U.S. industrials riding high

Two other industries — aerospace/defence and industrial machinery — are making new highs in relative strength. This extends their 13-year trend of superior performance.

On the surface, the industrial sector marches closely with the broader market: industrials lag for a year or so, then catch up and outperform for a year or two. The sector is riding high these days, with the strongest relative performance among the 10 sectors of the S&P 500. That said, it’s one of the smaller sectors, accounting for 10.7% of the index.

The placid exterior of the industrials sector hides radical moves by its individual industries. Airlines appear to be doing that now. After underperforming the overall market for 23 years, airlines have risen much more than the S&P 500 for the past 18 months.

It looks like a major about-face in relative strength. This perhaps signals anticipation of a fundamental change in airlines’ earning power. Airlines are cutting capacity to be more in line with demand, thus improving their financial results. And industry consolidation may reduce fare-cutting battles.

Airlines have been a disaster since 1989. In the decade from 2002-12, there were 43 airline bankruptcies in the U.S. Mergers continue, and the latest pending would amalgamate U.S. Airways Group and AMR Corp., owner of bankrupt American Airlines.

Southwest Airlines Co., whose strategy is to operate more like a bus line than an airline, was the exception in the airline subindex’s long slide. Between 1987 and 2000, this stock rose to $23.32 a share from 55¢, adjusted for splits. (All figures are in U.S. dollars.)

Southwest Air, with a market capitalization of $12 billion, has strong fundamentals, but Delta Air Lines Inc. is a current price-momentum leader. Delta also is, by far, the largest by market cap, at $21 billion. Delta leads the U.S. airlines in making the most efficient use of assets. Delta’s sales/assets ratio is $1.20 in sales for every $1 of tangible assets. In contrast, other airlines produce between 70¢ and 90¢ in sales each year per dollar of tangible assets.

Alaska Air Group Inc., with its market cap of $5 billion, and JetBlue Airways Corp., with its market cap of $2 billion, also are leaders in upside price momentum. These companies, as a group, regularly make 40%-plus gross profit margins, with Alaska and Southwest Air the year-to-date leaders at 49%.

As for aerospace and defence stocks, they have risen by more than the overall market since 2000. The S&P GICS subindex for this industry has moved to a new high in relative strength after four years of consolidation.

Aerospace and defence industry stocks began to outperform the market in 2000, then stopped in 2009 and resumed this year. This is a big industry, accounting for 2.7% of the S&P 500.

Three stocks lead the rush higher: General Dynamics Corp. ($31 billion in market cap), Raytheon Corp. ($24 billion) and United Technologies Corp. ($99 billion).

All three firms display financial strength. For example, United Tech’s gross profit margin was 25% in the latest 12-month period, ended June 30. Raytheon followed at 22%, and General Dynamics trails at 16%.

Returns on equity are robust, with Raytheon and United Tech at 20% and General Dynamics at 15% (based on earnings before extraordinary items) in the 12 months ended June 30.

All three firms have high efficiency, as shown by their sales/assets ratios. Raytheon generates $1.80 of sales per dollar of tangible assets; General Dynamics, $1.45; and United Tech, $1.36.

Records of consecutive dividend payments illustrate the long-term stability of these companies. United Tech has paid a dividend every year since 1936, Raytheon since 1964 and General Dynamics since 1979.

Similarly, the industrial machinery industry subindex has moved to a new high after several years of no gains vs the S&P 500. This industry also has risen from a low in relative strength in 2000. Like the aerospace/defence industry, industrial machinery shares started to outperform the market in 2000, but paused in 2011-12.

Price momentum leaders in this industry include three large-cap stocks — Eaton Corp. ($33 billion in market cap), Pall Corp. ($9 billion) and Pentair Inc. ($13 billion).

Eaton’s financial statements this year reflect the acquisition of Cooper Industries Inc. in November 2012. This almost doubled total assets to $35 billion, including $21 billion in intangibles, from $18 billion. Eaton’s gross margin has dropped to 25% in the 12 months ended June 30; previously, it was in the 30% range.

Pall’s gross margin hovers around 50%, and its return on equity this year is running at 20%. Pall has a high market valuation, trading at 3.3 times sales.

Like Eaton, Pentair concluded a major merger last year, when Tyco International Ltd.’s flow-fluid business was brought into the fold. This merger dropped Pentair’s gross margin this year to 20% from the 30% range. IE