Are Industrial Stocks Expensive

5 Best Industrial Stocks to Buy Now for 2020

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The Best Industrial Sector Stocks to Watch in the Next Year

When should you invest in industrials stocks and how do you find the very best in the sector?

In this video, I’ll not only show you real data on how the industrial sector stocks do in bull and bear markets, I’ll show you how to think of this group as a whole and how it fits with your investment strategy.

Then I’ll show you how to find the best stocks to buy and reveal the five industrials stocks to watch for 2020.

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A Missed Opportunity in Industrial Sector Stocks

The industrial sector is really weird and I’m glad we’re including it in our stock sector series. There are some extremely popular companies here but I feel like investors don’t think of it like a sector as they would tech or energy stocks.

Like I hear all the time from investors that they’re really excited about tech sector stocks or want those big dividends in utility stocks. Now individual companies in the industrials are hugely popular, companies like 3M and Boeing are some of the most active on the market.

But you’ll never hear an investor say, I think I need more industrial stocks in my portfolio. They just don’t think of the sector as a whole, how it fits with their strategy.

I think that’s a missed opportunity so in this video, I want to open you up to the idea of thinking about the sector. We’ll talk about how it performs versus the stock market in both bull and bear markets. I’ll show you when to start increasing your exposure to the sector and reveal the five best industrials stocks to watch going into 2020.

It’s part of our 11-video series, uncovering the best companies in each stock sector. Over these 11 episodes, one for each stock sector, I’ll show you how to pick the best of breed in each. We’ll look at some of the big trends and how to pick stocks to buy, then I’ll reveal my five favorite stocks in each.

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What are Industrial Sector Stocks?

So when we talk about the industrials sector, we’re actually talking about a huge part of the economy and many more industries than is on our sectors chart. The sector includes pretty much every industry in manufacturing, aerospace and defense, construction and transportation.

The sector underperformed the stock market only slightly over the past five years, by about six percent, but has almost exactly matched the market returns in the past year.

Industrial Stocks vs the Stock Market
Industrial Stocks vs the Stock Market

And because the sector includes so many industries, so many groups of companies that fulfill a basic component of the economy, the sector tends to follow the economy almost exactly. It’s why industrials is called a cyclical sector, because it tends to rise and fall along with the economic cycle.

Industrial Sector Stocks and the Economy

We’re going to use that to our advantage, building this into our investment strategy which I’ll explain in a bit. First though, I used the industrials sector ETF to compare returns for the sector on bull and bear markets back to 1998.

Industrial Sector Stocks and the Economy
Industrial Sector Stocks and the Economy

We see the return on the stocks in the industrials sector against the return on the broader market, the S&P 500, in five periods here. And you can see that the industrials tend to outperform the stock market during bull markets, so when the economy is growing and stocks are doing well.

The evidence on bear market periods is a little less clear. The industrials sector did better during that 2000 to 2002 bear market, beating the market by almost 7% over the two years. It underperformed though in the next bear market from mid-2007 to March 2009, the industrials lost almost 6% more than the broader market.

So we can say that the industrials sector is probably going to do really well, produce those stronger returns, during a bull market. In a bear market, it might or might not lose more than the rest of the market but we can be more certain that it will still track the market pretty closely.

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Are Industrial Stocks Expensive?

Now hang on to that thought because I want to look at one more chart, research by FactSet we’ve been using through the series. This shows the price-to-earnings ratio by sector, so that measure of how expensive a sector is versus the other groups.

Are Industrial Stocks Expensive
Are Industrial Stocks Expensive

The dark blue bar is the current PE ratio on a forward basis while the green bar is the longer-term 10-year average ratio. This not only tells us if a sector is more expensive than another sector but if a sector is more expensive than its own average over time.

Here we see the industrials sector, third from the left, with a current PE of 16.2-times earnings which is just slightly less expensive than the market average at 17-times earnings. Again, this gets us back to the idea that the industrials follow the broader S&P 500 closely.

So the stocks in the sector are about 5% cheaper than the rest of the market and we can compare that current PE to the 10-year average of 15.2-times earnings. So while the sector is cheaper than the market, it looks like it’s about 6.5% more expensive than what it’s been on average.

Now while the sector might be a little more expensive than its long-term average, that 6% premium, it’s still nowhere near as expensive as we see in other sectors like tech or utilities which are both more than 30% over their long-run PE ratios.

So right now as we head into 2020 a lot of this is going to depend on your market outlook but I feel like the industrials are in a good spot right now. You definitely want to think about increasing your exposure to the sector as a whole if you think the economy is going to keep growing. We saw how the sector wins out in a bull market.

Even if you think the economy might struggle a little, I don’t think you should neglect the sector. It’s a toss-up whether it’s going to underperform and it’s not an expensive sector anyway.

Industrial Sector Stock ETFs to Buy

Now I want to cover two sector ETFs before revealing those five stocks I’m watching in the industrials. You can think of these industrials funds for that broad exposure when the stock market looks to keep rising, giving you an investment in a sector that will likely beat the market.

First is the Industrial Select Sector SPDR ETF, ticker XLI, and its 2% dividend yield.

The fund holds 69 of the largest industrials companies and across every industry and we’re talking companies with an average market cap of $74 billion. The expense ratio is fairly low at 0.13% annually and if nothing else, just looking at the fund holdings gives you a good idea of the diversity and exposure of industries in the sector.

For our next fund, I wanted to highlight the aerospace and defense industry with the SPDR S&P fund, ticker XAR.

This one is a little more expensive at a 0.35% expense ratio but I love this theme right now. We’re in just a historically partisan time right now, the Republicans and Democrats in Washington just seem like they want to fight about anything and everything. There’s only one industry that’s getting pretty much bipartisan support, that’s aerospace and defense.

An increase to the budget to defense is pretty much the only thing that passes without argument and now with what’s looking like the beginning of a space race part two, this industry could be in for big sales growth over the next decade or longer.

The fund holds shares in 30 companies and has produced a 21% annualized return since it started trading in 2011.

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Finding the Best Stocks in the Industrial Sector

Now I want to focus on individual stocks in the sector because this is where I think you get better returns, finding the leaders with a competitive advantage in each industry. As I’ve done in the other videos of the series, I’ve tried to pick stocks across as many of the industries in each sector as possible to give you a broader mix.

I used the same fundamentals we described in the first video of the series. I screened for stable or rising sales and an operating margin competitive against other companies in the industry. I looked for debt-to-equity and other debt measures that were lower than competitors.

I detailed these factors and how to use them to find stocks in our first video so I don’t want to repeat too much here. Make sure you check it out because these are the fundamental measures you can use to find the best companies in any sector.

Looking for our five best industrial stocks, I also looked for catalysts for growth, companies with not only a competitive advantage over their peers but a reason to send the stock price higher. For some this might be low energy prices, higher government spending or just the potential for that surprise in a part of the business.

Best Industrial Stocks for 2020

Our first industrials pick here is going to be $78 billion Caterpillar, ticker CAT, and a solid 2.9% dividend yield.

Caterpillar is the largest heavy manufacturing equipment maker in the world with 16% of the global market share alone. Like most in the heavy equipment space; weak buying in energy, agriculture and mining have all weighed on shares over the last few years.

Instead of buying to replace the equipment they sold in the third quarter, dealers sold down their inventory on worries about the trade war, which led to a miss on sales and earnings.

Despite all these problems, Cat has managed it well and kept overall sales rising year-to-year. There’s reason to believe a turnaround is coming in the near-term as well as longer.

Dealers will need to restock inventory this quarter or next which should help boost sales beyond expectations. Also the service revenue, offering maintenance on equipment is becoming a larger share of total revenues. This revenue is recurring and actually a little counter-cyclical if you think about it.

If the economy slips, heavy equipment users are going to be keeping old models instead of buying new so they’ll need more service to keep them running which could help offset lower purchases revenue for the company.

Shares trade for just under 13-times earnings which are expected lower by 4% over the next four quarters. The recent string of earnings misses makes this one a little more volatile, especially around quarterly reports. If they can beat expectations on that inventory restocking next quarter, it could lead to a bump in the share price.

Cat has $7.9 billion in cash on the balance sheet and just $25 billion in debt. It has a debt-to-equity ratio of just 1.7-times which is well under the 2.5-times debt ratio at competitor Deere.

Analysts covering Caterpillar have a wide range in targets from a low of $110 per share to a high at $165 each.

Next here is one I think investors can get excited about, United Technologies, ticker UTX.

UTX is a really interesting play because essentially you’re getting three companies over the next year. The company is spinning off its Otis elevator and Carrier HVAC businesses before a merger with aerospace giant Ratheon. The spinoffs are scheduled to happen early in 2020 with the merger to follow during the year.

Otis is THE name in elevators with over two million elevators globally and no real competition. The division makes a lot of money on servicing and the transition to greater connectivity through internet of things could really drive profitability.

For its part, Carrier isn’t the biggest HVAC company but it’s a strong brand and I think both these companies can do better when management can focus on their single business instead of being wrapped in a $127 billion industrials conglomerate.

As for UTX after the split, it’s merging with defense electronics maker Raytheon to create a more pure-play on the aerospace and defense idea.

Shares trade for 17.7-times earnings which are expected flat over the next year. Of course when the three companies split and then you’ve got the merger, earnings are going to be hard to estimate for a little while.

This one has had a strong run over the last two years and is a little more expensive versus the sector but I like the spinoff idea and think it could produce three stronger companies.

Analysts have a low target at $150 a share and a high at $170 per share over the next year but this is one you’ll have to hold for a few years to really see where the three companies can go.

As much as I like that UTX play, our next pick Northrop Grumman, ticker NOC, could just be the stock of the future. The $59 billion aerospace and defense company will be smaller than that UTX/Raytheon combination but it’s in all the right businesses. Nor

Not does Northrop gobble up a good chunk of our ever-higher defense spending with its mission systems and cybersecurity services, it’s also deep into the space systems that could get a big boost over the next decade.

The company won an F-35 contract this year that took its order backlog to $65 billion. That’s two years’ worth of revenue booked on backlog.

Shares trade for 17.2-times earnings so a little more expensive than some of the stocks we’ll look at but worth it for a strong company. Earnings are expected 6.5% higher over the next year but will likely be much higher given management’s history of beating expectations.

Analysts have price targets from $350 at the low end to $437 per share at the high end. With everything Northrop is in from defense and cybersecurity to space systems, I think this one could run strong for the next decade…or well at least until its products become self-aware and come for us all.

Next in our industrial stock picks is $2 billion Terex, ticker TEX, a leader in heavy equipment manufacturing including cranes, materials processing and platforms for pretty much every sector in the economy.

The environment for heavy equipment manufacturers has been tough but Terex has managed to eke out sales gains and greater profitability. Management has improved the operating margin from 4.7% in 2016 to 9% this year and the company has a $746 million backlog of projects that should support sales.

Shares trade for just eight-times earnings though profits are expected to nosedive 35% over the next year on divestitures and some weakness in the platform division. This is already baked into the shares though and even on that lower earnings, shares are still only at 12-times earnings.

This one is closely affected by non-residential construction which could mean a rebound if we get any kind of increased infrastructure spending out of Washington. It’s the only kind of fiscal stimulus with support from both sides so there’s a chance we see something in the next few years.

Analysts covering Terex have one of the widest spreads on price targets we’ll see in the group with a low target of $20 per share and a high at $44 each. The company has a strong balance sheet and some attractive assets that could make it an acquisition target someday.

3M or ticker MMM is the most diversified in our list and offers a 3.4% dividend yield.

3M makes products for just about every industry imaginable and it’s one of the few with sales to the consumer market. Those consumer sales have helped a lot on weakness in some of the commercial markets like auto and semiconductors. The company is also the most geographically-diverse in the list with 60% of total sales coming from outside the United States.

A combination of a weak auto market, china sales and a scare over PFAS litigation risk have hit the shares for the better part of two years. Shares trade for 18-times earnings which are expected flat over the next year.

Despite the negative sentiment, this is a company that constantly innovates and is a best of breed in so many products. 3M’s advantage has always been its research & development with more than 120,000 patents granted to it over the last 117 years. Since it doesn’t license most of its products, it’s able to keep a better lid on those patent secrets and charge a premium on products.

Analysts are split on the shares with a low target of $143 each and a high at $200 per share.

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Investing in industrial company stocks isn't as popular as tech investing and might not offer the dividends of other sectors but it's a great way to diversify your portfolio and be ready for any economy. Follow the ideas in this article to find the very best industrial sector stocks for your money.

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