The Value Line Investment Survey

The Value Line Industrial Composite

This week we are updating our forecast for The Value Line Industrial Composite (last published in Selection & Opinion on May 11, 2007). The Industrial Composite represents the pooled results of 600 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 eight 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 4443. Forecasts for the Industrial Composite have been published in Selection & Opinion since July 11, 1975.

Nearing the Finish Line

The Industrial Composite looks to be on its way to a solid year. Most companies have wrapped up at least three quarters of their 2007 fiscal years, and the earnings reports released thus far have shown that profits remain generally on the rise. In the U.S., companies continue to operate in a fairly accommodating economic environment. Gross domestic product edged ahead just slightly in the first three months of the year, but the pace picked up considerably over the past two quarters. The business climate has probably been even more inviting overseas, thanks in part to a weakening dollar and rapid economic development in emerging markets. Still, it has not been entirely smooth sailing, and the Industrial Composite will likely end a four-year run of double-digit earnings growth, falling just short of this mark in 2007.

Corporate America hasn’t been without its share of challenges, including rising oil prices, turmoil in the housing market, and concerns over conditions in the credit markets. Overall, these difficulties haven’t derailed the expansion in corporate profits, though the impact of these developments has varied widely from industry to industry. Not surprising, the sting of housing slump has been felt acutely in home building and building materials. Meanwhile, the rise in oil prices, though likely to extend the profit strength at the oil companies at least into 2008, has contributed to higher costs in most other industries. Meanwhile, readers should note that banks and other financial-services companies that have taken direct hits from the upheaval in subprime credit markets are not represented in our group.

Thoughts on 2008

Taking a look at 2008, we expect some further deceleration in the rate of earnings growth. Our caution largely reflects concerns that the weakness in the housing market, and the prospects for moderating industrial growth, will create a more challenging operating environment for business. This will likely manifest itself in a slightly deceleration in the rate of top-line growth. Too, operating margins figure to face some additional pressure, as companies may well find it more difficult to pass along rising operating costs in a slower growth environment.

Finances

The companies in the Industrial Composite remain on firm financial footing. Long-term debt to total capital, after edging up past 40% earlier in the decade, is back in the 35%-40% range, and coverage ratios indicate that the companies can comfortably handle this degree of leverage. Moreover, these companies continue to generate strong cash flow, which goes well beyond their needs for capital spending or dividends. Stock buybacks have become an increasingly popular use of these excess funds in recent years, and we suspect that companies will continue to favor returning cash to shareholders, through buybacks and modest increases in dividend payouts, over paying down debt. Notably, spending on acquisitions fell off sharply in 2006, perhaps reflecting a diminished desire to compete for deals with private equity.

Investment Perspective

The share price of the Industrial Composite has risen nicely since our last report back in May. It is now within sight of its previous high reached around the turn of the century. Profits are up sharply since then, meaning that the Industrial Composite, consistent with the trend in the U.S. equity markets, is trading at much more reasonable valuation than was the case earlier in the decade. In all, though, total return potential to 2010- 2012 looks to be unexciting.

Robert Greene, CFA
Senior Industry Analyst