Industrial Stocks Living in the Past

Companies' financial results are always backward looking. None more so than the recent round of quarterly reports from America's big industrial companies. On the face of it, the sector held its own. Of 53 S&P 500 industrial-sector stocks -- there are 58 in total -- that reported as of Aug. 7, three-quarters beat the consensus earnings estimates. They did so by an average of 10%, according to Thomson Reuters. The Street's view on second-quarter earnings growth for industrial stocks had collapsed from negative 11.3% on Jan. 1 to negative 35.5% by July 1. Since June 30, the sector has rallied almost 12%, beating the wider market handily, as the average forward price/earnings multiple has expanded to 16 times from around 14 times. Heard on the Street columnist Liam Denning explains to Simon Constable why he thinks the recent rally in industrial stocks like Caterpillar has been overdone. Plus why Emerson Electric, Honeywell, Ingersoll Rand might do better than many others in the sector. In other words, that the sector largely managed to beat beaten-down earnings estimates in the quarter has fueled renewed optimism on the future. But based on what? Results from bellwether Caterpillar demonstrated the problem perfectly. It beat the consensus estimate threefold, but largely because of cost cuts, a lower tax rate, currency gains and accounting gains on shrinking inventories. Meanwhile, its revenue slumped 41%, and the company was reticent on the outlook for 2010. That lack of clarity hasn't stopped investors from pushing Caterpillar's stock price up to 26 times the average 2010 earnings estimate. Overall, industrial companies took the opportunity to trim midpoint 2009 earnings forecasts 4%, according to Nigel Coe at Deutsche Bank, suggesting caution in the boardroom, at least. Evaporating demand is the real theme investors should be considering when pricing industrial stocks. Scott Davis, who runs Morgan Stanley's industrial research team, calculates that revenue across the sector dropped 20% year-on-year in the second quarter. Even worse was a 30% drop in the order book, a real leading indicator. Not only did that outpace an already worrying drop in sales, it also was more than double the average rate of inventory decline in the sector, according to Mr. Davis. This raises concerns on two fronts. First, if future demand is weak, it suggests further inventory liquidation and continuing weak industrial capacity utilization, already at a record low. Second, it throws doubt on industrial companies' ability to preserve pricing power. Amazingly, despite the recession, they managed to eke out small price increases in the second quarter. However, if this partly reflects fulfilling orders struck some time ago and demand remains weak, pressure on prices will increase, particularly as idle secondhand product is put on the market. Government stimulus programs offer hope. But U.S. efforts will take several years to ramp up, while China's more immediate program already has contractors swarming, putting pressure on margins. Pretty soon, the explosive summer rally could be a distant memory. Write to Liam Denning at liam.denning@wsj.com