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Stock Strategist Industry Reports

4 Attractive Diversified Industrials Stocks

Plus, five takeaways from this year's Electrical Products Group Conference.

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Chief executives of some of the most well-known, global diversified industrial firms gathered in Florida late last month at the annual Electrical Products Group conference, where they touched on several broad themes, including robust demand leading to resilient organic growth, the muted impact from tariffs, and strong digitization trends sweeping the industry.

We had the opportunity to press these leaders on issues like portfolio optimization, both from the merger and divestiture side, and we asked what factors lead to strong switching costs in the aftermarket and how differentiated technology intangibles lead to securing a firm's installed equipment or software base. After attending the conference and reviewing our coverage, our top picks among the diversified industrials we cover include  DuPont (DD),  Emerson Electric (EMR),  Johnson Controls International (JCI), and  3M (MMM).

Five Key Takeaways From the Conference
First, broad demand for diversified industrials and electrical products remains robust. In fact, organic growth is quite healthy. Many of the firms attending the conference posted 3%-4% organic growth during 2018, and solid results continued through early 2019. Among the weaker firms,  Parker Hannifin (PH) reported “only” 2% organic growth in its most recent quarter. No CEO at the conference said that the broad U.S. economy is weak or even slowing. Leadership highlighted only two industries as near-term weak spots, autos and semiconductors, but also confirmed that this was expected. Broad macro sentiment is that the U.S. is good, the European Union is weaker, and China has some weakness, particularly in autos (3M said explicitly that it remains cautious on China, automotive, and electronics—attractive-margin businesses for the firm).

Second, organic revenue growth and simplification initiatives are driving operating margins to excellent if not record highs. Most of these companies boast considerable recurring revenue, for example, from high-margin post-sale services, and any tilt toward software is probably a tilt toward high gross margins.

Third, tariffs pose a relatively minor headwind to the companies presenting at the conference. Not a single leader expressed strong concern about the impact of tariffs. In fact, most have countered by producing products where they're sold, by increasing prices, and by reducing costs in time to largely offset them. For example,  Rockwell Automation (ROK) forecasts that the cost impact of tariffs will be net neutral in fiscal 2019, but the company is prepared for additional actions.  Honeywell International (HON) anticipates a $100 million headwind that it will fully offset with price/cost actions, with no timing lag. Fortive said it expects a modest 25 basis points of margin headwind, with the impact of most 2018 tariffs already mitigated with countermeasures, including price increases.

Fourth, portfolio management remains a pervasive objective, as it should, given that most of these firms are diverse holding companies and serial acquirers. None announced any new mergers or acquisitions during the conference, but most had already been involved in some significant corporate actions in the past 12-18 months. Among the most material: Johnson Controls spun off Adient automotive seating and then its power solutions segment; Honeywell spun off both its Garrett Motion turbochargers and Resideo Technologies residential HVAC and security products segments; and Stanley Black & Decker purchased Craftsman. Some of the most significant previously announced mergers and acquisitions include 3M’s largest acquisition in company history announced a few weeks ago, DuPont has separated into three companies,  United Technologies (UTX) is spinning off Carrier and Otis in mid-2020,  Ingersoll-Rand (IR) industrial and Gardner Denver are merging,  Siemens (SIEGY) is spinning off power and gas, and Parker Hannifin will acquire Lord in late 2019. We believe portfolio pruning and additions will continue, with cheap debt providing a ready deal lubricant. Indeed, just this week, United Technologies announced that it intends to merge its aerospace segment (remaining after it spins off its HVAC and electors segments) with defense specialist  Raytheon (RTN) in one of the largest deals of the year.

Finally, “digital” is still an active buzzword, with both internal and external efforts lumped into vague initiatives. These may be as sophisticated as equipping as much hardware as possible with data transmission and networking capabilities and as committed as adding high-return, recurring-revenue software products to portfolios when possible ( Roper Technologies (ROP) being the extreme example of this). Or they might be as obvious as improving customer-facing digital properties like websites. NVent sounds to us a bit late in allowing customers to see online what enclosures are available at nearby distributors, but it is working to close this gap. Honeywell said it is trying to reduce its footprint of 2,000-plus applications and 1,500 websites in a continuation of CEO Darius Adamczyk's promise of declaring "war on fixed costs" at last year's EPG conference.

Our Top Picks

 DuPont (DD)
Fair Value Estimate: $93
Moat Rating: Narrow
Formed by the merger of Dow Chemical and DuPont in 2017, DowDuPont spun off its commodity chemicals business, Dow, in April and its Corteva agriculture business in June. Now, DuPont is purely a specialty chemicals business.

We believe DuPont will benefit from multiple secular trends, including lighter vehicles and electrification in the automotive industry, increased demand for semiconductors, and a rise in the interconnectivity of devices that require more electronic components. Given the predecessor companies' history of innovation and premium pricing, we are confident that DuPont will be able to continue to develop patented products to maintain high margins even as patents expire; this underpins our narrow moat rating.

Current share prices reflect lower near-term profits due to global trade uncertainty, but with shares in 5-star territory, this could be an attractive entry point for investors to own a quality business.

 Emerson Electric (EMR)
Fair Value Estimate: $81
Moat Rating: Wide
Emerson is the undisputed powerhouse in process manufacturing on the left side of the Atlantic. After a series of capital allocation missteps several years ago and a burgeoning recovery from declining oil prices, Emerson is poised for several years of organic growth. According to 2017 data, the total addressable automation market, both served and unserved, amounts to $204 billion, including approximately $140 billion in devices, $40 billion in control and safety systems, and $20 billion in asset management. Even though Emerson is one of the more established players in automation, it only has 6%, 5%, and 2% share participation in each respective category, suggesting a long runway for growth.

Properly applied, we believe automation can add more to manufacturing firms’ bottom line than nearly any other investment. Additionally, we think predictive analytics will augment these results, given the mission-critical nature of manufacturing services.

With the pending retirement of David Farr in 2021, activist intervention during a CEO transition could unlock meaningful value for any fund looking to split Emerson's automation and commercial platforms, and we believe Emerson's automation segment in particular could garner a higher multiple. However, with the current consolidated firm trading at about $63 per share, we’d recommend a larger margin of safety, around our 5-star price in the mid-$50s.

 Johnson Controls International (JCI)  
Fair Value Estimate: $46
Moat Rating: Narrow
Narrow-moat-rated Johnson Controls was long viewed as an auto-parts supplier by the market, given that it historically generated about two thirds of its annual revenue from the automotive industry. However, after selling its power solutions business in April, Johnson Controls no longer has any automotive exposure and is now a pure-play building technology company with a focus on HVAC, building controls, and fire and security products and services.

We think prudent capital allocation in tandem with a simplified business model that is clearly showing improving fundamentals will help Johnson Controls close the gap between its current stock price and our estimate of its intrinsic value. The firm's large share repurchase program after the sale of power solutions could be another catalyst. The stock is trading in 4-star territory.

 3M (MMM)
Fair Value Estimate: $187
Moat Rating: Wide
3M's stock has fallen off recently, and we think the market has overreacted to woes in 3M's automotive and semiconductor end markets, as well as recent macroeconomic weakness out of China and the potential impact from PFAS environmental liability litigation (which we believe at worst would only knock about 7% off our fair value estimate). From a defensive standpoint, 3M could be one of the best diversified industrials to own if a global recession occurs in the next couple of years.

In our view, 3M is a GDP-plus business, the "plus" a testament to the value-additive nature of the company's products, churned out by its virtually inimitable research and development platform. Unlike many diversified industrial companies, 3M has committed to leveraging innovation across its disparate businesses, making it worth more than the sum of its parts. This commitment manifests itself in the apportionment of just under 6% of net sales to R&D, which we expect to increase toward 6% by 2023. We forecast the firm will earn just under $9 in gross profit for every dollar spent on R&D, even with recent organic growth weakness.

3M also benefits from positioning its portfolio toward faster-growing portions of GDP that benefit from strong secular trends. We think the healthcare segment will gradually take a more pivotal role in contributing to the firm’s revenue and operating income mix, particularly as the economies that 3M is geographically exposed to mature. We see this segment rising to a larger portion of the firm’s revenue by the end of our explicit forecast. Aside from superior profitability, healthcare benefits from several secular trends, including an aging population, rising chronic disease and surgical procedures, as well as demand for efficient management of large volumes of medical data.

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