Manufacturing malaise over? Don't bet on it

It was only two months ago that we were debating whether there was a manufacturing recession. Now, investors are pricing many industrial stocks like one has already come and gone.
Stocks of manufacturers and other industrial companies within the S&P 500 Index have risen more than 35% off a low set on Christmas Eve last year, when recession fears reached a fever pitch. A downbeat round of earnings in the second quarter proved the manufacturing slowdown many feared was really happening, and third-quarter results largely showed that downturn accelerating. But throw in an Institute for Supply Management reading for October that could be construed as a sign of a bottoming, then add some encouraging words from the Trump administration on a trade war resolution, and investors were off to the races again. This quick shift in sentiment tests the limits of logic.

A bottoming?

No one knows, but the uncertainty that drove the industrial sales slump continues to linger.

For one, the uncertainty that's kept industrial customers on the sidelines seems likely to persist. A "phase-one" trade deal with China, if it happens at all, may spare the consumer from tariffs expected to take effect in December, but President Donald Trump has resisted a rollback of existing levies, including those on the initial $250 billion of mostly manufacturing-related products, and it seems unlikely that will be on the table in the near term. Meanwhile, impeachment hearings got under way this week in the US, and the 2020 election looms large. 

Protests have turned increasingly violent in Hong Kong. Britain is heading toward a December election that will decide the fate of Brexit. Caterpillar Inc. this week reported slowing sales growth in Latin America in October amid riots in Chile, political issues in Argentina and a disappointing Brazilian oil deposit auction.

But even putting those political headaches aside, it's not clear where industrial companies are going to get the kind of growth they need to support current valuations. Sales hitting a bottom doesn't necessarily mean a huge upward trajectory from here; it might also mean that companies are just stuck in a lower-to-no-growth environment. The automotive and semiconductor markets, for example, have been a source of weakness this year and that appears likely to continue. 

Continental AG is assuming no material improvement in global light-vehicle production over the next five years and is bracing for a third straight decline in 2020, Chief Financial Officer Wolfgang Schaefer said this week. German chipmaker Infineon Technologies AG said inventories are returning to healthier levels, but the absence of macro improvement and the weak automotive outlook make a recovery hard to predict.

"It's like all of these problems have been forgotten," Joshua Aguilar, an analyst at Morningstar, said by phone. Whereas a lot of stocks looked too cheap last December when investors were acting like the world was about to end, "things are now a little expensive and heading into unsustainable territory." Based on companies' ability to generate free cash flow over a normalized economic cycle, "the math just doesn't make sense to me in some cases," Aguilar said. He pointed to names like Illinois Tool Works Inc., which is up 38% this year and flirting with its all-time high, and Rockwell Automation Inc., which spiked 10.5% on Tuesday off of better-than-expected earnings.

Getting Expensive

Stocks like Illinois Tool Works, Rockwell and Emerson are at or above Morningstar's estimate of their fair value. 3M is cheaper, but for good reason.
Rockwell is a good test case because it sells automation equipment to a wide variety of industries, including chipmakers and automakers. Its products also entail a big investment, meaning customers have to feel relatively confident. Rockwell reported core sales growth of 1.4% in its fiscal fourth quarter, hardly a blockbuster showing but much better than the decline many analysts had been modeling. Hence the enthusiasm. The caveat here is that Rockwell's business can be volatile. 

The fact that the company cited unforeseen weakness in automotive and food-and-beverage markets in the third quarter, and then saw a rebound in the fourth speaks to this, notes Gordon Haskett's John Inch. There's a risk that a similar lumpiness is bleeding into economic data as companies wrestle with the trade news of the day. A gauge of New York factory activity released Friday showed a "reassuring bounce" in capital expenditure intentions, but the result was still the weakest since 2016 on a three-month average, and the extent to which trade war uncertainties linger will determine whether those plans translate into actual spending, according to Andrew Husby of Bloomberg Economics.

For all this talk of better-than-feared or better-than-expected earnings, the middle of Rockwell's guidance range points to zero organic growth in fiscal 2020. It's also worth remembering the company had to cut its 2019 outlook several times. But say Rockwell is right and growth is flat or even slightly up in 2020. That would lend credence to the theory that the industrial economy is just paused, rather than in a true recession. But that also means there's less room for an earnings "recovery" at companies like Rockwell, Gordon Haskett's Inch points out. Put another way, even optimists on growth should be skeptical of a forward Rockwell price-earnings ratio of more than 22 times and the similarly high valuations at some of its competitors.

Rockwell's stock price is now back in the range of where it was in late 2017, when Emerson Electric Co. launched a pricey (and ultimately failed) pursuit of Rockwell. Emerson CEO Dave Farr is typically an optimist and has every reason to present his business in the best light as an activist investor agitates for changes, so it seems telling that he expects the environment for industrial companies to remain "challenging" over the next 12 to 18 months. "There are a lot of people who believe that we'll see a second-half recovery" in 2020, Farr said. "We are not planning on that." I think you can cross out a second run at Rockwell at these valuations then.

A farewell to arms

A fatal shooting at Saugus High School in Santa Clarita, California, this week was a grim reminder of how little President Donald Trump's administration has done to answer Americans' call for stronger gun regulations amid frequent mass shootings. But in a twist, Trump has also been terrible for the gun-making industry. American Outdoor Brands Corp. announced this week that it would separate its camping and hunting-accessories business from its legacy Smith & Wesson firearms division. 

Gun sales are driven in large part by fear of looming government crackdowns. That's because preexisting owners do most of the buying: A Gallup poll in October found that 37% of Americans had a gun in their home, down from a high of 51% in 1993 and below the average over the past 20 years. With little real concern among that population that Trump will take away their weaponry, American Outdoor's firearm sales fell more than 40% in fiscal 2018, the first full year after his election. While Trump expressed support for stronger background checks after an August shooting at a Walmart in El Paso left 22 people dead, the National Rifle Association quickly talked him out of that. In the current period, which includes the Walmart shooting, analysts expect American Outdoor's total sales to be flat.

Enough guns?

Do you have a gun in your home? Ownership has held relatively steady over the past few decades and recently declined.

To top it off, American Outdoor's accessories business depends heavily on China manufacturing, so it's been hit hard by Trump's trade war. In August, American Outdoor blamed the levies for a cut in its profit guidance. Still, the accessories operations have more stable growth prospects and likely better access to capital than the gun division, with companies including Bank of America Corp. planning to stop lending to makers of assault-style weapons for non-military purposes. 

There's also the matter of the Supreme Court's decision this week to allow the families of the Sandy Hook massacre to sue Remington Arms Co., the maker of the AR-15-style weapon used in that tragedy. American Outdoors chief financial officer, Jeffrey Buchanan, cited the financing squeeze and rising insurance bills as one factor for the split, according to the Financial Times. Notably, American Outdoor CEO James Debney has decided to lead the accessories business, not the firearms one.

Disclaimer: This article first appeared on Bloomberg.com, and is published by special syndication arrangement.