When bargain hunting U.S. industrials, best to tread lightly

By Chuck Mikolajczak

NEW YORK (Reuters) - Some investors may have begun to sniff around the beaten-down U.S. industrial sector for bargains in the wake of the stock market sell off of the past month, but those betting on a broad advance in the group's stock prices may wind up disappointed.

The S&P industrial stock index <.SPLRCI> is down nearly 10 percent for the year, putting it in the bottom half of performers among the 10 major S&P index sectors, partly due to concerns about the effect a slowdown in China would have on the global economy.

But since the S&P 500 <.SPX> hit a 10-month low on August 25, industrials have slightly outperformed the benchmark index, suggesting investors may be looking for stocks that have become cheap.

"Maybe industrials were overdone on the downside and are due for a nice bounce back," said Terry Morris, senior vice president and senior equity manager for National Penn Investors Trust Company in Reading, Pennsylvania.

Overall, the sector is still pricey by measures that weigh its future growth prospects, and the China effect could continue for some time, and by some measures the broad sector remains expensive, even at its sold off levels.

But there is promise in companies that are more dependent on U.S. economic growth, such as auto-parts suppliers and atypical industrials like the airlines, said Phil Orlando, chief equity market strategist at Federated Investors in New York.

In the United States, "employment is doing pretty good, housing is pretty good, autos are pretty good, the consumer is pretty good," he said.

MORE AFFORDABLE, STILL COSTLY

The forward price-earnings ratio of the industrial sector stands at 14.6, below the current 15.7 of the broad S&P 500, according to Thomson Reuters data.

But the ratios vary widely within the sector. General Electric (NYSE: GE) holds a forward PE of 17.1, while Delta Air Lines (NYSE: DAL) has a low 8.6 ratio. Fastenal (NASDAQ: FAST) which makes construction supplies such as screws and bolts holds a 20.1 forward PE.

Jonathan Golub, chief U.S. market strategist at RBC Capital Markets in New York said in a recent note to clients that the forward price to earnings growth ratio for the sector stands at 2.2, a more expensive valuation than the 2.1 for the S&P 500.

"They are (expensive) because you have a growth problem," said Golub.

The slower growth has been reflected in earnings and revenue estimates for the sector. As of Sept. 9, earnings are expected to decline by 3.5 percent in the third quarter, in line with the S&P 500, but down from the anticipated 1.6 percent growth seen on July 1. Revenue is expected to fall by 5 percent compared with the 2.8 percent expected fall in S&P 500 revenue and the 2.2 percent decline expected at the start of the quarter.

That could make industrials primed to bounce when they report results, as they have a lower bar to jump over.

"Take advantage of the fact it doesn’t seem nearly as much has changed about the ongoing earnings and earnings growth of the companies as the stocks have declined and that creates an opportunity," said Kate Warne, investment strategist at Edward Jones in St. Louis.

While Orlando is waiting for a turn in the manufacturing data before broadly recommending the sector, he has a favorable view on stocks that are benefiting from the current state of the economy, such as airlines and auto-related stocks.

A slowly improving economy, low interest rates and falling gas prices are seen as a plus for airlines, and names such as American Airlines (NASDAQ: AAL) and United Continental (NYSE: UAL) currently hold forward PE ratios of around 6.

And while there are no automakers in the industrial sector, names that supply parts are likely to take advantage of the robust vehicle sales. Makers of engines and engine parts such as Cummins Inc (NYSE: CMI) and BorgWarner (NYSE: BWA), with forward PE's of 11.4 and 12.5 respectively, could have some upside, he said.

(Reporting by Chuck Mikolajczak)

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