The market reaction to the global pandemic changes by the day. More than three months into this crisis, the world is beginning to open back up driving market expectations for a recovery, and resulting in changes in the current street estimates.
In this post, I will look at valuation and estimates dynamics for a broad set of US industrials (excluding the aero-linked names as that subsector has its own dynamics during the crisis), focusing on a basket of 25 publicly traded US industrials in several subsectors. A list of the companies, along with very brief descriptions, is at the bottom of the article.
The first question is “where are we at?” in terms of valuation. Given the cyclical nature of industrials, we would argue that the LTM (last twelve months) earnings represent the cyclical peak EPS for the sector. Therefore, looking at LTM PE is a good proxy for where Industrials are priced relative to the cyclical peak. In the chart below, we are looking at the unweighted average LTM PE for the last five years, along with the 5-year mean and 1-standard deviation bands. We can see that our basket is trading at above-mean peak earnings (interactive chart viewer)
Next, we will look at the forward PE valuation on a rolling next twelve months (NTM) basis, but in relation to the overall market (S&P 500) NTM PE. Again, we have added the 5-year and 1-standard deviation bands. Looking at the basket multiple in relation to the market multiple helps us remove any “market-wide” changes in valuation. Since we have a sizable basket, the five year mean relative valuation is very close to 1. Currently, investors are currently paying a fairly wide premium, on a NTM PE basis, for our industrials basket. (interactive chart viewer)
In the next chart, we look at the fundamentals estimates change (specifically change in YoY% in NTM EBITDA, on a rolling basis) for our basket of industrials. We can see the overall trend of a slowdown visible in H2 2019, with a very sharp downward trend beginning in March 2020, with some very recent inflections upwards. Again, remember that this is year-over-year percentage change.
Adding an unweighted average for the YoY% change in rolling NTM EBITDA estimates, and zooming in on the YTD timeframe, we can see that the average of the estimates change bottomed in May of this year at around negative 25%, and has seen an inflection upwards in the first week of June.
Finally, by combining the “peak” PE multiple from the first chart, with a longer-term version of the YoY% change in EBITDA estimates we can see that the change in PE has been “leading” the estimates change most of the time in the last five years. We can see this in the most recent three months: PE inflected sharply upwards while the change in estimates began to inflect only very recently.
If recent history is a guide here, the market expectations for a recovery in the industrial economy are leading the current street estimates for the underlying fundamentals. It is also possible that despite the near-term Covid-related headwings, the market is beginning to price structural tailwinds from supply chain re-shoring and near-shoring.
For our broad industrials basket, we included the following companies:
Allegion (ALLE)- security/access products
AO Smith (AOS)- water heating and air purification
Caterpillar (CAT)- construction, mining and forestry machinery
Colfax (CFX)- fabrication, welding and orthopedic products
Cummins (CMI)- diesel engines and components
CSX Corp. (CSX)- railroads
Deere & Co. (DE)- agricultural, forestry and construction equipment
Danaher (DHR)- diversified medical, commercial and industrial products
Dover (DOV)- diversified engineered, fueling, imaging, pumps and food equipment
Emerson (EMR)- automation, process management, climate technology and other solutions
Fastenal (FAST)- wholesale industrial and construction supply distribution
Graco (GGG)- fluid and powder materials equipment
Illinois Tool Works (ITW)- diversified products and equipment, including OEM, Food, Testing, and Welding
Kennametal (KMT)- tooling and engineered components
Lear (LEA)- Auto seating and electrical systems supplier
Lincoln Electrics (LECO)- welding products
Leggett & Platt (LEG)- wide range of engineered components for home, office and auto
PACCAR (PCAR)- commercial trucks
Parker Hannafin (PH)- wide range of motion and control technologies
Proto Labs (PRLB)- 3D-printed, machined and injection-moulded parts
Robert Half (RHI)- staffing
Rockwell Automation (ROK)- industrial automation power, control and information solutions
Stanley Black & Decker (SWK)- hand and power tools
United Rentals (URI)- equipment rentals
WESCO (WCC)- industrials distributor
Instructional video on how to build these visualizations in Sentieo: