Barron's: Laggards, But Not For Long

A number of Wall Street's strategists have been pointing investors toward the industrial sector, citing their expectations for a reacceleration of economic growth later this year and into next. Given the recent spate of strong global economic data, it looks like they're on to something.

But the industrial sector is hardly homogeneous, and its constituents are subject to a wide variety of catalysts. Barron's ran a screen of the 61 industrial names in the Standard & Poor's 500, paying close attention to those with stocks that have underperformed the broader index in the past year and are likely to get a boost from economic growth this year. Names that stood out include Caterpillar, Joy Global, Textron, and General Electric.

Industrials "are not as cheap as they were a few months ago, but there's still more upside," says Jim Paulsen, chief investment strategist at Wells Capital Management. "In the last 12 months we've seen an increase in confidence," as investors have put their fears of "Armageddon" to rest, he says. The market has another leg up if economic growth moves past the 2% it's been stalled at, and gets closer to 3%.

Last week's economic data bolstered the bulls' case. Friday's report on U.S. nonfarm employment showed 169,000 jobs were added and the unemployment rate fell 0.1 percentage point to 7.3%. Earlier in the week the Institute of Supply Management reported its manufacturing index climbed to 55.7 in August, the highest level since June 2011. Historically, cyclical sectors outperform when the index is higher than 50 and rising, notes David Kostin, U.S. equity strategist at Goldman Sachs, who recommends investors overweight industrial companies.

Yet despite this strong backdrop, industrials have only managed to keep pace with the S&P 500 so far this year, rising 18%. Industrials have also trailed other cyclical sectors of the market: Consumer discretionary stocks are up 24% thus far in 2013, financials and small companies have enjoyed a 21% jump.

Industrial stocks had a tough 2012 as emerging markets slowed, Europe entered a recession, and commodity prices fell. Industrials spent that soft patch restructuring their operations. "The incremental profitability is much larger than investors would have thought," predicts Nick Heymann, an analyst with William Blair.

The industrial sector -- and our list of underperformers -- is very diverse, including railroads, conglomerates and defense companies. Analysts have strong earnings expectations for many of them next year; several are expected to post earnings growth in the mid-teens, beating the 11% earnings growth expected for the S&P 500.

Making our list of underperforming stocks are Deere (ticker: DE) and Caterpillar (CAT). Though often lumped together, Deere has much more exposure to agriculture than Caterpillar, which is more influenced by the mining sector. Rob Wertheimer, an analyst at Vertical Research Partners, remains bearish on agriculture but has taken a shine to mining. Caterpillar shares, now at $83, could climb to $110 if the consensus estimate of $7.25 of earnings per share for 2014 climbs to $8.17, as Wertheimer expects.

The drop in commodity prices and mining stocks has also taken a toll on Joy Global (JOY). The shares of this manufacturer of mining equipment have fallen 0.7% in the past year, vastly underperforming the broader index. But Lawrence De Maria, an analyst with William Blair, believes the company's orders are in the process of bottoming out and may even rise in the fourth quarter compared with the third. "Shares trade off orders and the anticipation of orders," he explains. Any increase will signal a coming bounce in earnings. As of now, earnings still reflect the decline in the business over the past year. In its October 2013 fiscal year, Joy is expected to earn $5.84 a share; expectations fall to $3.94 for the following year. In the meantime, Joy announced a $1 billion stock repurchase program, which could enable it to buy back 20% of its shares at the recent price of $50.85. De Maria's price target: $60.

Jeffrey Sprague, managing partner at Vertical Research Partners likes Textron (TXT) shares, which are up 13% so far this year. The company has an automotive division and a defense business. But it's Textron's private-jet business, Cessna, that has depressed the company's earnings. Private-jet sales have been soft since the recession, as even those who can afford to fly privately may not want to be seen doing so.

But the market for new jets may be firming. The age of the jet fleet is increasing, which means more jets will need replacing, and the number of used aircraft on the market is decreasing, says Sprague. When the market turns, Textron's $2 a share of earnings could climb to $3or more, and its multiple could expand to 15, which would put the stock closer to $45 than today's $28. The current consensus targets earnings of $1.99 a share this year and $2.35 next year, giving shares a below-market 12 multiple.

General Electric (GE) is certainly the largest name on our list. The company has been trying to improve margins in its industrial business while shrinking its financing arm, GE Capital. GE aims to improve industrial margins by 0.7 percentage point this year, but margins shrank the first quarter, and the second quarter's improvement didn't quite make up for it. The second half of the year will be vital, as that's when GE tends to ship most of its products.

GE shares currently trade at 12.7 times 2014 earnings estimates. But if it can shrink its financial business -- which it has already begun by announcing the spinoff of its store-branded credit-card business -- to less than 20% of its total earnings, the market may give the stock a better multiple. Financial multiples tend to be about 10, and industrial multiples are closer to 16. If GE Capital is less than a fifth of GE's total earnings, investors may apply the higher industrial multiple to the entire company, says Heymann. His immediate target on the stock is $26, 10% higher than its recent price of $23, but shares could climb to the low- to mid-$30s by the end of 2015 if GE hits its goals and provides more visibility into its results, he says.

Add a little revenue growth, thanks to an improving global economy, and many of the names on our list could easily go from lagging behind the market to leading it.