With the bull market heading into its seventh year, and the stock market near all-time highs many investors are concerned that stocks have become overheated and are overdue for a correction. This is especially true with dividend-growth favorites such as industrial stocks Rockwell Automation (NYSE:ROK), Illinois Toolworks (NYSE:ITW), Honeywell International (NYSE:HON), and 3M (NYSE:MMM), which have handily beaten the S&P 500 over the last five years on a total return basis.
While I am long-term fan of all of these companies, there are two reasons I think dividend growth investors may do well to avoid investing new money into Rockwell Automation and Illinois Tool Works at today's prices, and instead choose to invest in shares of Honeywell International or 3M instead.
|Company||Yield||5-Year Average Yield||Price to Operating Cash Flow||20-Year Historical P/OCF|
|Illinois Tool Works||2%||2.4%||21.2||17.5|
As this table shows, all four companies are offering yields superior to the S&P 500, however, all but 3M are trading below their average five-year dividend yields. This is partially a result of yield-hungry investors bidding up share prices of dividend growth blue-chips in recent years.
However, on a price to operating cash flow basis -- which I believe to be a superior metric to the P/E ratio because of the capital-intensive nature of this industry -- you can see that Honeywell and 3M are trading at discounts to their historical P/OCF valuations, while Rockwell and Illinois Toolworks are not only offering lower than historically average yields, but are also trading at a valuation premium.
Given two major headwinds that American industrial companies are currently facing, I believe it would serve investors best to stick with historically undervalued companies rather than those trading at a premium, as this is most likely to help you achieve long-term market-beating total returns.
A weakening U.S. and global economy means industrial sales might be weak in the quarters ahead
As this chart shows, in recent months, growth in U.S. manufacturing has ground to a halt, and forecasts for future short-term growth -- the black line -- indicate economists' expectations that the first half of 2015 may be a bad time for American manufacturing companies.
Part of the reason for this slowing growth may be the collapse of oil prices and the declining demand for products associated with the oil and gas industry such as Rockwell's Integrated Control and Safety Systems, which is an important component for drilling rigs. With rig counts down 43% compared to a year ago,it's not surprising that industrial companies' oil and gas-related products are potentially seeing a large decrease in demand.
Meanwhile, weakening foreign industrial demand, courtesy of economic weakness in major economies such as China, and Japan, is further adding to a potentially difficult 2015 for these companies -- and industrial companies in general. However, another major concern for U.S. industrial companies is the strong dollar, which is likely to continue hurting sales for the foreseeable future.
Strengthening dollar a potentially short-medium term threat
When the U.S. dollar rises, U.S. industrial exports become more costly for foreign buyers, and demand can weaken, resulting in a significant hit to sales, and over the past year, the dollar has been on a tear.
Rockwell Automation expects 2015's organic growth to be between 2.5% and 5.5%, yet it expects negative currency effects to decrease sales by about 4.5%, potentially turning sales growth into a sales decline.
Meanwhile Illinois Tool Works expects organic growth of 2.5% to 3.5% in 2015, but warned investors in its most recent earnings release that negative currency effects would likely result in an overall 2015 sales decline of 1% to 2%.
That's not to say that industrial companies are powerless to fight a strong dollar. For example, Honeywell and 3M -- in their most recent quarters -- beat earnings expectations thanks to currency hedging. However, investors shouldn't expect currency hedging to offer long-term protection, because Honeywell's currency hedging only lasts through 2015. 3M's -- the company hedges 50% of its potential currency risk -- will end in mid 2016.
With the Federal Reserve expected to start raising interest rates later this year, and Europe and Japan both aggressively pursing quantitative easing in an effort to restart economic growth, it's possible the strong U.S. dollar will potentially last for several years.
Combined with a weaker global economy, this could create significant headwinds for sales growth of U.S. industrial blue-chips. In such an environment, I think it's fair to say that investing in historically undervalued as opposed to overvalued industrial stocks is an investor's better bet to beating the market in the long-term.
Bottom line: Rockwell and Illinois Tool Works are too rich given current industry headwinds
While I'm a fan of Rockwell's and Illinois Tool Works' long-term prospects, I believe today's valuation is a bit rich given the headwinds a strengthening dollar and weaker U.S. and global economy represent. While I feel these companies certainly deserve a spot on your dividend growth radar, I would recommend waiting for a pull-back before investing new money into these stocks.
As an alternative for new money in this sector, I would advise dollar-cost averaging into historically undervalued industrial companies such as Honeywell and 3M.
Adam Galas has no position in any stocks mentioned, however, he does lead The Grand Adventure dividend project, which owns Rockwell Automation, Illinois Toolworks, and Honeywell International in several portfolios.The Motley Fool recommends 3M and Illinois Tool Works. 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.