Our outlook for industrials stocks

We don't think the current scenario in the United States is all bad, however. For instance, breaking apart the pieces of industrial production tells a slightly different story that is a bit more sanguine for many of the country's industrial companies. The manufacturing portion of the index ticked up a bit from April and actually improved its year-over-year growth rate to 1.7% from 1.3% in the prior month (although outside last month, May's rate is still also the slowest since February 2010). Automotive was again a winner on a month-to-month basis, climbing 0.7%, helping to offset sequential declines in aerospace (down 0.6%) and machinery (down 0.4%).

Mining activity within industrial production also remained very strong in the month on the back of increased coal mining, with a 0.7% month-to-month gain and a solid 4.8% increase from a year ago; based on absolute index values, mining is at its highest level since 1982.

Utilities were the real drag on the month, falling 1.8% sequentially and 3.6% year over year. That said, the series faced a very difficult comparison in May; last year's seasonally adjusted reading was the highest in 18 months as the hot, drought-filled summer was getting underway. Barring a sudden return to very hot weather, it seems likely that utility activity could remain a drag on industrial production for a few more months. It stands to reason that this could eventually negatively affect mining activity as well. Much of the recent coal-related strength was tied to increasing natural gas prices, but natural gas has again recently slipped below $4 per million BTU because of the potential for reduced electricity usage.

Investors in Industrial Select Sector SPDR XLI looked past this near-term slowing during the quarter, and the index outperformed the broader S&P 500 (XLI climbed 5.9% versus 5.3% for the S&P 500). The industrial sector enjoyed positive contributions from the aerospace and defense, automotive and homebuilding industries.

Overall, we still believe the industrial sector is roughly fairly valued, albeit with continued opportunities in several individual stocks that offer sizable margins of safety.

Housing continues to impress, but non-residential construction takes a pause

In the quarter, we saw continued improvement in U.S. homebuilding metrics. Although May housing starts came in a bit below consensus expectations and fell about 9% from first-quarter ending levels, the metric still ticked up to a seasonally adjusted annual rate of 914,000, 29% higher than a year ago. We continue to believe there is pent-up buying demand in housing. Falling prices, a weak economy, and a lack of financing for the past six years have prevented many would-be buyers from buying. The housing psychology pendulum is quickly swinging the other way, and as prices rise people feel more compelled to jump in, especially when valuations have yet to be stretched. Several ratios paint housing in an even more favourable light, including price/income, price/rent, near-record housing affordability and very low housing inventory. Also, over time banks should gradually relax their stringent lending standards, clearing the path for more people to own a home.

In our opinion, it would take a lot to derail the housing recovery given these favourable fundamentals; it would probably entail a continued sharp increase in interest rates, another economic recession or reduced government incentives to buy and own a home (the last seems highly unlikely). There are pockets of the U.S. where things are running a little hot (such as Florida and California), but they're still well off their prior highs. Further buoying our optimism, the National Association of Home Builders' homebuilder sentiment index climbed to 52 in June, the first reading above 50 since April 2006.

Conversely, we've seen U.S. non-residential activity remain muted, with the seasonally adjusted April reading 6.4% below the year-ending figure. Moreover, the Architectural Billings Index--a good leading indicator for future commercial construction activity--slipped below the key growth demarcation of 50 in April for the first time since July last year. We remain encouraged that the new inquiries reading within the ABI remained solidly above 50 (at 58.5), but caution that several of the companies we cover in the sector, such as Terex TEX, Caterpillar CAT and Deere DE, have reported a more challenging sales environment in recent months.

Still, we believe positivity in the U.S. housing market should provide further support for continued non-residential construction spending. Although the housing end market directly makes up only a portion of heavy equipment manufacturers' sales, construction of new homes, apartment buildings and (eventually) subdivisions typically leads to increased investment in commercial buildings, infrastructure and other non-residential projects. Within this space, we think wide-moat Caterpillar is best positioned, and we estimate its fair value at $98 per share.

U.S. auto sales still strong, but dealerships look overvalued

U.S. automakers reported a rebound in May U.S. light-vehicle sales after a challenging April, which was the first month since October that the seasonally adjusted annualized selling rate fell below 15 million units. According to Automotive News, May's SAAR was 15.3 million compared with 13.9 million in May 2012. May industry sales totalled 1,443,311, up 8.1% year over year. We continue to expect full-year sales of 15.2 to 15.5 million units, which on the high end would be a 7% increase from 2012's 14.5 million. We see an old fleet, available credit, reasonably stable gas prices, attractive new products and a housing recovery continuing to drive traffic to dealerships.

However, we think the shares of these dealer groups have become overvalued. The auto and truck dealership industry currently trades at our highest price/fair value ratio of all industrial sectors, at 1.31. While we think these businesses' prospects look sound for the foreseeable future, we note that companies such as AutoNation AN, CarMax KMX and Group 1 Automotive GPI are rated 2-stars, while Penske Automotive Group PAG is rated 1-star.

We continue to believe value exists in automotive manufacturing, but we also call attention to several suppliers that are trading well below our estimated intrinsic values. In particular, we think Gentex GNTX is still undervalued; although it has climbed roughly 25% since the start of the year, we still rate the narrow-moat company 4-stars.

Boeing has moved past its 787 troubles, but still looks slightly overvalued

We believe Boeing's BA commercial segment is poised to deliver strong sales and operating margins as production rates increase, major development programs mature, new programs' complexities decline, and productivity measures take hold. The defense segment has proactively rightsized its footprint for the opportunity at hand, and international orders have helped maintain flat revenue results. Strong positions in the refuelling tanker program, fighter aircraft, helicopters, unmanned vehicles and satellites give us confidence that our forecasts are reasonable. Furthermore, the clearing of inventory and working capital from the balance sheet will lead to strong cash generation that will flow to shareholders. The company posted record revenue and backlog in 2012, offering strong visibility for years to come.

We recently increased our fair value estimate for Boeing to $93 per share from $80 on the basis of higher sales growth and operating margin estimates in the commercial segment. Also important is that our fair value estimate includes $24 per share of retirement liabilities, driven by the low interest rate environment; each 25-basis-point increase in discount rates potentially adds $3 to our fair value estimate. Over the long run, we see strong, sustained returns on capital for the company. Its narrow moat, which stems from customer relationships, know-how, engineering talent and incumbency, generates powerful competitive advantages. However, with the stock currently trading roughly 10% above our updated fair value estimate, we believe the market appears to be pricing in higher interest rates that would decrease the pressure from retirement obligations. Without a sustained move higher in these rates, the stock may experience additional volatility over the near term. Boeing is currently rated 3-stars.

Near-term prospects for mining equipment likely to remain soft

Miners' 2013 capital expenditure plans outline substantial declines versus 2012, and reduced global production growth could also lead to lower near-term aftermarket sales opportunities. We continue to believe the medium-term picture for mining equipment manufacturers like Caterpillar and Joy Global BA is more encouraging, stemming from China's push toward safer mining operations, further building of global coal-fired thermal plants and additional capacity planned for iron ore and copper.

While coal, iron ore and copper production will probably see slowing growth as mining customers hold back on capital spending, we don't anticipate a sudden drop-off in these commodities' output. In fact, none of these products saw a decline in volume during the 2009 global financial crisis. We also remain upbeat regarding the longer-term prospects for thermal coal. Per the International Energy Agency, coal-fired power demand should continue to grow at a single-digit annual pace during the next five years, owing to further buildouts in emerging economies, European coal power expansion and the commodity's cheap cost compared with other global solutions.

Aftermarket opportunities should also help to support the equipment OEMs' medium-term revenue. Although Cat and Joy will probably face continued near-term difficulty as customers reduce parts inventory, cut costs through third-party parts substitution, and delay maintenance spending, we believe these actions can only persist for a limited time. In fact, in many cases, delayed maintenance can lead to increased rebuild costs down the road, negating the short-run cost-saving initiatives by miners. Given a large installed base of original equipment (itself growing during the past several years as a result of the mining boom) and lower-quality iron ore and copper output (necessitating increasing mining activity to achieve the same level of commodity production), we expect improved growth in higher-margin service and parts sales past the next few quarters. In this industry, we think Joy Global remains an attractive investment option because of its narrow economic moat, palatable valuation and solid balance sheet. The stock is currently rated 4-stars.

Our top industrials picks

We currently view the industrial sector as a whole as roughly fairly valued, similar to our view in the prior quarter. We previously noted that auto and truck dealerships is our most overvalued sector, on average, but we also believe trucking (price/fair value of 1.29), airlines (1.13) and aerospace and defense (1.1) remain too heated for long-term investment. Instead, we point to auto manufacturing (0.81), farm and construction equipment (0.95) and diversified industrials (0.97) as our most undervalued industries. While these valuations don't offer particularly mouth-watering margins of safety, the companies below are among our top ideas in industrials.

	Top Industrials Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
	Royal Philips NV		$34.00	None	High	$20.40
	Ford Motor		$21.00	None	High	$12.60
	Gentex		$27.00	Narrow	Medium	$18.90
	CSX Corp		$29.00	Narrow	Medium	$20.30
	Data as of 6-18-13

Royal Philips  PHG
Philips is a leader in consumer electronics, lighting and medical equipment, but it has operated with higher costs than peers in recent memory. We're encouraged that CEO Frans van Houten appears to be focusing on eliminating this bloated cost structure, but we're also becoming increasingly concerned about the fundamentals facing the lighting business. Still, we think Philips has the potential to push margins back to prior levels once restructuring actions surrounding this segment are complete over the next several quarters. The company's declining position in lighting and exposure to highly competitive consumer end markets underlie our no-moat rating, but we think the market remains too pessimistic on the ultimate turnaround capability of this conglomerate.

Ford Motor  F
Since we highlighted Ford following the third quarter of 2012, shares have climbed nearly 60%. Nonetheless, our fair value estimate remains $21 per share, and the stock is rated 4-stars. We expect continued excellent results for Ford's U.S. sales this year thanks to a very competitive line-up in nearly all segments, and although we caution that Europe will remain in bad shape for the mid-term, we believe the weakness still offers long-term investors a decent margin of safety. Also positive is that the company will be taking as much as $500 million of costs out of the system with the closing of its Genk, Belgium, assembly plant at the end of 2014 and two UK plants this year.

Gentex  GNTX
Shares of this narrow-moat auto supplier have increased more than 25% for the year to date, but our $27 fair value estimate still leads to a 4-star rating for the stock. We continue to like the firm's debt-free balance sheet, and we think Gentex's sizable market share is unlikely to be threatened, given the firm's constant innovation and its relationships with automakers. We believe more auto-dimming mirror content in small vehicles is likely as the U.S. fleet seeks to comply with CAFE rules while still offering desirable vehicles to consumers. In addition, the dividend seems safe with U.S. tax law uncertainty resolved, and we think Gentex can easily pay a large special dividend if it chooses.

CSX  CSX
Although we think the railroad industry looks fairly valued overall, Eastern operator CSX still stands out as a long-term winner based on its attractive valuation and improving profitability. However, CSX is highly exposed to coal, which faces cheap natural gas as a competing utility fuel and weakened international steelmaking; while intermodal will help backfill, less coal means less income. Although near-term coal malaise dominates concerns, CSX's competitive advantages should endure. As 80% of volume is unrelated to coal, we expect the market to eventually recalibrate on CSX as a less coal-reliant enterprise. In our $29 fair value estimate, we model coal volume continuing to contract, but total volume (including coal) expanding 1% annually due to population growth, automotive and homebuilding recovery, and aforementioned intermodal gains. Importantly, we also think the rail can achieve a 66% operating ratio by 2016, far improved from 2012's 71% reading.