It May Be Time for a New Industrial Stock Revolution

Recession or no, could industrial stocks be the market’s next leaders?

Early in 1989, some savvy investors looked at consumer and service stocks such as Federal National Mortgage, Circus Circus, Tiffany and Pepsico and decided that they were drastically undervalued. They were right, and the stocks took off like rockets.

Now, some investors are taking the same view of long-unloved industrial stocks. If these stocks were cheap before the Mideast crisis, they’re a lot cheaper today. Even if we’ve entered a recession, say the industrial bulls, a year from now you’ll be glad you started buying these stocks in 1990.

The temptation to believe that the industrial story is strong. While the average stock in the Standard & Poor’s 500-stock index sells for about 13 times estimated 1990 earnings per share, many major industrial names sell for eight times earnings or less. And although the average annualized S&P; dividend yield is 3.8%, you can earn 4.5% or better from many industrial stocks’ dividends.

Of course, there’s a reason for the seemingly cheap stock prices in such economically cyclic industries as paper, steel, aluminum, railroads and industrial parts: Wall Street is fearful that a recession will cause demand for their goods to dry up, slashing sales and earnings.

But some industrial-stock fans say Wall Street has been worried about recession for so long that the actual event will be anti-climactic. “The cyclicals started under-performing the market two years ago. They’ve been anticipating a recession for a long, long time,” says Ron Clark, who runs the Putnam Energy-Resources Trust stock mutual fund in Boston.

John Neff, a legendary investor who runs the Vanguard Group’s Windsor stock mutual fund in Valley Forge, Pa., agrees: “It seems to me the stocks discount the next recession, and then some.”

In fact, the best thing for the industrial stocks might be an overwhelming view on Wall Street that the U.S. economy has finally been tipped into recession by the Mideast oil-price shock, some analysts say. Once recession is accepted as fact, Neff says, the nature of Wall Street is that “it won’t be too long before investors begin to anticipate coming out of recession” and start hunting for stocks to play in the recovery.

Is that wishful thinking? Perhaps. Neff, one of the market’s best-known “value” players, has long been a champion of depressed industrial stocks. He has been far outpaced during the past year by the “growth” investors who stayed with consumer stocks such as Pepsico, Merck and others. Nonetheless, it’s true that industrial stocks tend to begin rebounding long before an economic recovery is evident.

Yet, even some of the growth players who concede that industrial stocks will eventually come back into favor--and probably explode sharply higher in a hurry--say the question is timing. What if the economy isn’t yet in recession and just continues to plod along? Industrial stocks could continue to lag for a long time.

Another risk is that, instead of the mild recession Wall Street expects, the economy goes deep into the tank because of soaring oil prices. If that happens, a stock price-to-earnings ratio of 8 could quickly turn to 16, if an industrial company’s earnings were cut in half. So the stocks’ “cheapness” is relative.

Even so, investors who are intent on bargain hunting would be smart to consider the long-term allure of industrial stocks, especially at newly clipped prices. “These companies went through tremendous restructurings in the 1980s,” notes Peter Anderson, who runs $1.5 billion for Federated Investors in Pittsburgh. Most of the firms have slashed costs, lowered their break-even points and reduced debt dramatically, he said.

“The financial condition of most of these basic industrial companies is extraordinarily good,” says Putnam’s Clark.

What’s more, the continuing drop in the dollar’s value versus foreign currencies makes U.S. industrial exports cheaper overseas, enhancing what already has become a booming market for many American exporters. That’s a big story that is going mostly unnoticed in the current gloom.

Take a look at what’s behind some industrial stock names:

* Aluminum giant Alcoa is trading for $62.125, down from $77.25 earlier this year. The current price is eight times the $7.43 a share Wall Street expects the Pittsburgh firm to earn this year. Last year, it earned $10.67 a share. But Neff notes that more investors have begun looking at Alcoa and other aluminum stocks lately because aluminum pricing has improved. “Inventories are only about half what they’ve been in the past,” Neff says, so any increase in demand could lead to much tighter supplies in a hurry.

* Houston-based Quanex, which makes specialized steel bars, tubing and aluminum products for transportation, home building and capital equipment markets, is “less vulnerable to a recession than almost any other steel company,” says analyst Aldo Mazzaferro at C. J. Lawrence Inc. in New York. Yet the stock has been beaten down from $18 in mid-July to $13.75 now. That’s just seven times Wall Street’s consensus earnings estimate of $1.95 a share for 1990. And Mazzaferro sees the company earning $2.45 a share next year without much change in the business environment, simply because results will benefit from the absence of this year’s strike-related penalties.

* Cleveland-based TRW, a major auto parts producer, should ride the auto sales recovery, if one begins next year, says Prudential-Bache Securities analyst Philip Fricke. At nine times the current-year earnings estimate, Fricke doesn’t see much risk, especially given the stock’s 4.5% dividend yield. Meanwhile, you’re buying a company that already derives almost 50% of its auto-related revenue from overseas markets, and one that has 33% of the worldwide market for auto passenger restraints, which include seat belts and the newly booming market for air bags.

Could these stocks go a lot lower before they recover? Certainly. That’s why you don’t want to bet the ranch on them now. But just as the oil-service stocks skyrocketed last year in anticipation of that industry’s recovery, the time will come when many industrial stocks once again become money managers’ favorites. And it could happen, as Windsor’s Neff believes, right in the middle of any recession, when investors begin seeing the other side of the valley and the potentially strong market for industrial goods in the next economic cycle.

If you don’t have at least some investment in these downtrodden stocks, now could be a good time to start building a position. And if you can’t afford a diversified portfolio, many of the big mutual fund firms can steer you to funds that target such stocks.

VALUE HUNTERS’ PARADISE?

The market’s recent plunge has left many industrial companies’ stocks trading at levels that may already discount a mild recession--meaning that it’s time to start looking at what comes after that, some experts say.

Tues. ’90 est. ’90 Div. Stock close EPS P-E yld. Alcoa $62 1/8 $7.43 8 2.6% Burlington North. 29 3/8 3.58 8 4.1% Georgia Pacific 40 1/8 4.75 8 4.0% Magnetek 9 1.40 6 nil Phelps Dodge 60 1/8 11.47 5 5.0% Quanex 13 3/4 1.95 7 2.9% TRW 38 1/2 4.17 9 4.5% Tenneco 56 7/8 5.21 11 5.6% United Technol. 50 6.08 8 3.6% S&P; 500 321.35 24.15 13 3.8%

Source: EPS (earnings per share) estimates are Wall Street analysts’ consensus estimates, from Zacks Investment Research