Manufacturing Isn't a Four-Letter Word

 | Oct 13, 2011 | 10:30 AM EDT
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Manufacturing was once the king of the U.S. economy. But the widely accepted perception of U.S. manufacturing today is that the king is dead, long live the king. But is that view entirely accurate?

The World Bank ranks the U.S. behind every industrial nation but France in its percentage of overall economic activity accounted for by manufacturing. The New York Times reports that the recent recession reduced U.S. industrial production by 17.3%, "the sharpest drop during a recession since the 1930s."

Wow, that sounds bad for manufacturing, and it is; however, the picture of the manufacturing sector is not uniformly bleak.

The Federal Reserve Bank of Philadelphia reported in its September 2011 Business Outlook Survey (which covers the bank's three-state region of Pennsylvania, southern New Jersey and Delaware): "Indicators for future activity remained positive and strengthened this month. The broadest indicators for future activity improved notably, increasing 20 points and nearly reversing the 22-point decline in August. The indexes for future new orders and shipments also improved, increasing 5 points and 13 points, respectively. The index for future employment increased a modest 3 points."

At the same time, the Federal Reserve Bank of New York in its September 2011 Empire State Manufacturing Survey, which focuses on New York, reported: "Future indexes were generally positive, suggesting that respondents expect business activity to improve in the months ahead, but optimism was well below levels observed earlier this year. The future general business conditions index advanced four points to 13.0, a low level by historical standards but still an indication that conditions are expected to improve."

I am not suggesting that manufacturing is doing well. It is struggling -- but there are winners among the strugglers. Not every area of the country or every manufacturer is performing poorly.

One manufacturing company that is performing full steam ahead is Sauer-Danfoss (SHS), which designs, manufactures and sells engineered hydraulic and electronic components such as transmissions, motors and valves. These are used by off-highway vehicle manufacturers that produce equipment for the agriculture, construction and material-handling industries, among others. I believe Joel Greenblatt would like this company. He created an investment strategy that he described in his bestseller The Little Book That Beats the Market, which I computerized so I could instantly screen all publicly traded stocks using his criteria. This strategy is very fond of Sauer-Danfoss.

The strategy's first criterion is earnings yield, which is calculated by dividing a company's earnings before interest and taxes by its enterprise value. Enterprise value includes not only share price but also the amount of debt used to generate earnings. Of the thousands of stocks in our database, Sauer is ranked number 56 by this criterion. The second criterion is return on total capital, which examines how well a firm uses the capital it employs. Here, Sauer ranks number 193. The strategy's final step ranks each stock based on a combination of the first two criteria. Sauer comes in at number 35 among all the stocks in our database, which is excellent.

Another manufacturer worth looking at is Regal Beloit (RBC), which makes electrical and mechanical motion-control products such electric motors, generators, gear reducers and electronic switchgear used in a wide array of products. The strategy I modeled from Benjamin Graham's writings finds a lot to like about Regal. It has sizable sales of $2.5 billion. It's highly liquid, with current ratio at a solid 2.53:1, modest long-term debt of $428 million and robust current assets of $749 million. It's had strong long-term EPS growth of 189% over the last five years and a modest price-to-earnings ratio. After multiplying PE by the price-to-book ratio (1.32 in Regal's case), this strategy requires a product of 22 or less. Regal's is 19.

Yes, both of these companies are manufacturers -- but they are doing well and their stocks are reasonably priced. In morning trading, SHS was down 2.5% to $33.64 and RBC was off 2.8% to $50.15.

So, don't let the word "manufacturer" scare you. Many investors are avoiding manufacturers, which is precisely why you should not.

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