Industrials: Investing Essentials

This sector contains way more than just smokestacks.

Aug 20, 2014 at 1:29PM

Dow Chemical Tarragona Spain

The industrials sector includes plenty of manufacturing, as at the Dow Chemical facility in Spain. But it also includes companies in the business of supporting traditional industrial firms as well. Source: The Dow Chemical Company

If the word "industrials" makes you think of big factories with smokestacks, that's not entirely misplaced. Companies in the industrials sector are generally engaged in providing big-ticket products and services to other businesses and to governments. 

A lot of these companies are what we might call "old school": railroads, defense contractors, construction-equipment makers.  But there's plenty of cutting-edge technology to be found here, too. 

Aerospace firms and chemical companies -- and giant conglomerates built around a knack for invention -- are all part of today's industrials space.

What is the industrials sector?

Simply put, the industrials sector consists of companies whose businesses are dominated by one or more of these kinds of activities: 

  • Manufacturing and distributing "capital goods," such as defense materials, aircraft, construction equipment, and industrial machinery 
  • Providing commercial services or supplies, such as printing, office services, or employment services 
  • Providing transportation services, such as airline services, shipping, or transportation infrastructure

In other words, the industrials sector includes the heavy manufacturing and commercial transportation services that you'd expect -- but it also includes companies like Equifax (NYSE:EFX), best known for its credit reports, that provide data and services to other businesses.

How big is the industrials sector?

It's huge. The sector includes big-name heavyweights like General Electric (NYSE:GE), with a market cap of $257 billion, 3M (NYSE:MMM) and its $91 billion market cap, and Lockheed Martin (NYSE:LMT), with a market cap of $52.6 billion, as well as a host of smaller (but still big) companies.

According to Fidelity Investments, the market cap of all of the companies in the industrials sector was about $3.28 trillion as of Aug. 12, 2014.

How do industrials companies work?

It varies widely. But industrials companies that are engaged in heavy manufacturing have some things in common. 

First, the fixed costs involved in heavy manufacturing are very high. A company like Caterpillar (NYSE:CAT) has to maintain factories full of specialized equipment, a skilled workforce, and contracts with suppliers of commodities and parts. Those represent substantial costs, month after month -- costs that are very hard to cut when sales slip.

Caterpillar

The fixed costs involved in manufacturing huge vehicles like Caterpillar's 777G dump truck are substantial. Source: Caterpillar

Many companies with high fixed costs tend to be cyclical -- profits decline dramatically (and may even disappear) when sales fall during economic downturns. This can lead to second-order effects: A provider of services that includes cyclical industrial companies among its clients may not have especially high fixed costs, but it may see business decline when its clients have to cut back during downturns. 

But not all industrials companies with high fixed costs are cyclical in this way. A defense contractor like General Dynamics (NYSE:GD) that is dependent on business from government entities may be relatively insulated from economic ups and downs. But those companies face another kind of risk: Shifting political winds can have dramatic effects on their bottom lines.

For investors, the upshot is this: Few of these companies will be "high fliers" with rapid growth. But the best of them will give you solid growth if you catch them at the right point of the business cycle -- and many pay decent dividends, giving their stocks a long-term appeal.

What drives the industrials sector?

As noted above, firms like defense contractors can be somewhat insulated from economic cycles. But for most of the firms in this sector, their business is business -- their customers or clients are other businesses.

And those businesses aren't always industrial firms. For United Parcel Services (NYSE:UPS), the rise of Internet retailers like Amazon (NASDAQ:AMZN) has been a huge boon -- but if Amazon's sales were to fall sharply, UPS would feel considerable pain.

But long story short, the answer is the same as it is for most businesses: Assuming it's well-managed and its products are competitive, the biggest factor affecting most of these companies will be the cycles of the economy in the regions in which they do business.

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John Rosevear owns shares of Amazon.com. The Motley Fool recommends 3M, Amazon.com, and United Parcel Service. The Motley Fool owns shares of Amazon.com, General Dynamics, General Electric Company, and Lockheed Martin. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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