Machinery Stocks Help Lead Recovery
By KENNETH N. GILPIN
RADITIONALLY, cyclical stocks tend to outperform the market in the early stages of an economic recovery. At least one segment of the cyclicals - machinery stocks - appears to be doing just that.
A Smith Barney machinery index was up more than 30 percent this year through Thursday, easily outpacing the Standard & Poor's 500-stock index, which was up more than 17 percent through Thursday.
David Raso, a machinery analyst at Smith Barney, took some time last week to talk about the industry's prospects. Following are excerpts from the conversation:
Q. What are the components of the machinery sector and in what order do they tend to move in the stock market?
A. There are four subsectors: farm equipment, construction equipment, heavy-duty trucks and component suppliers/diversified industrial companies.
The sequence should be heavy-duty truck stocks, which tend to move the earliest, then components and then construction.
But the biggest surprise of the last six months has been that construction stocks have been right behind the trucks, due to strength in construction spending. That usually doesn't happen early in an up cycle. That is why I am wondering if this is the beginning of something, or the tail end of what has been driven by residential construction.
This time, the component suppliers are moving last. Parker Hannifin is a classic component supplier. Their orders have been weak for the better part of two years. Now, we think that orders are turning positive.
Q. What about farm equipment?
A. I am reticent to throw a stake in the ground and say we are going to get a recovery, but if there is a risk, it is to the upside. Commodity prices are rising, payments from last year's farm bill are going to start flowing, and tax law changes on accelerated depreciation should help.
But you need a very stimulative backdrop to make this happen. On average, tractors today can last as long as 7,000 to 8,000 hours. On average, they get used about 300 hours a year. So they have a life of 20 to 25 years. In addition, a large part of the farm age population is aging, and their children by and large are not interested in farming.
Q. Worldwide, spending on machinery is a $40 billion business. Which markets are doing the best?
A. North America, which at $15 billion is the biggest market, has been a pleasant surprise.
But China has been a big driver. In the last five years, unit sales in China have just about tripled, to just over 96,000 units. I estimate that next year the Chinese will get to 120,000 units. The big stimulus is that the economy is growing, they are hosting the Olympics in 2008 and the government has a big infrastructure program to build out the country's highway system.
Europe is a laggard. It turned down later than the U.S., and it will lag North America coming out. Next year, business is likely to be flat. Conditions in Latin America are likely to improve. There is still a lot of natural resource equipment demand, and with the improvement in copper and gold prices, mining equipment sales should be improving.
Q. This group of stocks has done very well this year. Is it too late to jump in?
A. You have missed making the easiest money. But machinery stocks can be categorized as falling into three stages.
Stage 1 stocks are the companies with the greatest operating leverage. Cummins is a classic Stage 1 company. The stock is up more than 70 percent so far this year. I think there are still some months left for Stage 1 stocks, but the returns from here will be more modest.
In Stage 2, you take your profits from the Stage 1 movers and shift into names that provide less earnings leverage but a smoother, more predictable and diversified earnings stream. Eaton and Ingersoll-Rand are Stage 2 companies. And those stocks generally run for a year to 15 months.
Stage 3 companies are the highest-quality industrial stocks. The classic here is Illinois Tool Works. It has a pristine balance sheet, terribly strong cash flow and one of the strongest pension funds out there.
Eaton and Ingersoll-Rand are our top two picks. And Illinois Tool is a fundamental core holding for the next couple of years. With the exception of Illinois Tool, you should definitely be out of these stocks by the winter of 2005.
Q. What is your assessment of Caterpillar?
A. It used to be a big construction equipment maker and a very cyclical company. They are much more balanced now.
I have a hold recommendation on the stock. Cat is the second-best performer of the Dow Jones industrials so far this year, and is pretty fully valued. |
