Should You Be Overweight or Underweight Industrial Stocks?

For most investors, maintaining a diversified portfolio is a good way to help minimize risk and sleep better at night, while also making sure that they don't miss out on winning sectors.

Diversification can mean many things -- small versus large stocks, value versus growth stocks, and so on -- but most often it's taken to mean spreading your bets among a variety of industries. Of course, just because you want to have some exposure to a variety of industries doesn't mean that you want to have the same amount of exposure to all industries.

So what about the industrial sector? Should we be digging in or pulling back right now?

Performance
Here's a look at how performance has broken down among the S&P 500 industries:

Source: Standard & Poor's as of April 28.

It has been a fantastic year for industrial stocks, as the group has more than doubled the performance of the overall S&P 500. It shouldn't be all that surprising, though. The industrial sector is very highly tied to economic output, and many industrial companies have a healthy operating leverage, which means that moderate changes on the top line can lead to big profit swings.

But with such stellar performance, is it too late to hop on the industrial gravy train?

Let's take a closer look
Here's a peek under the hood of some of the major U.S. industrial stocks.

Source: Capital IQ, a Standard & Poor's company.

If you think about the businesses of these companies, it's easy to see why they'd be so sensitive to changes in the economy. The two largest drivers of United Technology's business are its Otis and Pratt & Whitney segments. Otis sells escalators and elevators -- whose sales hinge largely on construction -- while Pratt & Whitney sells airplane engines. When the economy is in the dumps, we're far less likely to see strong momentum in either business. And on the subject of airplanes, Boeing can certainly relate to pressure that the economy can put on that business.

UPS, meanwhile, depends on the volume of deliveries it makes around the world. Tough economic times mean less commerce, which means fewer deliveries for UPS. From 2007 to 2009, the company's daily package volume fell 4% and revenue slipped 9%, but its operating income plunged 42%.

And finally, GE and 3M are simply massive industrial conglomerates that have exposure to a range of industries. Many of these industries -- aviation and industrial sensors for GE and 3M's industrial and transportation group -- are heavily tied to the economy. But some, such as health care -- in which both companies have a significant presence -- have a bit more insulation from economic swings.

Two industrial areas that aren't reflected in the chart above also bear mentioning: defense and services. While Boeing and United Technologies do play in the defense market, other industrial giants like Lockheed Martin (NYSE: LMT) and General Dynamics focus almost solely on defense-related products. That's a key differentiator for these companies, because the market for defense equipment is leveraged more to the government defense budget and far less to the economy as a whole.

The services subsector is more of a mixed bag. The group ranges from waste collectors like Waste Management (NYSE: WM) -- which has some insulation from economic conditions -- to providers of temporary staffing like Robert Half, which are very highly leveraged to the economy and the labor market.

Putting it all together
If you wanted to match the S&P 500's allocation to industrials, you'd need to have 10% to 11% of your portfolio invested in these companies. And, frankly, I don't think that going much higher than that is the path to outperformance right now.

The recovery has pushed up the entire sector, and valuations just don't look all that attractive today. Investors making a broad bet on the sector will very likely see reasonable returns on their investment, but probably not market-beating ones.

That said, there are likely individual companies among the industrials that will produce market-beating results. There may be a few among the big caps -- I think United Technologies is pretty attractive -- but outperformers will more likely be among small and mid-cap companies that have been left behind in the rally or are just overlooked in general.

The bottom line on industrials right now is that some exposure to these high-quality powerhouses is probably worthwhile, but investors looking to beat the market are better off being underweight than overweight this sector.

What do you think? Are you bullish or bearish on the industrial sector? Scroll down to the comments section and share your thoughts.

The industrial sector may not be particularly cheap, but these three stocks are.