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 9, 2008). The Industrial Composite represents the pooled results of 582 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 3851. Forecasts for the Industrial Composite have been published in Selection & Opinion since July 11, 1975.

Tough Times Ahead

The profit outlook for the Industrial Composite has deteriorated considerably since the time of our last report in May. Corporate America now appears to be in for some tough times over the next several quarters, as the reverberations from the bursting of the housing and credit bubbles begins to penetrate more deeply into the broader economy. A recession, likely beginning in the third or fourth quarter of 2008 and extending into next year seems to be most likely course for the U.S. economy.

The upward march in profits for the Industrial Composite likely continued in the first half of 2008. The U.S. economy pushed ahead at a respectable clip, and few companies had direct exposure to the catalysts for the current downturn. In particular, financial-services companies are excluded altogether from our presentation, while housing-related businesses account for just a small sliver of total sales. Too, many of the companies included in this group are well established overseas, putting them in position to benefit from the strong growth taking place overseas, particularly in emerging markets.

A very different story, though, will likely unfold in the second half of 2008 and next year. A variety of economic indicators, from rising unemployment to slumping retail sales, suggest business in the U.S. is cooling off. Meanwhile, the strengthening of the dollar since midyear, along with signs of slower economic growth abroad, means that the boost provided by export sales and international operations will likely ebb. Companies are beginning to move to adjust their cost structures in response to the looming recession. The recent moderation in commodity prices should augment these efforts, but we don’t expect enough progress will be made to prevent a contraction in margins and profits. In all, the prospect of an imminent slowdown in business activity has prompted us to cut our estimates for the Industrial Composite, and we now look for a roughly 15% decline in earnings next year.

A Recession By Degrees

From a sector perspective, those companies operating in noncyclical segments of the economy will likely fare the best over the next year or so. Looking back, we note that profits declined almost 50% between 2000 and 2002 for both the high-tech and oil sectors. By comparison, profits for consumer staples and health-care businesses, in the aggregate, rose nicely over this same stretch. (This data was compiled from a slightly different roster of companies than that used for our current industrial array.)

Balance Sheet

The balance sheet of Industrial America appears to be in solid shape. Recent debtto- total-capital ratios (about 37%) were about the same as they were heading into the last recession. Interest coverage, though, is much stronger (8.1x to 6.1x). Still, given the turmoil in the credit markets, we think companies will be keeping a close watch on capital over the next several years. Corporate America has been spending relatively liberally on capital projects in recent years, but we suspect these budgets are now receiving a great deal more scrutiny. Companies have also been aggressively buying back stock in recent years, and the downturn in equity prices will present opportunities to further reduce share counts on the cheap. Still, we expect many will proceed cautiously here, in order to minimize the need to tap the credit markets in the current environment.

Investment Perspective

The stocks in the Industrial Composite have provided little relief from the recent bear market. At the current share price, which is off 35% since our May report, total return potential, including a current dividend yield of 2.8%, is quite attractive, suggesting patient investors will be well rewarded.

Robert Greene, CFA
Senior Industry Analyst