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 November 9, 2007). The Industrial Composite represents the pooled results of 583 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 4149. Forecasts for the Industrial Composite have been published in Selection & Opinion since July 11, 1975.

Maintaining the Momentum

Although the final tally isn’t in yet, 2007 looks like it was another solid year for the Industrial Composite. (Fiscal years ending as late as June 30th will be included in our numbers for 2007.) From 2002 through 2006, earnings rose at an annual rate of nearly 19%. Last year’s advance likely boosted share net another 12%. Solid, but uneven, economic growth in the U.S. for most of the 2007 provided a decent backdrop for business on the home front. Moreover, companies serving international markets got a big boost from the weak dollar and more rapid economic development overseas, especially in emerging economies.

Looking at 2008, Corporate America has some considerable headwinds to overcome in order to maintain this momentum. In fact, probably at no other time during this profit upswing has the sustainability of this trend been as much in doubt. Most of these issues, including rising oil prices, a depressed housing market, and turmoil in the credit markets, were on the scene last year, but we have seen few indications that these difficulties will resolve themselves in the near term.

Better than the Rest

From an earnings growth perspective, we expect the roster of companies in the Industrial Composite to outperform Corporate America in 2008. We suspect this was also true in 2007. A key consideration here is that banks and other financial- services companies that have taken direct hits from the upheaval in the subprime credit markets are not represented in our group. (Results within our collection of companies will likely vary, as well. Those on the sell-side of commodity transactions, such as producers of oil and other natural resources, will likely continue to rack up strong results. Others connected to housing or discretionary consumer purchases probably face a bumpier road.) Meanwhile, the representatives of the Industrial Composite figure to be better positioned than the typical company to capitalize on the likelihood of stronger economic growth outside the United States. To be included in the Industrial Composite, a company must have at least eight years of operating results, suggesting these competitors have had time to put down roots overseas. In all, we expect earnings growth to slow this year, likely back into the mid-single digits. By comparison, overall corporate profits are likely to show little improvement from last year.

Cash to Spare

The financial health of the Industrial Composite looks to be quite sound. Companies have steadily deleveraged their balance sheets in recent years. Based on current interest-coverage coverage and debt-to-capital ratios, this probably won’t be as much of a priority going forward. Meanwhile, operating cash flow should continue to be more than sufficient to meet capital spending requirements. In view of this, companies figure to return sizable chunks of cash to shareholders. Share repurchases, though, seem to have become the preferred means of doing this, and we expect this trend to continue in the years ahead. Still, with payout ratios in the high twenties, dividends don’t appear to be much of a burden, and ought to continue to increase.

Investment Perspective

The Industrial Composite hasn’t fared that much differently than the broader equity market of late. Since our November report, its share price has declined about 5%. Overall, valuations are a long way removed from the rich multiples common during the last market bubble around the turn of the century. With the compression in the price-to-earnings ratio since then, long-term total return has become more appealing, though this group probably will perform no better than the broader market over this stretch.

Robert Greene, CFA
Senior Industry Analyst