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The First Stock to Buy in a Market Sell-Off

By Lee Samaha - Feb 22, 2021 at 10:32AM

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The market is demonstrating that it's willing to give a premium valuation to companies that invest in their employees and believe in their purpose.

Illinois Tool Works (ITW 0.36%) is one of the best-run companies in America, and despite facing significant headwinds from the COVID-19 pandemic, the company is in excellent shape in 2021. The positive state of affairs comes about as CEO Scott Santi utilizes a playbook almost of his very own. Let's take a look at what's going on and whether Illinois Tool Works is a good value for investors right now.

How Illinois Tool Works proved its resiliency

When the pandemic spread out of China, most companies immediately turned to a recession playbook involving job cuts and furloughs for unneeded workers. ITW chose another way. In the words of Santi during the most recent earnings call, the multi-industry industrial company's management decided not to "initiate any enterprisewide employment reduction mandated programs at any point in 2020."

Two industrial workers.

Illinois Tool Works deserves praise for not firing workers during the pandemic. Image source: Getty Images.

Similarly, the company provided "full compensation and benefits support to all ITW colleagues through the entirety of Q2 when the economic effects of the pandemic were at their most widespread and severe."

In addition, Santi decided to bet on a recovery and the company's divisional leadership was encouraged "to think long term and to remain aggressive through the pandemic." It's an overall strategy that appears to have worked for the company, as sales trends across its businesses have turned up since the second quarter.

Illinois Tool Works segment sales trends.

Data source: Illinois Tool Works presentations. Chart by author.

Furthermore, although only the automotive original equipment manufacture (OEM), polymers and fluids, and construction products segments saw positive growth in the fourth quarter of 2020, management is expecting all of its segments -- including the hard-pressed commercial food equipment business -- to turn positive in 2021.

Illinois Tool Works Segment YOY Growth

2021 Est.

2020

Automotive OEM

14% to 18%

(16%)

Test & Measurement and Electronics

5% to 9%

(5%)

Food Equipment

8% to 12%

(21%)

Polymers and Fluids

4% to 8%

(1%)

Welding

5% to 9%

(12%)

Construction Products

3% to 7%

2%

Specialty Products

3% to 7%

(8%)

Total

7% to 10%

(10%)

Data source: Illinois Tool Works presentations.

Continued outperformance

Clearly, Santi's strategy proved to be astute, but it should not be seen in isolation, nor should it be seen as an act of charity. In fact, it's a combination of management's belief in a recovery and ongoing self-help initiatives that have seen the company dramatically improve operating margin since Santi became CEO in 2012.

In fact, the remarkable increase in operating margin over the last decade has enabled the company to grow its earnings per share (EPS) even as ITW came up against a U.S. industrial recession in 2015/2016 and the ill effects of the fall in global auto production in 2019. Throw in the COVID-19 pandemic and it's definitely not been a favorable five years from an end market perspective.

However, ITW's margin and earnings resiliency has proved remarkable during the period.

ITW Operating Margin (TTM) Chart

Data by YCharts

The reason why ITW has done so well with margin comes down to Santi's relentless application of its enterprise strategy. In a nutshell, the enterprise initiatives within the strategy are to focus on the 80% of business done by 20% of its customers, the so-called 80/20 principle. As such, over the years, Santi has pruned unprofitable product lines, improved the supply chain, and refocused the businesses on ITW's key customers.

The success of this strategy can be seen below. When margin is expanded from, say 22% to 23%, it's denoted as a 100 basis point (bp) movement. Therefore, the chart shows just how much of ITW's margin expansion over the years has come from its own enterprise initiatives. It's something that's helped the company overcome operating margin pressures from any falls in sales volumes.

ITW margin expansion.

Data source: Illinois Tool Works.YOY= year over year. bp is basis points, where 100 bp = 1%.

Moreover, it's also a strategy that's created a highly efficient company that was positioned to react aggressively when the pandemic hit. As such, ITW is well placed to recover in 2021.

Is Illinois Tool Works stock a buy?

In fact, the only thing "wrong" with ITW is its valuation. Using the common enterprise value (market cap plus debt)-to-earnings before interest, depreciation, and amortization (EBITDA) valuation method, ITW is the most expensive stock in its peer group.

ITW EV to EBITDA Chart

Data by YCharts

I would draw two conclusions from the valuation premium and ITW's business strategy in general. First, it's evidence that the market will reward companies with a premium rating if they keep employees on during a recession and invest in growth.

Second, while ITW may not be a screaming buy right now, it's definitely the sort of stock investors should be buying in a general market sell-off.

All told, ITW has proved the resiliency of its business, and that's why investors should keep it on their watch list of stocks to buy.

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Stocks Mentioned

Illinois Tool Works Inc. Stock Quote
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*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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