Our Outlook for Industrials Stocks

• The industrial sector likely enjoyed solid, if slower, growth in the first quarter, led by continued advancement in the U.S. economic environment and further gains in emerging markets.
• Both housing and nonresidential construction spending look to climb in the near term, with several leading indicators suggesting more-positive results over the remainder of 2012.
• Overall, we don't think valuations in the industrials universe currently offer sizable margins of safety, although we still believe investors can enjoy some opportunities in individual companies.

Our outlook for the industrials sector hasn't changed much over the past several months. In the U.S. we've seen continued signs that growth rates for most companies in our universe should plod along at slow, but steady rates. Leading indicators such as the ISM Purchasing Managers Index remain at levels that suggest industrial production growth, but likely at less robust levels than in the latter part of 2010 and the early portion of 2011. Nonetheless, when combined with nascent recoveries in housing and nonresidential construction, North America will likely offer continued solid results for most industrial firms in the first quarter.

Conversely, Europe is still a critical near-term risk. Although the region's PMI has climbed from the doldrums seen in the fourth quarter, the metric remains below the key 50 demarcation, which is indicative of manufacturing contraction. That said, both Germany and the U.K. have seen improving results, with metrics above 50 in February (at 50.2 and 51.2, respectively) versus sub-50 readings in late 2011. We caution that growth expectations remain fragile, but most industrial company management teams still do not expect a return to sharp recessionary levels in the near term.

However, we are hearing more about China's slowing economic activity, which particularly affects many of our covered companies in the construction, mining, and industrial space. We expect continued above-average growth in the geography, but likely at a slower rate; the region's PMI remained below 50 for the first quarter, only slightly ahead of the fourth quarter's average metric and well below the mid- to high-50 level seen a year ago. Importantly, a measure slightly below 50 here isn't consistent with actual contraction, but slower growth.

Amid this largely stable demand environment, the  Industrial Select Sector SPDR (XLI) exchange-traded fund climbed about 12% last quarter, nearing its 2011 high. As such, we generally see even slimmer margins of safety in equity prices across our universe than in the prior quarter, with the overall sector price/fair value ratio at 0.95 compared with 0.85 at the end of the fourth quarter. That said, we continue to see pockets of opportunity in areas such as U.S. nonresidential construction, automotive, and commercial aerospace.

Housing Renascence on the Horizon
What a difference a few months can make. In our last outlook we were hopeful that 2012 would be a year in which positive signs would emerge in the housing market after more than half a decade of unabated misery. Back then, some early signs were pointing in a positive direction, but we indicated it was still too early to mention revival. Today, the evidence points much more strongly toward higher production levels this year and, eventually, firming prices. As long as the U.S. avoids a recession, we believe single-family housing starts will likely log their first material annual gain since 2005 this year (2010 witnessed a slight 6% annual increase, but this was due to a temporary tax credit as opposed to organic demand). The reason is simple. Listed inventories are now back in line with historical norms, rents are increasing throughout the country, and potential buyers are starting to feel more confident about their economic situations.

Increased builder backlogs, higher confidence index levels, and the most bullish comments we've heard from those in the field in several years confirm this optimistic view. For instance, at the end of 2011, the combined backlogs of the nation's top builders stood more than 20% higher than the year-ago levels, the first non-tax-credit-induced year-over-year aggregate increase since mid-last decade. The majority of these backlogs have since converted to starts in the past few months, indicating the year is off to a strong beginning. In addition, several builders and other industry participants have indicated order volumes continued their above-average pace into the first quarter. Most builders are now increasing community counts and enjoying higher absorption rates to boot, all good signs for higher annual starts over the next few quarters.

Investors shouldn't discount the effect that higher rents are having on the rent/buy decision, as this dynamic is rapidly shifting the landscape. Homes have been cheap for a couple of years now, but builders hadn't been able to attract much interest until very recently. Today, rising rents have finally injected a bit of urgency into the decision as potential buyers weigh a mortgage payment that stays constant for decades against rent payments that today are the same or higher and likely to increase annually for the foreseeable future. There are many drawbacks of owning a home, but the availability of a cheaper alternative in the form of renting is quickly disappearing from the list.

Finally, home prices have been mostly disappointing to date, but this too could be changing before our eyes. Inventories of listed existing homes are now at their lowest point since before the bubble popped. Combined with empty new homes, we think the total non-shadow inventory situation is now squarely back inside an equilibrium range, indicating stability in pricing can't be far off. In fact, we've started to see strength in median listing prices in excess of what normal seasonality would suggest in late February, and the trend has persisted thus far through March. Barring an economic collapse, these modestly firming prices should start to show up in the popular home price indexes in a few months. And although there's still a formidable amount of shadow inventory in the pipeline, stronger potential cap rates on rental units should blunt the impact of an increase in distressed sales.

Bottom line, we're confident 2012 will be the first year in several to enjoy a genuine increase in production, and we're not counting out flat to modestly higher median prices by the end of the year either.

Nonresidential Construction Turning the Corner as Well
Until late last year, nonresidential construction spending in the U.S. had declined year-over-year every month since January 2009. Since October 2011, combined public and private spending has begun to climb from its bottom, and actually leapt nearly 9% in January, per the U.S. Census Bureau. Power-related construction projects have led the way (up 23% in the most recent data), although commercial and manufacturing spending have also increased materially. We believe this nascent recovery will continue, based on a strengthening Architecture Billings Index (ABI) and solid order rates for most heavy construction equipment companies we cover.

In particular,  Terex (TEX) and  Caterpillar (CAT) have enjoyed stronger demand lately, with double-digit revenue gains in each quarter over the last 18 months. We attribute a good portion of this to replacement demand, as many customers' delayed capital expenditures had led to aged equipment fleets, but we think the U.S. market will continue to enjoy strong growth as construction spending rises.

However, one area we've noticed substantial weakening is in China's construction equipment market. Unit volumes of key products such as hydraulic excavators have declined sharply in recent months compared with year-ago periods in the region, and as the largest construction machinery region in the world, this negative growth has impacted many global manufacturers. In addition, Chinese OEMs such as Sany and Zoomlion have enjoyed increasing market share and have launched international acquisition plans to further expand their geographic breadth. Although this trend will likely play out over multiple years rather than quarters, we believe Cat,  Komatsu (KMTUY), and others will face substantially increased competition within the next decade.

Commercial Aerospace Orders on the Rise
Both Airbus (a division of EADS (EAD)) and  Boeing (BA) have enjoyed swelling commercial aircraft orders over the past several quarters; in fact, Airbus' A320neo single-aisle plane was the fastest-selling jet in history. With aircraft backlog greater than 8 years of annual production for both Airbus and Boeing, we anticipate continued solid growth, which should benefit not only these manufacturers, but also aerospace suppliers.

As such, we think firms such as  Rockwell Collins (COL),  Precision Castparts (PCP), and  Moog (MOG.A) will enjoy continued near-term strength in their commercial aerospace divisions, although we remain relatively bearish on near-term defense spending prospects. We still believe that extremely large cuts are not in the pipeline, but 3% to 5% annual cuts over the next several years are possible, in our opinion. That said, many defense contractors now seem to be pricing in this outlook, with a price/fair value of about 1.0. 

A Mild Winter Has Interesting Effects
In many parts of the U.S., we've enjoyed an uncommonly mild winter that has presented odd short-term scenarios for many companies we cover. For instance, we've seen several utilities shutter coal-fired power plants due to reduced electricity demand and lower natural gas prices, which has taken a toll on the domestic demand for firms such as mining-equipment manufacturer  Joy Global (JOY) and railroads  Norfolk Southern (NSC) and  CSX (CSX). Nonetheless, we think this situation has presented near-term buying opportunities for these companies, as all are currently rated 4 stars.

The weather has also led to reduced demand for automotive aftermarket companies, especially repair-part specialist  LKQ (LKQX). Because of the warmer winter, ice- and snow-related automotive accidents have fallen compared with last year, likely hampering the company's first-quarter results. That said, there may also be an upside to the weather; deer create a significant amount of business for body repair shops and with a mild winter, there could be an increase in the population, leading to a greater number of collisions in the fall. Admittedly, it's hard to predict deer collisions, but the National Highway Traffic Safety Administration estimates that there are about 1.5 million car wrecks involving deer, resulting in about $1 billion of collision repairs. Relative to the overall collision market at $42 billion, it's a significant enough number that it could offset the decline in collisions from the mild winter's driving conditions.

Our Top Industrials Picks
After a solid quarter of stock price appreciation, many of our individual industries feature far slimmer margins of safety than three months ago. Residential construction is one area in particular that has enjoyed a nice run, climbing to a price/fair value ratio above 1.0 compared with 0.79 at the end of 2011, with only railroads (at 0.85, from 0.87) seeing a falling ratio. That said, we still think some individual companies are offering suitable margins of safety, highlighted below.

Top Industrials Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Masco		$16.00	None	High	$9.60
Parker Hannifin		$100.00	Narrow	Medium	$70.00
Terex		$33.00	None	High	$19.80
TRW Automotive		$65.00	None	High	$39.00
Data as of 03-20-12.

 Masco (MAS)
Few construction product makers have been hurt by the several-year housing downturn more than Masco. Two of its five segments, Cabinets and Installation Services, haven't made money in over three years, while a third, Other Specialty Products, is barely profitable. Yet Masco's reliance on new construction and renovation of existing structures is about to become virtuous as both sectors recover. Management has taken significant costs out of the business by combining several facilities and now likely enjoys a breakeven point at much lower production levels. Although we're not looking for much from these businesses in early 2012, by late in the year they may be approaching profitability. In addition, Masco's higher-quality paint and plumbing segments continue at high levels of profitability even at today's low volumes. In all, we think Masco enjoys earning power of between $1 and $2 per share in a more normal housing environment.   

 Parker Hannifin (PH)
As a leading supplier of motion products, Parker Hannifin is a proxy for global industrial activity. With exposure to equipment manufacturing and distribution, the firm's balanced business model helps add stability to otherwise cyclical end markets. Although the company recently lowered its short-run outlook on the heels of a weak fourth quarter, our long-term thesis for Parker remains strong as the broad distribution business the company has built helps offset the bull-whip effect coming from original equipment manufacturers. The company has done an impressive job of coordinating across the firm and shifting from component manufacturer to an integrated systems provider. We think strong industrial production should push Parker's revenue higher in 2012 (likely up high-single-digits), with operating margins remaining lofty due to a continued focus on lean initiative implementation.

 Terex (TEX)
Over the past several quarters, Terex has enjoyed solidifying end markets, improved internal operations, and an appreciating stock price, but we still think the company has a runway for further improvement. Although the firm holds sizable exposure to both Western Europe (more than a quarter of total revenue), some leading signs in the region have proven encouraging in recent months. Moreover, the U.S. nonresidential construction picture has seemingly bottomed, and indicators here also suggest improvement in coming quarters. Along with better cost control, continued working capital improvement, and further integration of acquired companies, this environment should help Terex expand its operating margin over the next few years, with potential for additional debt reduction as well. In all, we think the company's prospects still remain sound, and the market currently offers a decent margin of safety for investors.

 TRW Automotive (TRW)
We think this 4-star stock has legs to our fair value estimate of $65 per share, representing price appreciation potential of approximately 38%. Even though about half of TRW's business is derived from Europe, we expect revenue to improve in 2012 due to the company's customer base. Although 49% of TRW's 2011 revenue was derived from European customers, about 57% of the 49% came from German customers that have solid export businesses and expect to post record revenues in 2012. We also think TRW will continue to benefit from increasing safety regulation around the globe. Developed countries' average safety components content runs around $350 per vehicle while some developing markets' safety content is less than $100. However, the potential for an antitrust settlement overhangs the stock. Even so, in our opinion, liquidity and cash flow should be adequate if regulators conclude that TRW did in fact break antitrust laws. As of Dec. 31, 2011, TRW's cash balance was $1.2 billion while total debt outstanding was $1.5 billion, leaving net debt at a historic low of $291 million. Operating cash flow was $1.1 billion while capital expenditures were $571 million, leaving full-year 2011 free cash flow of $549 million. Net debt to EBITDA was a very impressive 0.2 times. Total liquidity including cash balance and availability on credit lines and committed securitization programs was in excess of $1.3 billion at year-end.

If you'd like to track and analyze the stocks mentioned above, click here to create a watch list. Then simply click "continue," name your watch list, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.

More Quarter-End Outlook Articles

• Outlook for the Stock Market
• Economic Outlook
• Credit Market Outlook
• Credit Sector Updates and Top Bond Picks
• Basic Materials
• Consumer Cyclical
• Consumer Defensive
• Energy
• Financial Services
• Health Care  
• Real Estate
• Tech & Communication Services
• Utilities