It is a point of pride among those of us who follow industrial stocks that the companies we value are actually, well, valuable. I had an old colleague from DLJ in the 1990s say "I follow anything with assets" and that's the gist of analyzing companies that manufacture. I'm not saying Facebook (FB) , Amazon (AMZN) , etc. don't have balance sheets; Facebook has built up a massive array of flash-based servers, and Amazon's warehouse network and Amazon Web Services hosting businesses are both quite impressive. But those companies still don't make anything.
Companies that do make things are always susceptible to economic cyclicality, and the key to generating returns on these stocks is to buy them when they are trading at discounts to historical levels based on "mid-cycle" earnings, i.e. the amount the company can earn in a period of normal economic growth. So you buy them when things look bleak and sell them when things look rosy.
We are almost exactly one year removed from last year's presidential election, and the bleak forecast in the event of a Trump victory had hit industrial stocks, including the four I focus on here: Caterpillar (CAT) , Cummins (CMI) , Deere (DE) , and Navistar (NAV) .
Well, Trump won, the world did not end and the United States has not engaged in "massive trade wars" with China, Japan, Lesotho or any other country. Also, the U.S. is closer to meaningful reform of its corporate tax code than at any time in the past 31 years.
So, it stands to reason that pre-election was a good time to buy industrial stocks, and the one-year performance numbers do not lie:
S&P 500 +21.3%
Over the past three months, the performance numbers are similar:
S&P 500 +4.2%
So, the old head in me wants to see "whoa, stay away." CAT is currently trading at 18.1x next year's earnings when the S&P 500 is trading at 17.7x? To initiate a CAT position I would have to pay a premium to the market for a company whose earnings are much, much, much more volatile over the course of an economic cycle than sectors such as IT, media/entertainment, and (most) financials? I can't do it.
The closest to a "buy" in that industrial Gang of Four would be Cummins. On the consensus EPS estimate of $11.42 for 2018, CMI is trading at a reasonable 15.1x P/E multiple. Also, recent strength in orders for heavy trucks indicate that that consensus estimate could be conservative. From Ward's Auto last week:
North American orders for Class 8 semi-trucks more than doubled in October compared with the same period in 2016, and strong orders should continue to bolster truck production into 2018, FTR, a company that tracks the industry, said on Thursday.
So Cummins has been the laggard in that group with "only" a 32% gain over the past year, and, in my opinion, it represents the best value for the next 12 months.
When dealing with industrials at cycle-peak valuations, it is important to remember that there will be a time in the not-too-distant future when earnings estimates are lowered, not raised. In these stocks, capital preservation can be as important as capital gains, and when the pendulum swings too much toward the former, it is time to take profits.
-- This article was originally published on Nov. 7
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