Why Industrial Stocks Stand Tall and Strong

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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 BusinessWeek's Finance channel.

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