Monday, June 22, 2009

Perils in Indiscriminate Bets on Industrial Resolution

By LIAM DENNING Beware falling machinery. Industrial-sector stocks have been on even more of a tear than most others since March, jumping about 40%. The concomitant jump in the average 2009 price/earnings multiple for S&P 500 industrials from single digits to about 14 -- while consensus estimates were actually trimmed -- serves as a warning. That doesn't mean avoiding the sector altogether, but it does mean a different investment approach. Recent exuberance is predicated on perceived economic "green shoots," helped by government stimulus spending. Industrial companies are particularly sensitive to such sentiment. Studying previous sector downturns in the mid-1980s and early 1990s, Scott Davis of Morgan Stanley highlights a pattern of multiples rising early in the downturn followed by renewed pressure as actual earnings fall short of hopes. This one looks no different. Manufacturing capacity utilization hit a miserable 65% in May. In the last recession, U.S. manufacturing inventories contracted year-on-year for 22 months, according to Sanford Bernstein. In the current downturn, inventories began falling year-on-year in January. Quickly working off that much slack would require an "I"-shaped recovery, never mind "V"-shaped. Emerson Electric Chief Executive David Farr, for one, doesn't envisage this. Moreover, in a recent Reuters interview, he cautioned that even when the global economy recovers, underlying annual growth for the industry could be half of the high single-digit percentages it has grown used to. That scenario of slow recovery and lower growth expectations means less pricing power, hitting profit margins. Investors can try picking more resilient subsectors. Government spending on transportation and energy infrastructure will tend to benefit big, diversified companies like General Electric, Siemens and ABB, as well as niche competitors like Vestas Wind Systems. GE, however, remains under the cloud of its finance arm. More generally, infrastructure projects are long-term earners, not the quick hit to profits investors might dream of. And there is a headwind from other projects being canceled. Mr. Davis estimates about 13% of emerging markets infrastructure projects were canceled in 2008, versus an average since 1993 of 5.9%. An alternative for investors is to target companies ahead of the game in cutting capacity and costs. This offers a shield to margins while uncertainty remains about demand trends and revenue growth, particularly if raw-material costs remain elevated. Emerson, for example, will have cut fixed production expenses by 15% in the two years ending in September, reckons Sterne Agee. Along with that, investors can draw comfort from knowing that its chief executive holds no rosy preconceptions about what lies ahead. Write to Liam Denning at liam.denning@wsj.com