As the dust of the U.S. presidential elections starts to settle and uncertainty abates, jittery investors on the sidelines are scouring sectors for opportunities as they prepare to get back in the game.
One sector that particularly stands out as well-positioned to benefit from the post-election bounce is industrials. Market analysts have argued that regardless of who goes to the White House, industrials as a sector will benefit from increased spending as laid out in the economic agenda of both leading presidential candidates. In a pre-election investor report, Morgan Stanley said it was upgrading industrials to overweight, calling the sector a win-win in either administration.
On a one-year basis, the sector has handily outperformed the S&P 500 Index, returning 15.1% versus 9% respectively, as of Nov. 17, 2016. Similarly, on a year-to-date basis, the sector's return of 16.4% has been far superior to that of the S&P 500 (9.1%).
As the U.S. economy gains strength and macroeconomic headwinds subside, large-cap industrials stocks are likely to continue to top the S&P 500. Moreover, with an average price-earnings multiple of 18.5, industrial stocks are trading at a discount to the S&P 500 (19.4), as of Nov. 18, making them even more attractive from a valuation perspective.
| W.W. Grainger Inc | ||
| Ticker | GWW | |
| Current yield | 2.22% | |
| Forward P/E | 17.9 | |
| Price | $217.62 | |
| Fair value | $226 | |
| Data as of Nov. 18, 2016 | ||
W.W. Grainger (GWW) distributes maintenance, repair and operating supplies to an industrial-oriented customer base. The company generated US$10 billion of revenue in 2015 by selling motors, HVAC equipment, lighting, hand and power tools, pumps and electrical equipment. Approximately 78% of sales are in the U.S., 9% in Canada and 14% in the rest of the world.
"The largest industrial maintenance, repair and operations (MRO) distributor [in the U.S], it has generated a 19% average return on invested capital over the past 10 years and a 20% average ROIC over the past five years," says a Morningstar report.
The company has a sustainable competitive advantage, or a wide moat, stemming from network effects and a cost advantage, which is projected to improve, along with margin expansion, over the next several years. "As long as companies continue to outsource MRO supply procurement, industrial distributors like Grainger will generate outsized returns on invested capital and reward shareholders along the way," says Morningstar equity analyst Kwame Webb, who put the stock's fair value at US$226 and forecasted earnings per share to grow at an 8% average annual rate to US$17.33 by 2020.
In addition to operating stores, Grainger has made a heavy push in ecommerce, a more cost-effective distribution model. "Its emphasis on online sales is so significant that today, the company generates US$4 billion in online sales," says Webb, who forecasted an annual revenue growth rate of 1% to 7% over the next five years and operating margin to grow from 12.7% in 2016 to 13% in 2020.
| United Technologies Corp. | ||
| Ticker | UTX | |
| Current yield | 2.46% | |
| Forward P/E | 16.1 | |
| Price | $106.50 | |
| Fair value | $122 | |
| Data as of Nov. 18, 2016 | ||
A diversified conglomerate, United Technologies (UTX) sells a range of aviation products and building components through its parent company and subsidiaries -- Pratt & Whitney, UTC Aerospace Systems and Otis. The firm makes engines for both military and commercial aircraft, breaks, landing gear, as well as elevators and escalators.
UT recently delivered solid third-quarter results, reporting a 5% year-over-year jump in revenue to reach US$14.4 billion, buoyed primarily by the firm's aerospace businesses, which are beneficiaries of a lucrative aftermarket revenue model.
As much as 60% of UT's consolidated revenue comes from high-margin recurring aftermarket maintenance and repair services, which is indicative of "sticky relationships sustained by customer reliance on the original-equipment manufacturer," says a Morningstar report.
Pratt & Whitney derives more than 40% of its revenue from Airbus alone, whereas Airbus and Boeing represent 29% and 28% of revenue, respectively, at UTC Aerospace Systems. "Moreover, in each segment, the U.S. government accounts for approximately 20% of sales, representing another powerful customer relationship with a high degree of bargaining power," says Morningstar equity analyst Barbara Noverini, who estimated the stock's worth to be US$122.
Pratt & Whitney has been ramping up production of its innovative geared turbofan engines, and has already secured more than 7,000 orders. "This new installed base will secure a long runway of aftermarket services that will plump segment cash flows for decades," says Noverini. Morningstar forecasted a compound annual revenue growth rate of 4.5% over the next five years, and consolidated revenue of about US$70 billion by 2020.
| Union Pacific Corp. | ||
| Ticker | UNP | |
| Current yield | 2.20% | |
| Forward P/E | 18.4 | |
| Price | $99.83 | |
| Fair value | $100 | |
| Data as of Nov. 18, 2016 | ||
The largest public railroad company in North America, Union Pacific (UNP) operates in the western two thirds of the United States. The firm generated US$22 billion of revenue in 2015 by transporting coal, industrial products, intermodal containers, agriculture goods, chemicals and automotive goods. It also owns about a quarter of Mexican railroad Ferromex (10% of its revenue).
"UP is surprisingly nimble for a huge asset-based enterprise," says a Morningstar report, underscoring the firm's ability to cut costs faster than sales decline during tough times and improving margins consistently. "Even a 9% coal carload decline in 2013 couldn't keep UP from reaching record margins."
Over the longer horizon, Morningstar forecasted the railroad company to "attain a 62% operating ratio next year and 58% by 2019." A lower operating ratio reflects a higher margin on earnings.
The company produced a staggering US$2.7 billion of free cash flow in 2015 -- greater than 12% of sales -- and returned most it to shareholders in the form of US$2.3 billion of dividends on common stock. "The firm more than tripled dividends per share from the start of 2010 through 2015, making the stock attractive to yield-seeking investors," says Morningstar sector director Keith Schoonmaker, who pegged the stock's fair value at US$100.
Although Schoonmaker expects some price decreases over the short term, he remains confident that "rails will generate positive economic profits for the benefit of share owners with near certainty 10 years from now."
| WestJet Airlines Ltd. | ||
| Ticker | WJA | |
| Current yield | 2.63% | |
| Forward P/E | 9.1 | |
| Price | $21.31 | |
| Fair value | $28 | |
| Data as of Nov. 18, 2016 | ||
Calgary-based WestJet (WJA) is a Canadian low-cost airline that offers service to more than 90 destinations in Canada, the U.S., Mexico and the Caribbean.
"WestJet serves around 50% of the destinations in Canada that Air Canada and its partners do, which total more than 70, offering a long runway for growth for WestJet's business model of low fares, strong customer service and happy employees who drive profitable returns," says a Morningstar report, noting that a strong ownership culture helps the firm generate "high-single-digit to low-double-digit operating margins."
WestJet's regional airline Encore has added both revenue and profits and, says Schoonmaker, "should help propel growth for years to come and could increase load factors as regional traffic feeds into the carrier's mainline operations.”
The airline sustainably achieved a return on invested capital of 12% while increasing its capacity by 2.6% to 11.1% over the past five years. A stellar track record of generating operating profits makes it "an exception in the airline industry and will allow it to continue to return cash to shareholders," says Schoonmaker.
WestJet earned $116 million in net profit, its best third-quarter profit yet, in the third quarter of 2016, boosted by lower oil prices and expanded routes. The company reported $1.12 billion in revenue, up from $1.05 billion the year before, or a jump of 7.6%, as it posted its fifth straight month of double-digit passenger growth.
The stock is currently trading at a nearly 25% discount to Schoonmaker’s $28 fair value estimate.
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