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Stock Strategist Industry Reports

Some Hidden Gems in Diversified Industrial Stocks

These stalwarts look cheap, and could benefit from a boost in business spending.

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Economic cycles usually play out according to a loosely defined sequential cadence. The depth and duration of each cycle differ considerably over decades, but the sequence of when segments of the domestic economy (loosely defined as consumption, production, and investment) progress through each phase of the cycle is relatively consistent. As we digest second-quarter earnings and study the macro indicators, it's quite apparent that the production-centric section of economy, while still firmly in rebound mode, is bumping up against some headwinds, and that investment-centric names are just starting to heat up.

The Consumer is the Canary in the Coal Mine
Generally speaking, early signs of trouble in the U.S. economy typically show up at the consumer level. Comprising more than two-thirds of overall output, the spending behavior of consumers holds huge sway on the direction of GDP. Once the consumer goes south, production of any goods he or she is no longer buying quickly follows.

Added to the decline in consumption is usually an inventory reduction throughout the entire chain, as retailers, distributors, and everybody in between prepare for more difficult times by emptying their shelves and back rooms. This inventory effect assures that swings in production are much larger than movements in consumption. Though the offshoring of much production to low-cost overseas regions has dampened the effect, it hasn't eliminated it by any stretch.

Finally, as profits shrivel, managers' appetites for repairing or upgrading plants deteriorate such that overall business investment usually declines by an even greater magnitude than production. Yet, the lack of investment is a sure way to lose competitiveness, so when confidence recovers, investment usually returns with a vengeance. This dynamic makes capital spending by far the most volatile of the three segments described above. The same phenomena usually play out on the way up, as consumer spending bottoms first, and the other two categories follow suit in sequential fashion, with industrial production bottoming slightly before investment.

Looking Around, Thinking Ahead
Where, then, does the U.S. economy stand in the current cycle? What can we expect from diversified industrial names over the coming quarters? Though driven by a severe contraction in credit availability, the great recession of 2008 and 2009 generally played out according to script, albeit with some distortions due to the malaise in homebuilding. While consumer spending started to decline sequentially in the first quarter of 2008--just after industrial production began to slide in the fourth quarter of 2007--business investment (capital spending excluding residential structures) actually improved sequentially through the second quarter of 2008, only to plummet shortly thereafter. Personal consumption expenditures bottomed by the second quarter of 2009, at around 2.4% below peak levels, in inflation-adjusted terms. Industrial production also hit bottom during the second quarter of 2009, at nearly 15% below peak levels, while business investment bottomed at more than 20% below peak in the fourth quarter of 2009.

Though one wouldn't know it from various gloomy media accounts, real consumer spending as measured by the highly inclusive personal consumption expenditure figures--published by the government--is within a percentage point of its all-time high. The current 1.6% year-over-year growth rate isn't quite what we'd like to see, but consumer expenditures are, in fact, growing. Industrial production, on the other hand, sits roughly half way between its bottom and its 2007 high. Meanwhile, investment is only 5.5% above its 2009 low, and still about 17% below its recent highs.

The takeaway is that investors should expect names with significant exposure to investment-centric markets to post exceptional results. Anything related to business spending is likely to enjoy a material boost over the next several quarters.

But, we urge caution: The current prices of many diversified names already incorporate a rosy outlook.

For instance, we're big fans of  Emerson Electric (EMR), but at almost 20 times our estimate of this year's earnings, the name currently doesn't offer a large margin of safety. The same goes for  United Technologies (UTX). Its Otis elevator, Carrier HVAC, and fire and security businesses, among others, will all benefit from a big pickup in investment spending in the U.S. and abroad. Even so, we're a bit leery of the company's exposure to what's sure to be a declining defense budget over the next several years. At a bit over 15 times this year's earnings, we think it's pretty fairly valued at the current quote. Similarly, we generally think highly of  Danaher's (DHR) management team and operating model. However, at more than 17 times this year's earnings, we think better opportunities lie elsewhere.

We Think These Names Deserve a Second Look
A few diversified industrial names we think appear relatively cheap at current levels are  Illinois Tool Works (ITW),  Honeywell (HON),  Actuant (ATU),  ITT Corporation (ITT), and  Parker Hannifin (PH).

 Illinois Tool Works (ITW) is sure to benefit from its exposure to several of the markets that we expect will enjoy outsized growth over the next few years. The firm derives 18% of its top line from general industrial demand, an area enjoying strong growth today. It earns another 15% of sales in transportation markets, an area of severe underinvestment during the past two years. Finally, ITW enjoys material revenue from a segment of the industrial economy that's just now getting revved up: capital spending. Trading at only about 14 times this year's likely $3 earnings per share, Illinois Tool Works looks cheap to us.

Generating a megawatt of electricity costs triple the price of saving a megawatt of energy. This gives a strong economic motivation for making products that use electricity more efficiently.  Honeywell (HON) aims a significant portion of its portfolio at helping customers decrease energy consumption. The company is in the early stages of launching a lean six-sigma initiative, which has proven to improve operating margins and reduce working capital at Honeywell sites that have already implemented the system, enhancing returns to shareholders. Trading at less than 14 times our 2011 earnings projection, we think Honeywell is attractively priced, since the market appears to discount the possibility of additional margin lift from operating improvements.

In the years preceding the recession,  Actuant (ATU) beefed up its energy services business, anchored by its Hydratight business. As an equipment and service provider to the oil and gas industry, we think Actuant is well-positioned to take advantage of rising demand for asset maintenance. We expect consolidated margins to rise when the energy business regains its footing, making the overall business more attractive. The company is currently trading at less than 14 times fiscal 2011 earnings--a multiple we think underestimates the firm's strong growth prospects.

Though a major defense player,  ITT Corporation (ITT) derives half of its revenues from water, wastewater, and industrial end markets. Further, ITT invests nearly 65% of its earnings back into the business, mostly to acquire smaller rivals. At the midpoint of management's 2010 EPS forecast of $4.13, the firm is currently trading for a bit over 11 times forward earnings. Given the attractive nature of water and industrial end markets and the high reinvestment rate of the firm, we think this is a low multiple to pay for a high-quality firm like ITT. Further, we appreciate ITT's focus on acquiring firms outside the defense space, whereby it aims to tilt its portfolio towards higher growth.

 Parker Hannifin (PH) supplies many global manufacturers with motion and control equipment. Strong industrial manufacturing is leading to rising demand for industrial maintenance, repair, and overhaul activity. Capital spending ground to a halt during the recession, but we believe firms that are sitting on cash will reinvest in their equipment and give rise to a growing market for the company. Parker is presently trading for 13 times our 2011 earnings estimate--less than historical trading levels. When coupled with the firm's current organic growth opportunities, we think Parker's stock is attractively priced.

Finally, investors may be intrigued by  Ingersoll Rand (IR) at current prices. Though the company is a bit less diversified than it was in the past, earnings may be on the verge of significant growth. Management is now focused upon increasing profitability as it better integrates its operations, after undergoing a massive portfolio restructuring. And though the firm has high exposure to commercial construction, Ingersoll will harvest a decent amount of low-hanging margin improvement fruit over the next several years. Capacity utilization is sure to go up as the company closes several duplicate facilities. Management is shooting for earnings of more than $5 per share by 2013, and has laid out a detailed road map of how it plans to attain this lofty goal. If it achieves even most of this goal, the stock looks cheap at current prices.

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