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Quarter-End Insights

Our Outlook for Industrials Stocks

Slowing demand and higher input costs create head winds for industrial firms.

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After enjoying recent torrid growth in emerging economies, a potential slowdown in both developing and developed nations looks to impact the third quarters of many of the industrial companies we cover. Principally, weakening growth in China and India--as evidenced in part by declining auto sales throughout the region in August--could affect firms heavily levered to project and infrastructure spending (such as  ABB (ABB) and  Emerson (EMR)). Similarly, demand for automobiles and construction has weakened in western Europe, where unemployment and housing problems recently encountered in the United States seem to have spread. The quarter's precipitous drop in the Baltic Dry Index (a measure of demand for commodity and project-cargo shipping around the world) to its current 4,700 from an all-time high near 12,000 highlights this global deceleration.

That said, slowing demand has driven down crude oil prices 35% during the third quarter, and several of our service-based firms stand to benefit. Legacy airline carriers such as  United (UAUA) and  American (AMR) will likely enjoy widened profitability, as more than 25% of the firms' costs are fuel-related, and it appears that the extra revenue-generating surcharges, such as baggage fees, are sticking. Similarly,  FedEx (FDX) and  United Parcel Service (UPS)--which have seen fuel run up as a percentage of costs--should see rising operating margins, even as their fuel surcharges wane. Finally, the outlook for Mexico's airport operators such as  Grupo Aeroportuario del Centro Norte (OMA) (OMAB) and  Grupo Aeroportuario del Pacifico (GAP) (PAC)--highlighted in our previous quarterly outlook--has improved given the more-upbeat outlook for the country's low-cost carriers.

Nonetheless, oil and other commodities remain elevated above historical levels, and mining projects and agriculture investment remain economically feasible. As a result, we expect demand for specific equipment used in these developments to stay robust, benefiting companies like  Caterpillar (CAT) and  Deere (DE). However, the North American construction market remains in decline and doesn't look likely to rebound for some time, and continued credit issues have led to further slides in auto sales and home prices. Times are certainly tough, but we think several wide- and narrow-moat firms have positioned themselves to succeed over the long haul.

Valuations by Industry
Given the market's rapid sell-off, several industrial sectors look cheap, in our opinion. For instance, we think marine transportation firms--on which we've been generally bearish over the past year--now offer investors substantial upside and strong dividend yields. Similarly, our outlook for industrial conglomerates remains positive, as we think these companies' diverse portfolios will continue to provide avenues for growth. On the other hand, we no longer see a margin of safety for homebuilders after they've rebounded from their lows.

Industrial Stocks for Your Radar
We've picked five industrial stocks to keep an eye on for your portfolio. Three-- 3M (MMM),  Tyco (TYC), and  General Electric (GE)--are large industrial conglomerates that feature wide diversification. The others--UPS and  Mohawk Industries (MHK)--lead their respective industries, but have struggled due to macroeconomic challenges.

 Stocks to Watch--Industrials
Company Star Rating Fair Value Estimate Economic
Fair Value Uncertainty

Fair Value

3M  $97 Wide Low 0.72
Tyco $55 Narrow Medium 0.70
General Electric $42 Wide Medium 0.60
UPS $79 Wide Low 0.83
Mohawk Industries $103 Narrow Medium 0.68
Data as of 09-23-08.

 3M (MMM)
Despite slowing growth among European economies, we continue to think that 3M's diversified array of patent-protected technologies will benefit the company and investors. We expect the firm's health-care segment--typically a more-inelastic business--to perform especially well. With over two thirds of revenue stemming from overseas, we think 3M's geographic breakdown shields the company from domestic economic issues.

 Tyco (TYC)
We thought this market-leading firm's third quarter was impressive, with strong organic growth and profitability expansion. We expect this trend to continue for the next several years stemming from the firm's restructuring plan and strong end-market demand. The firm continues to buy back its own shares and churn out hefty amounts of cash, which is another positive.

 General Electric (GE)
Though GE owns one of the country's largest banks, its strategy for the financial sector differs greatly from that of other investment houses. Most notably, its financial leverage is considerably lower than the industry average. Furthermore, we believe that GE's industrial arm offers the greatest potential, and comprises nearly 80% of our fair value estimate. 

The spike in fuel costs has challenged both UPS' profitability and demand in its end markets. Nonetheless, the company's fuel surcharges--though on a six-week lag--have mostly recovered these increased expenses, and recently mitigating oil prices should lead to widening operating margins. We think this wide-moat firm will continue to lead its industry.

 Mohawk Industries  (MHK)
As a leader in the flooring industry, Mohawk has seen demand dip from the slowdown in residential construction. Still, nearly 60% of the firm's sales stem from the replacement market, which historically has been somewhat countercyclical (although it has recently suffered along with housing starts). In all, though near-term head winds remain, we're optimistic about the firm's long-run prospects.

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Adam Fleck does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.