Industrial Stocks Are Hotter Than Their Profit Prospects

From lug nuts to linerboard to latex, Wall Street suddenly sees gold in basic industrial products.

The long-depressed stocks of many American industrial companies are soaring as investors make a simple assumption: If the economic recession is indeed ending, demand for all sorts of goods will soon return.

And if that happens, the producers of the stuff that makes up those goods--basic metals, chemicals, forest products, etc.--ought to see their profits mushroom.

At least, that’s the theory. But some experts now are warning investors not to let their profit expectations run wild for industrial companies. This is likely to be a tough recovery.

So far, Wall Street doesn’t want to hear that talk. On Thursday, the Dow Jones industrial average soared 30.86 points to 3,000.45--only the second time in history the Dow has closed above 3,000.

Leading the Dow’s advance were such classic industrial names as chemical giant Du Pont, up $1.375 to $46.75; machinery maker Caterpillar, up $1.50 to $49.125, and International Paper, up $1.375 to $68.625.

Yet as the emotion driving these stocks intensifies, some Wall Streeters believe that the chances of a dramatic earnings rebound for industrial America are rapidly fading--not just for this year, but for 1992 as well. And if that’s the case, the industrial stocks may quickly get far ahead of themselves in this rally, leading to another big letdown later this summer, some experts warn.

Many industrial stocks have been laggards for the past two to three years, with intermittent rallies that have quickly faded. The problem: Even before the recession officially began last year, U.S. consumers’ demand for autos, appliances and other goods had been weakening for some time. That cut demand for industrial materials, and hence the producers’ profits.

Earnings of auto parts and electronics firm Eaton Corp., for example, peaked at $6.17 a share in 1988, slipped to $6 in 1989 and fell to $5.05 last year. The recession only began last summer.

Now, with growing signs that the recession is ending, investors want to believe that it’s finally time for the industrial stocks to shine again. That hope is partly rooted in the belief that the stable-growth consumer stocks that have led the market for nearly 10 years--Coca-Cola, Eli Lilly, and others--have overstayed their welcome.

“People are sort of bored with the old (stock) stories,� says Byron Wien, market strategist for Morgan Stanley & Co. in New York. “They’re tired of recommending the food and drug stocks.�

That would be fine if investors could count on industrial companies’ earnings to soar once the recovery begins in earnest. Earnings, after all, are the name of the game here. People want to own companies that are making good money, and making more of it each quarter.

But Wien and others warn that the economy’s climb out of recession is likely to be agonizingly slow--not like the quick rebounds that followed other recessions. That should translate into slower profit growth for the industrial companies. Which means investors have to be careful about the prices they are willing to pay for these stocks, especially if your time horizon extends only into 1992.

“According to our work, it looks like these stocks are very fully priced based on the recovery--especially if it’s an anemic recovery,� Wien says.

Wait a minute, though. Isn’t industrial America now lean and mean thanks to all of those 1980s restructurings? Aren’t the companies capable of generating enormous earnings gains on even small revenue gains?

L. Crandall Hays, investment strategist at Robert Baird & Co. in Milwaukee, says the alleged earnings leverage is probably more myth than reality. “It’s not that easy,� he says. “The incremental sales just don’t run through like that. You have to get big incremental sales to get big profits.�

Despite their restructurings, industrial companies still face heated--and in many cases, growing--competition at home and abroad, Hays says. “Look at their profit margins,� he says. “Everybody’s still fighting with each other for market share.�

Indeed, that was evident in 1989, a year of moderate economic growth. If 1992 also is a year of moderate growth, why think that margins should improve much?

But perhaps the most worrisome problem for the industrial companies is slowing economic growth overseas. Last year and so far this year, strong exports of industrial goods from the United States to the rest of the world helped keep many industrial companies at least marginally profitable, while our economy plunged into recession.

Now, “Just as the U.S. is trying to stabilize, Japan and Europe are losing steam,� says Lacy Hunt, chief economist for Hongkong Bank in New York. Investors may already be expecting some drop-off in exports by U.S. companies this summer and fall, Hunt says, but he believes that “1992 is a more questionable year for exports even than this year.�

Add it all up, and you begin to see why many industrial companies may have trouble meeting Wall Street’s 1992 earnings estimates. Even though the stocks’ rally hasn’t gone very far, the stock prices relative to 1992 earnings expectations aren’t necessarily cheap.

Does that mean you shouldn’t own industrial stocks? On the contrary--an investor who has avoided this group for years probably ought to have some exposure to it now, most investment advisers agree. Chances are, by the mid-1990s, strong economic growth could be the norm around the globe. Many basic-goods producers could be booming by then.

The lesson here is, just don’t buy these stocks for 1992 earnings, because the numbers may not be there to support them.

Instead, any commitment to industrial stocks ought to be a three- to four-year commitment at a minimum, many advisers say. The buyers now probably aren’t thinking much beyond the next three months. “These people want to make money fast,� says Wien of the money behind the stocks’ current rally. “These buyers may not be making investment decisions--they’re making trading decisions.�

Industrials Lead the Market . . .

The best-performing stock groups in the week ended Wednesday, out of 87 industry groups tracked by Standard & Poor’s:

Percentage change: Stock group One week Year to date Auto makers +11.9% +27.0% Building materials +8.1% +40.3% Electronic instruments +7.3% +62.2% Paper containers +7.3% +38.5% S&Ls; +5.8% +45.8% Paper/forest products +5.7% +23.5% Aluminum +5.4% +13.0% Trucks and truck parts +5.2% +23.7% Personal loans +5.2% +42.1% Specialty chemicals +4.8% +20.9% S&P; 500 index +1.8% +15.9%

Source: Smith Barney, Harris Upham & Co.

. . . But Will Profits Disappoint?Analysts’ consensus earnings estimates for some key industrial companies suggest many firms will show 1992 results only marginally above 1990 levels.

Earnings per share: ’92 Company 1990A 1991E 1992E P-E* Alcoa $3.40 $5.36 $7.99 9 Caterpillar 2.07 0.64 3.66 13 Eaton 5.05 3.14 5.35 11 Emerson Elec. 2.75 2.87 3.19 15 GM -0.49 -2.42 2.66 16 Intl. Paper 5.21 4.51 5.68 12 Monsanto 4.23 4.86 5.79 12 S&P; 500 21.39 22.46 25.55 15

* Current stock price divided by 1992 earnings estimate

Source: Zacks Investment Research