4 billion in 2010. In the semiconductor industry, Intel has announced that it will spend $9.3 billion on new facilities and equipment in 2011, a 79% jump from 2010. Chipmakers as a whole will spend $42.2 billion in 2011, up from $38.4 billion in 2010, according to research by Gartner.

OK, so let's say you're convinced by this but that you don't know a diesel from a weasel or you think that BHP Billiton (NYSE: BHP) makes billabongs, whatever they are. How do you teach yourself enough about an unfamiliar group of stocks—and fast enough to profit before the economic cycle turns to another group?

NEXT: Start with What You Do Know

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Start with What You Know

Use what you know as an entry into the unfamiliar. Say you're familiar with companies such as Intel and Advanced Micro Devices (NYSE: AMD). That ought to give you a head start in researching the industrial companies that make their production equipment, such as Applied Materials (Nasdaq: AMAT) or ASML Holdings (Nasdaq: ASML). (It should help that ASML is a member of Jubak's Picks and that I updated the stock and the semiconductor equipment sector in this Feb. 3 post.)

Or if you're a commodities investor, it should be a relatively easy leap into the companies that make the tools—the great big tools—mining companies use. And that will lead you to companies that make the equipment, such as Joy Global (Nasdaq: JOYG), Caterpillar (NYSE: CAT), and Komatsu (OTC: KMTUY).

What if you're not an "expert" in any sector, or at least not in one that takes you into an industrial segment? Well, you consume industrial products every day. You probably drive a car; you follow the news, so you know about the near-death experience of the US auto industry; and you've bragged (or listened to a friend brag) about a new car. Go from those clues to the industrial companies that make the turbochargers that give the current generation of cars more power for less fuel, like BorgWarner (NYSE: BWA), or the companies that make those neat new rear-view cameras, like Gentex (Nasdaq: GNTX).

You also need to recognize that you're not coming into this game early and that you have to work to catch up with the folks who bought industrials months ago. So dig down another layer.

Sure, it would have been great to buy Joy Global when it was selling for $53.89 a share on Aug. 26, 2010. But absent a time machine—and no, I don't know the stock symbol for any time-machine maker—as of Feb. 2, you were stuck looking at Joy Global at $90.29, or 68% higher than back in August.

How about some names that are less familiar? There's Titan International (NYSE: TWI), which makes the wheels and tires for big trucks, diggers, and farm equipment. That one might be unfamiliar to you, but not to industrial-sector investors. The shares were up 96% from Aug. 26 to Feb. 2.

How about Timken (NYSE: TKR), a maker of ball bearings and specialty steels? Its shares were up 50% during that period. Or Tenaris (NYSE: TS), a maker of steel tubing for oil drilling, up 41%? Or steel maker Nucor (NYSE: NUE), up 31%.

And don't limit yourself to the United States. Like Caterpillar? How about Japan's Komatsu?

Don't fall back on only the familiar names in overseas markets, either. If you can name a European industrial stock, it's most likely Siemens (NYSE: SI). But Switzerland's Schindler has the number-one position in the global escalator market. Try to build a shopping center or just about anything else without one. And you know how much maintenance escalators seem to need. The stock trades over the counter in the United States as SHLAF or SHLRF.

My Five Favorites

Here they are, based on where I think we are in the cycle and their prospects:

  1. Nucor, because the steel industry lags behind much of the sector in its recovery

  2. BorgWarner, because auto sales in the U.S. have just started to recover

  3. ASML Holdings, because the war among chip makers is great for chip equipment makers

  4. Titan International, because despite its 96% gain from August, the stock still trades at only two-thirds of its 2008 high and the construction-equipment market still hasn't fully kicked in

  5. Keppel (OTC: KPELY), because right now I'd rather own a company that makes drilling rigs than one that owns them—and Keppel's water infrastructure business is a gem

At the time of publication, Jim Jubak did not own shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund, (JUBAX), may or may not now own positions in any stock mentioned in this post. The fund owned shares ofApplied Materials, ASML Holdings, BHP Billiton, BorgWarner, Cisco Systems, Cummins, Joy Global, Keppel, Komatsu, Nucor, and Vale as of the end of December. Find a full list of the stocks in the fund as of the end of December here.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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