The paint and coatings industry is not the most glamorous to invest in, but that doesn't mean you can't generate good returns from it. The companies in it tend to generate strong returns on equity and have a history of rewarding investors with dividends -- PPG (NYSE:PPG) and Sherwin-Williams (NYSE:SHW) are both Dividend Aristocrats, having increased their dividends for over 25 years consecutively. Moreover, there's reason to believe that the sector is set for a strong third quarter and beyond. Here's why.

A man inspecting a vehicle.

The automotive refinishing market appears to be in recovery mode. Image source: Getty Images.

Introducing the companies

As the chart below demonstrates, it's been a pretty good year for investors in Sherwin-Williams. The stock has outperformed the S&P 500 index and its peer group, including PPG and Axalta Coating Systems (NYSE:AXTA).

The reason for the outperformance? Simply put, Sherwin-Williams has relatively more exposure to the architectural coatings industry -- a market that's been strong as a consequence of stay-at-home measures encouraging households to repaint and remodel their homes. Around 57% of the company's sales come from its Americas group segment (the bulk of which is residential repaint, DIY, and new residential), with the consumer brands segment contributing 15%.

PPG is a more balanced company with 36% of sales coming from construction, 30% from auto (original equipment and aftermarket), and the rest from general industrial, aerospace, and packaging.

Finally, Axalta is really a play on transportation and light vehicle coatings. Around 37% of Axalta's sales come from the automotive refinishing market, with 28% from light vehicle original equipment coatings, and 27% from industrial coatings.

As such, the absence of significant exposure to architectural coatings is why Axalta has underperformed in 2020, and the strong exposure of Sherwin-Williams is why it has outperformed.

In fact, Sherwin-Williams' overexposure to architectural coatings (70% of sales) has helped the stock outperform PPG (near market exposure) and Axalta (100% industrial) in recent years. Not least because automotive production has slowed in the last few years and the U.S. industrial economy was in recession in 2016.

PPG Chart

Data by YCharts

Sherwin-Williams

This company's favorable sales momentum extended into the third quarter. Consequently, management recently upgraded its sales expectations for the quarter. Net sales are now expected to be up 3% to 5% on a year-over-year basis, compared to prior guidance for a rise or fall in the low-single-digit percentage range. It's no surprise to see guidance upgraded for the consumer brands and Americas group segments, but the upgrade to sales expectations in the performance coatings group (mainly packaging, industrial, and automotive refinish) suggests a broader-based recovery is occurring.

Management now expects third-quarter net sales to "be flat to down a low-single-digit percentage compared to our previous guidance of down a low-to-mid-single-digit percentage." CEO John Morikis called out "emerging momentum" in the automotive refinish and industrial wood end markets.

PPG

However, the good news in the sector doesn't stop there, because PPG management also upgraded its third-quarter sales volume expectations to be down 5% on a year-over-year basis, compared to prior guidance for a decline of 6% to 11%.

PPG's management noted: "We are continuing to deliver strong performance in our aggregated global architectural coatings and packaging coatings businesses, which is now being coupled with strengthening demand for our automotive original equipment manufacturer and general industrial coatings."

What the updated guidance means

It's well known that the home improvement sector has been a net beneficiary of the COVID-19 pandemic, so the updated guidance from Sherwin-Williams and PPG regarding architectural coatings shouldn't surprise many investors. However, it's very interesting that Sherwin-Williams is calling out "emerging momentum" in the automotive refinish market, and PPG is seeing "strengthening demand" for its automotive original equipment manufacturer market.

It all points to a brighter outlook for a company with significant automotive exposure like Axalta. In addition, PPG and Sherwin-Williams both referenced an improvement in their more cyclical industrial end markets -- a good sign. As such, investors in the company should look forward to the companies' third-quarter earnings reports with a sense of optimism.

For reference, Axalta's management is expecting its third-quarter sales to be down 15%-20% on the same period last year. It might be too early to expect Axalta to start beating its earnings estimates, but hopefully management's outlook will start to improve. 

Looking ahead

It looks likely that the sector is going to have a relatively upbeat collection of earnings reports in the third quarter, but the question is whether the momentum will be sustained into the fourth quarter and 2021. It's too early to confidently conclude anything on that front right now, but if you are positive on prospects for the economy in 2021, then the paint and coating sector looks like a good place to be invested.