Caterpillar stock is up 20% since Sept. 23.
DreamstimeInvestors have recently rushed into industrial stocks, sending valuations soaring. It could be just the time to buy.
The Industrial Select Sector SPDR exchange-traded fund (ticker: XLI) is up 17.5% since Sept. 23, a date that marked the start of a fresh rally in the stocks, which have outperformed the S&P 500’s 13.6% gain over that time. These large-cap industrials have even outperformed large-cap value stocks, which are highly correlated to changes in economic expectations. The Vanguard S&P 500 Value Index Fund ETF (VOOV) is up 16% since Sept. 23.
Investors are gaining confidence in the continuing economic recovery, even as the pace of recovery is expected to cool off in the next few months. The expectations of fiscal stimulus should tie over cash-starved small businesses and low-confidence consumers until vaccines are distributed. Many expect billions of doses of vaccines distributed by the end of 2021, allowing for aggressive reopenings and for companies to invest—tailwinds for industrial stocks that investors are pricing in.
One key signal that investors are highly confident in what is expected to be the start of a new expansionary cycle: the valuations of industrial companies.
Those valuations look stretched. The average industrial stock in the S&P 500 currently trades at just above 25.1 times the next 12 months of earnings-per-share estimates. That’s more than a 12% premium to the S&P 500’s multiple of just above 22 times.
Most stocks are trading at historically elevated multiples because interest rates are historically low, which boosts the value and attractiveness of corporate profits. Industrial valuations are usually roughly in line with S&P 500 valuations, according to FactSet data, but coming just before the economy comes out of recession, the sector often sees a pop in its earnings multiple relative to the index.
That’s because investors see earnings hitting a trough, and they begin to anticipate a bounce. But before those earnings projections materialize, investors rush into the stocks, sending valuations up. Industrials are among the most economically sensitive sectors, and their earnings are more volatile than in other sectors.
“Earnings for such a cyclical sector are going to grow at a faster pace than utilities, consumer staples, health care, et cetera,” Matt Arnold, industrials analyst at Edward Jones, tells Barron’s. “Right now, it’s normal to see industrials trade at such a premium to the market. We’re going to see such a cyclical recovery.” The last time industrials were at such an inflection point, he notes, was at the end of the financial crisis, and “the [valuation] chart almost rhymes with the shape of it back then.”
Indeed, in the very beginning of 2010, industrials were trading at an earnings multiple that was about a 15% premium to the S&P 500’s multiple. “What the market is doing with a price-to-earnings that high is it’s definitely heralding earnings coming off a bottom,” Arnold says.
Between Dec. 31, 2009—when industrial multiples were near a peak after the 2007-09 recession—and May 6, 2011, when the market began a brief decline, the Industrial Select Sector SPDR ETF rose 38%. The S&P rose only about 18%.
Industrial multiples can still rise near-term if this recovery looks like the last one. Back then, the sector’s multiple fell from a 15% premium in early 2010 to in line with the S&P 500 around the end of the first half of 2011, FactSet’s chart shows. By the start of 2011, industrial valuations were still at a 9.5% premium to the market.
Take Caterpillar (CAT), one of the most tracked—and highly cyclical—of all U.S. industrials. The stock is up 20% since Sept. 23. It trades at just over 23 times net year’s EPS, an almost 5% premium to the broader market. EPS in 2021 and 2022 are expected to grow 38% and 31%, respectively. That’s higher than the expected 22% and 17% for the S&P 500.
Conservatively assuming Caterpillar trades in line with the S&P 500’s multiple by the end of the year—and many strategists have the multiple moderating to 22 times by year-end 2021—the stock can still rise 23% in the next year. By the end of 2021, investors will price in 2022 expected EPS of $9.78.
It might seem counterintuitive, but buying industrials at a high valuation might work just as well as buying any random beaten-down stock at a low multiple.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
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December 04, 2020 at 01:04AM
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