Industrial Equipment: Investing Essentials

If you have wondered how to play the anticipated resurgence in manufacturing in the U.S., the industrial equipment industry could be the place to look for stocks to buy. The logic behind this view is simple: If the economy is flourishing, manufacturing companies will look to expand capacity and spending on capital machinery will increase. At this stage general industrial equipment companies such as Siemens, ABB (NYSE: ABB  ) , Parker-Hannifin (NYSE: PH  ) , Honeywell International (NYSE: HON  ) , and Emerson Electric (NYSE: EMR  )  start to look attractive. Investors should also consider more niche market players such as vision machine company Cognex (NASDAQ: CGNX  ) or Roper Industries (NYSE: ROP  ) . It's time to look closer at the industry.

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What is the industrial equipment industry?

In essence, the industry represents any item of capital machinery that is sold to an industrial company in order to enable its manufacturing or processing activity. While this traditionally means hardware, investors should recognize that software and information technology are becoming an increasing part of the industry. For example, Cognex is heavily exposed to growth in factory automation and increasingly in logistics, while Parker-Hannifin and Ametek (NYSE: AME  ) are leading players in the motion control market.

How big is the industrial equipment industry?

A definitive estimate is difficult due to the broad nature of the sector, but investors can use industrial equipment spending figures from the Federal Reserve as a rough guide. At the end of 2013, industrial equipment spending in the U.S. was more than $200 billion, up by $46.5 billion from the end of 2010. Other useful U.S. industry metrics -- used by companies such as Rockwell Automation (NYSE: ROK  ) -- are the Fed's Industrial Production Index and the Purchasing Managers' Index from the Institute for Supply Management.

How does the industrial equipment industry work?

Industrial equipment manufacturers tend to sell using a mix of direct sales and distributors, based on where their traditional end markets are located. As manufacturing and industrial activity increasingly shifts toward emerging markets, the challenge is for companies to develop sales operations or distributor relationships in those countries.

They will also need to establish manufacturing operations within emerging markets to be closer to their future customers, and to take advantage of low-cost production in these markets. This is a particular challenge because manufacturers generally prefer being serviced by companies with operations within their own country. That means U.S. companies need to be prepared to face strong local competition in emerging markets in the coming years.

What are the drivers of the industrial equipment industry?

The obvious driver of the industry is economic growth, more specifically within the industrial economy. This often comes relatively late in the business cycle. In plain English, this means that as the economy expands, manufacturers see a pickup in demand and increase production rates. At some point they will need to upgrade or expand production capacity. This usually involves purchasing new production equipment (whether it be plastic bottling systems, power transmission technology, automated equipment, packaging machinery, process controls, etc.) -- good news for industrial equipment companies.

However, this sort of spending tends to be relatively high ticket, and it's somewhat reliant on business sentiment being positive on future growth. In other words, it will only pick up strongly after a recovery is in place. As noted above, the shift to emerging market production is also an ongoing trend, and investors should look out for management commentary on how their companies intend to expand sales in these regions.

Another thing to watch for is the ongoing development of shale oil and gas plays in North America, Increased upstream activity (oil and gas extraction) should lead to more spending on downstream (processing and refining) activity,which is good news for companies such as Emerson Electric and Rockwell Automation. In addition, cheaper energy sources, such as gas, should lead to an increase in manufacturing activity in the U.S. -- another long-term trend that should offer support to U.S. companies servicing areas of growth in the domestic economy.

However, the winners in the sector are likely to be those that adjust to the shift in manufacturing toward the BRIC countries (Brazil, Russia, India, and China). This is something to follow closely in the coming decade.

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