Investing in Industrial Stocks

Updated: Jan. 6, 2021, 12:03 p.m.

The industrials sector is the backbone of the economy. It performs three main functions:

  • Manufacturing and distributing capital goods. This includes building products and machinery, and providing construction and engineering services.
  • Providing commercial and professional services, including environmental and facility services, and human resources and employment services.
  • Providing transportation services, such as by operating an airline or railway.

What are industrial stocks?

Industrial stocks comprise several subsectors focused on providing industrial products and services, such as:

  • Aerospace and defense
  • Air freight and logistics
  • Commercial and professional services and supplies
  • Industrial machinery and electrical equipment
  • Construction equipment and building supplies
  • Transportation (cars, airlines, and railways)
  • Waste management

The industrial industry, also known as the secondary sector, is one of the three main segments of the economy, along with the primary (agriculture, fishing, and mining) and service (hospitality, consultancy, and nursing) sectors.

Top industrial stocks

These industrial stocks offer some of the sector’s best long-term durability:

Company Focus
Waste Management (NYSE:WM) Waste disposal, recycling, and renewable energy
Raytheon Technologies (NYSE:RTX) A diversified defense contractor
3M (NYSE:MMM) Manufactures a diverse portfolio of industrial products

Source: The Motley Fool

Waste Management

Waste Management (NYSE:WM) is one of the leading waste management companies in North America, providing collection, transfer, and disposal services as well as recycling and resource recovery. The company is also a leading developer and operator of landfill gas-to-energy facilities.

Waste Management provides its services to residential, commercial, industrial, and municipal customers. Overall, the company's business is more recession-resistant than other industrial companies. However, an economic downturn would have some effect on the volumes it collects from commercial and industrial customers, as well as the prices it can command when selling recycled resources and electricity. That was the case in 2020: Waste Management’s revenue and earnings declined slightly as the COVID-19 outbreak hurt the economy.

The company has been able to blunt some of that impact through a continuous focus on reducing its costs and expanding its margins. It has invested money, for example, to automate its fleet of collection trucks and convert them to run on cleaner, cheaper natural gas. Moves like these have allowed Waste Management to consistently generate free cash flow, giving it the funds to make acquisitions and return money to shareholders via dividends and share repurchases while maintaining a strong investment-grade balance sheet.

Raytheon Technologies

Raytheon Technologies (NYSE:RTX) completed its merger with United Technologies in April 2020. The combined company specializes in developing defense, civil government, and cybersecurity solutions. It operates several business segments, which focus on missile defense, cybersecurity, electronic warfare, and precision weapons.

As an aerospace and defense contractor, Raytheon is fairly recession resistant. Because of that, it generates relatively steady cash flow. However, since it gets the majority of its revenue from the U.S. government, Raytheon is highly sensitive to changes in the U.S. defense budget. If the Department of Defense tightens its belt because of budget cuts, it could constrain Raytheon's revenue.

The company has worked to minimize this potential impact by focusing on increasing its sales internationally as well as diversifying into the aerospace industry. Its strong investment-grade balance sheet has helped to fund those moves. Combined with its steady cash flow, that sound financial profile provides Raytheon with the flexibility to invest in research and development and make acquisitions, even as it returns cash to shareholders via dividends and stock repurchases.

3M

3M (NYSE:MMM) is a diversified manufacturing company that operates four main business groups:

  • Safety and industrial
  • Transportation and electronics
  • Health care
  • Consumer

The company manufactures thousands of products that consumers and businesses use every day. That diverse product portfolio enables the company to generate steady cash flow in good times and bad.

3M ranks among the best companies in the industrial sector thanks to its excellent capital allocation. It has historically plowed around 30% of its available capital (combining its operating cash flow with its debt capacity) back into growing its business through research and development and capital projects. That enables it to develop new products to stay one step ahead of the competition. The company also typically returns about 30% of its available capital to investors via a growing dividend, which it has increased for more than 50 consecutive years. It's flexible with the final 40% of its capital, using it to make acquisitions when it finds the right target or repurchase shares when they trade at an attractive level. The company can invest in growth while also returning money to shareholders because it maintains a strong investment-grade balance sheet.

Durability defines the top industrial stocks

The industrial industry is highly susceptible to changes in the economy. That’s a concern for investors, since economic conditions can change almost overnight. That was the case in early 2020, as the COVID-19 outbreak caused much of the global economy to shut down, sapping demand for industrial goods and services. The sector’s economic sensitivity means companies in it must be durable so they can survive these ups and downs. Above all, that means having a strong financial profile so they have the flexibility needed to support their operations through tough times and thrive during healthy economic conditions.

How to find the best industrial stocks

The key characteristics of a strong industrial company are:

  • Diversified operations
  • An investment-grade bond rating
  • Low operating costs

Because of the industrial sector’s key role in supporting the economy, it's highly sensitive to changes in economic conditions. If the global economy slows down, demand for industrial goods and services will suffer, cutting into the industry's profitability and weighing on industrial companies’ stock prices. In 2020, the COVID-19 outbreak reduced demand for industrial goods and services. Diversified operations can cushion the worst of that damage.

The industrial sector is also very capital intensive, which means that companies need to routinely invest lots of money to sustain and expand their operations. Because of that, industrial companies often borrow money to buy new capital equipment and build new manufacturing facilities. An investment-grade bond rating helps industrial companies borrow more cheaply and efficiently.

Given how economic cycles can affect the industrial sector’s profitability, companies in the sector need to maintain strong financial profiles and wisely invest their money so they can navigate challenging market conditions. Low operating costs ease the fiscal pressures on industrial companies and help keep their finances strong.

With those factors in mind, investors need to be cautious when investing in the industrial sector. Buying shares of a financially weak industrial goods maker right as the economy begins to slow down could prove disastrous.

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