Banged-up industrials favored to bounce back

June 25, 2006|By LEON LAZAROFF | LEON LAZAROFF,CHICAGO TRIBUNE

NEW YORK -- As the market sold off over the past few weeks, fund managers have scoured their charts looking for quality stocks that have fallen noticeably.

At the top of that list, said Don Hodges, co-portfolio manager of the $900 million Hodges Capital Management in Dallas, are industrial companies. Among the sector's possibilities are a group of mid- and large-cap companies that have performed well over the past few years.

But as talk of inflation fears and another interest-rate increase overshadows all other market news, shares in some of these companies have been hit hard. Heavy equipment-maker Caterpillar Inc. and railroad giant Burlington Northern Santa Fe Corp., Hodges said, are two stocks beaten up after the Federal Reserve's May 10 decision to increase short-term interest rates.

Caterpillar "came down not because of anything internal but because of what's been happening in the market in general," he said. "That's something that's been happening across the market to one degree or another."

The day before the rate increase, Caterpillar touched $81.14 before falling as low as $64.41 in intraday trading a month later. Hodges said he bought the stock at $66 and $67 a share. Burlington Northern traded above $86 a share in April before dropping below $71 a share, where Hodges said he added to his position.

Hodges said he likes Caterpillar because worldwide demand for construction equipment is unlikely to dissipate. Also, he said, the company has shown in the past two years that it can increase prices without hurting demand.

The same goes for Burlington Northern, he said. With oil and natural gas prices remaining near historical highs, demand for coal and, increasingly, ethanol, is likely to grow. Neither coal nor ethanol can be transported through pipelines, and the trucking industry is struggling with a shortage of long-haul drivers, Hodges said.

What's more, Burlington Northern is expected to earn nearly $5 a share in 2006, according to a consensus of analysts polled by Thomson Financial. In 2003, it earned slightly more than $2 a share.

Robert Millen, co-manager of the $2.7 billion Jensen Portfolio in Portland, Ore., added to his position in General Electric Co., not because its share price had come down, but because it has largely held up since early May.

"That was an indication to me that some of these quality names that haven't moved much over the past few years will eventually be noticed," he said.

General Electric generates about $16 billion in free cash flow, Millen added, and its operating earnings in several recent years have grown more than 10 percent annually.

`Flight to quality'

Similar to Hodges' take on Caterpillar, Millen sees worldwide demand for infrastructure improvement favoring GE's most profitable units. Millen said the recent market downturn is likely to be short-lived.

Millen isn't completely unhappy with the way the market has performed of late. During 2005, the Jensen Portfolio took some criticism for having concentrated on large-cap companies at a time when smaller issues did quite well. But while the Standard & Poor's 500 fell more than 5 percent from May 9 to June 9, the Jensen Portfolio dropped just 1.5 percent.

"Recently, we've seen a strong flight to quality as investors realize that these companies represent a great opportunity because they haven't gone up as much over the past three years," Millen said.

David Fondrie, a portfolio manager at the Milwaukee-based mutual fund company Heartland Funds, sees a continuation of strong earnings from industrials.

Fondrie's analysis was backed up this month by a Merrill Lynch & Co. report by Richard Bernstein, the firm's chief investment strategist. The report noted that industrial stocks topped all other sectors in May for the highest revisions to their earnings expectations.

Among Fondrie's favorite buying opportunities is American Standard Cos., a diversified firm probably best known for its toilets. But American Standard sells a lot more than toilets - it offers an array of home and kitchen products as well as air conditioning and heating units.

`A lot higher'

Since May 9, American Standard shares have came down from $46.56 to the high $30s and low $40s. As a result, the company's shares are trading at a price-to-earnings multiple of 15 on 2006 estimates. "We think the '07 figure could go a lot higher," Fondrie said.

Industrials that could benefit from the drop in commodity prices have become particularly inviting, he said. Carlisle Cos., which makes construction materials, commercial roofing and specialty tires, among other products, stands to gain as the cost of raw materials comes down. Carlisle trades at about 15 times 2006 earnings projections.

"If some of these industrials get commodity relief, they're going to be printing money," Fondrie said. "It appears another interest rate hike is likely, and that is a concern. But longer term, I like these big cash flow companies that keep returning value to shareholders."

Leon Lazaroff writes for the Chicago Tribune.

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