This week we are updating our forecast for The Value Line Industrial Composite (last published in Selection & Opinion on August 13, 2010). The Industrial Composite represents the pooled results of 941 major industrial companies and provides a yardstick for evaluating the historical performance and future prospects of the diverse industrial businesses reviewed by Value Line. All of the companies included in the Composite must possess operating histories of at least 12 years. Unlike Value Line's stock market averages, the Composite is weighted by company size. For a more detailed description of the Composite, please refer to the "Explanation" on page 2351. Forecasts for the Industrial Composite have been published in Selection & Opinion since July 11, 1975.
Back on Track
The final returns are not yet in for 2010, but the results so far suggest that good profit growth was the norm among the companies comprising the Industrial Composite. From a revenue perspective, the recovery from the last recession has been uninspiring thus far, likely reflecting deflationary pressures in some quarters of the economy and hesitancy on the part of many consumers and businesses to return to the freer spending ways they demonstrated during the latter stages of the previous economic expansion. Many companies, though, moved quickly during the slump to adjust their cost structures to the more subdued economic times. These efforts, combined with a relatively benign pricing environment for raw materials, led to significant improvement in operating margins.
For 2011, we expect to see an acceleration in top-line growth. Commodity providers will likely be at the forefront of this upturn, thanks to the reemergence of inflation. Companies with exposure to emerging markets, which are likely to generate economic growth in excess of their developed counterparts, should also fare well. Operating margins figure to expand further, as companies are able to spread their fixed costs over a larger revenue base. The improvement, though, is likely to be modest compared to last year. Companies will probably find it more difficult to uncover additional opportunities to wring savings out of their cost structures. In addition, the return of inflation means that businesses will have to contend with higher prices for energy and various other key inputs.
With respect to capital, Corporate America has begun to loosen its purse strings again, dialing up capital spending and dividend payouts in 2010. With concerns of a double-dip recession receding, we expect this trend to continue in 2011 and 2012. Still, companies will likely need to exercise some restraint when deploying funds, whether it be to expand through acquisitions and capital projects or to return cash to shareholders via share repurchases and dividends. In the current interest rate environment, debt remains an attractive option, but financial leverage from a historical perspective looks to be relatively high, with debt currently representing about 40% of total capital. Also, equity valuations appear to be a little extended (more below), which figures to limit to some degree the attractiveness of share repurchases. Too, some companies have indicated that the high cost (via U.S. taxes) of repatriating overseas profits effectively means that they don't have unfettered access to all of the cash on the their balance sheets.
Breaking the Industrial Composite down by sector, we find that Energy companies were among the hardest hit by the recent recession. Given the sharp increase in oil prices, these businesses figure to play a leading role in this year's profit upturn. Meanwhile, the Healthcare sector suffered relatively few ill effects from the recent economic downturn. There are more questions than usual regarding whether this pattern of steady profit growth can be sustained, due to the need for many companies to adapt their business models in response to the sweeping legislative changes enacted last year in the U.S.
The share price of the Industrial Composite has risen steadily since late summer, nearing at times the all-time high reached back in 2007. The current valuation is quite staid in comparison to the earnings multiples at which these stocks traded a decade ago, but still looks a bit rich relative to more recent history. As such, total return potential to 2014-2016 is relatively modest for the Industrial Composite.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.