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Why Industrial Stocks Stand Tall and Strong

The U.S. manufacturing sector has stepped up in a big way, leading recent advances in both the stock market and the economy. The rebound has carried such big names as Boeing (BA) and General Dynamics (GD) to their highest share prices since September 2008.

After lagging the rest of the stock market in the recession years of 2008 and 2009, the industrials on the Standard & Poor's 500-stock index have vaulted ahead of it. The industrials index is up 4.3% in 2010, more than any other sector and ahead of the flat year-to-date return for the broad S&P 500.

A weaker-than-expected economic report on Mar. 1 failed to cool investor optimism about industrial stocks. The Institute for Supply Management's manufacturing index slipped from January's 58.4, which was the highest reading since 2004, to 56.5 in February. Economists surveyed by Bloomberg News were expecting a median reading of 57.9.

Still, any ISM reading index above 50 means that manufacturing is expanding—and February was the seventh consecutive month of manufacturing growth.

The report once again confirmed that manufacturers are performing much better than other sectors, says independent market strategist Doug Peta. "It's as if manufacturing is really leading the rest of the economy," he says.

Q4 earnings have surpassed forecasts

Despite the ISM report, the S&P 500 Industrials index rose 0.96% on Mar. 1, to its highest level since Jan. 19. The index is up 7.7% in the last three weeks .

Industrial companies make widely varying products and serve vastly different end markets, yet manufacturers large and small continue to offer the stock market better-than-expected news. On average, fourth-quarter earnings for the S&P 500 industrials are 9.8% above analyst expectations, according to Bloomberg.

Bemis Company (BMS), a maker of packaging products and pressure-sensitive materials with sales of $3.5 billion last year, said on Mar. 1 that it expected 2010 earnings per share to be 3% to 11% higher than analysts were predicting.

After reporting better-than-expected earnings on Mar. 1, drilling services outfit Rowan (RDC) hit its highest price level since October 2008. "During the last few months, we've seen improving activity and tendering in virtually every jack-up [drilling barge] market," President and Chief Executive W. Matt Ralls told analysts.

big plus: customers' Low inventories

Industrials are the "favorite sector" of Uri Landesman, ING Investment Management's (ING) senior portfolio manager. Stocks in the sector remain "very undervalued," he says, and will outperform in "any sustained recovery."

One advantage for manufacturers is that their customers' inventories are "drastically low," says Morningstar (MORN) analyst Adam Fleck, who specializes in heavy equipment manufacturers such as Caterpillar (CAT) and Deere (DE). Even without a strong economic recovery, merely replenishing inventories to normal levels should spur significant sales growth, Fleck says. "If the economy gets a little better, you've got the potential for stronger growth."

The U.S. economy isn't the only factor affecting manufacturers. S&P 500 industrial companies derive 34% of their revenue from outside the U.S., according to a Morgan Stanley (MS) report issued on Mar. 1.

Industrial CEOs spend a lot of time talking about their growth opportunities overseas, especially in China. After spurring the economy with stimulus money last year, the Chinese government this year is trying to slow growth by restricting lending. China's gross domestic product grew 10.7% in the fourth quarter.

Industrials remain bullish on China

China's local manufacturers appear to be getting the message. A Chinese government purchasing manager's index released on Mar. 1 fell to 52, its lowest level in a year, from 55.8 in January. "A moderation in Chinese manufacturing growth is actually good news," Qi Hongbin, HSBC's chief China economist, told Bloomberg News. "It helps contain overheating and inflationary risks."

U.S. industrial executives remain bullish on China. On Feb. 17, United Technologies (UTX) Chairman and CEO Louis R. Chenevert told an investor conference: "We remain confident in China, where credit tightening is not expected to impact the stimulus spending and the orders that we have seen at this point in time."

AT the same conference, 3M (MMM) Chief Financial Officer Patrick D. Campbell said his company expects to double Chinese sales by 2014, to $3 billion. Sales to India could be five times higher, at $1 billion, he said.

"Thank God we're in emerging markets," Campbell said. "Emerging markets—especially places like China, India, and Latin America—are performing very, very well right now. And obviously the developed market is kind of a little more stagnant."

Among the problems in developed markets are concerns over sovereign debt in Europe, especially Greece. "Europe is going to have difficult times for the foreseeable future," says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors.

U.S. manufacturers are hiring

In the U.S., manufacturing strength stands out against continued weakness in the consumer sector, especially in real estate. Still, the 9.7% U.S. unemployment rate could hurt manufacturing sales, warns Morningstar's Fleck. A weak U.S. consumer "filters through the entire industrial supply chain," he says.

The good news is that February's ISM survey showed that manufacturers, at least, are hiring. The ISM Employment index hit 56.1, up from 53.3 in January, reaching its highest level since January 2005.

Several investors and analysts warned that a stronger dollar might hurt U.S. exporters in 2010. A more expensive dollar makes overseas sales and profits appear smaller on U.S. income statements. The dollar index, measuring the greenback against a basket of foreign currencies, is up 8.7% since its most recent low, reached on Nov. 25.

"All else equal, a strengthening dollar would be a headwind" for U.S. manufacturers, Peta says. Luckily, a strong dollar also reflects a stronger U.S. economy, especially as compared with Europe.

Industrial stocks are benefiting from the early stages of economic recovery and could offer investors good news this year. However, Fleck warns that, after the S&P 500 Industrials have risen 14.6% in four months, they no longer look "super cheap." If industrial stocks retreat in the future, they may again become great long-term buys, he adds.

Steverman is a reporter for Bloomberg News in New York.

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