2 Value Plays from a Rebounding Sector

September 02, 2020 David Sterman

Once is a fluke, twice is a coincidence, three times is a trend.

That’s the dictum that came to mind after I saw the Commerce Department report last Wednesday that new orders for durable goods – products designed to last at least three years – rose in July for the third consecutive month.

And where there’s a trend, there’s money to be made. Let’s get to it…

— Bob Bogda, Editor

P.S. Like what you see? Don’t like what you see? Let me know.

 

 

The ongoing pandemic has impacted the U.S. economy in interesting ways. Technology firms are getting a boost as more people work and shop from home. Health insurance companies are making eye-popping profits as consumers continue to avoid costly elective surgeries and hospital visits. Leisure and hospitality stocks? Wait until next year.

Industrial firms, which operate our nation’s factories, took it on the chin this spring when the economy plunged. The Industrial Select Sector SPDR Fund (XLI) fell from $85 in mid-February to below $50 a month later, before steadily clawing its way back. XLI today closed at $79.90, its highest finish since Feb 24.

Even after the rebound, the outlook for these companies remains bright. That’s because pent-up demand has many factories now running full bore. In late August, the U.S. Commerce Dept. reported that orders for durable goods rose a sequential 11.2%. Michael Pearce, senior U.S. economist at Capital Economics, told The Wall Street Journal that the recovery in business equipment investment “looks pretty V-shaped to us.”

Here’s another way to look at this segment of the economy: Manufacturing employment in July was down less than 6% from its February 2020 peak. That compares to a 9% drop in the service sector. That July readout of rising durable goods orders wasn’t just a blip. Data firm IHS Markit notes that goods manufacturers recorded the fastest increase in production (in August) since January 2019, adding that “businesses remained optimistic towards the 12- month outlook for output, with the degree of confidence strong overall.”

That sets the stage for further gains among select industrial stocks, especially those that remain well below their all-time highs. Here’s a closer look at two of them.

 

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L3Harris Technologies (LHX)

This firm is the result of a July 2019 merger of a pair of defense and industrial titans (formerly known as L3 and Harris). The company secures long-term, profitable contracts in the construction and services of sea, land air, space and cybertechnology.

Bringing those two firms together has been quite profitable, thanks to a wide range of cost synergies and new contract wins that have come from greater industry heft. The company estimates that it has been able to bid on 41 major contracts this year that it would simply have been too small to qualify for when they were separate.

Back in 2018, the combined operating profits of the two independent firms stood at $2.7 billion. That figure should approach $4.5 billion by next year, according to Bank of America.

Indeed, sales and profits have been rising for L3 as the firm has topped estimates and raised guidance in the past two quarters.

Meanwhile, shares are recently trading hands for around $182, down from around $230 before the pandemic hit. As a result, shares are valued at just 14 times projected 2021 profits. That compares to a 23.3 times earnings multiple for the S&P 500, based on Yardeni Research’s estimate of $150 in per share profits for 2021.

Action to Take: Consider buying shares of L3Harris Technologies up to $205 and establish a sell target at $250.

Applied Industrial Technologies (AIT)

This provider of transmission and flow control products surely saw a slowdown this past spring, leading to an expected 7% drop in 2020 sales and 20% drop in profits. And while orders have begun to rebound, don’t look for this firm to be firing on all cylinders once again until 2021. As CEO Neil Schrimsher noted on a recent call with investors, “While more customers are bringing facilities back online following shutdowns in recent months, the pace remains gradual and balanced by adjustments to production schedules and working capital discipline.” He adds that “as industrial production regains momentum, we believe our customer requirements will be meaningful.”

Far-sighted investors have a chance to profit from short-term weakness as shares have slid from the upper $70s two years ago to $62.99 at today’s close. Here again, we’re talking about a bargain stock, trading at 15 times projected 2021 profits.

I also like that this firm is getting financially stronger. AIT has paid down $170 million in debt since 2018 and on the recent conference call with investors, CFO David Wells noted that his firm’s M&A initiatives and related pipeline “remain active.” That’s finance-speak for a growing desire to make a smart acquisition, now that the firm’s balance sheet is stronger. As an example, AIT bought Olympus Controls in 2019, bringing in products and expertise in the field of factory-floor automated visual inspection systems. Look for more smart tuck-in deals to come.

Action to Take: Consider buying shares of Applied Industrial Technologies (AIT) up to $68 and establish an $85 price target.

 

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