Growth and Diversification with the Industrials Sector

Enjoy growth and diversification of your portfolio with the industrials sector. Whether you are an income-seeking investor or growth-oriented, you’ll find plenty of solid candidates in this sector. However, learn about the benefits and pitfalls of this sector before choosing stocks.

Companies in the industrials sector produce and distribute goods and services related to industrial activities. This encompasses a wide range of businesses involved in manufacturing, construction, transportation, aerospace and defense, engineering, industrial services, and other industrial-related activities.

I feel that as investors, we often overlook industrials. There’s nothing sexy about industrial companies. They don’t create much hype on the stock market. Even worse, the sector is not seen as a source of high dividend yields.

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The case for the industrials sector

Industrials are highly cyclical, usually following the economy. For example, transportation volume (railroads, trucking, parcel delivery) depends on how much people consume. There are fewer resources or goods to move when people buy less. However, since industries within the sector are quite diverse, the peaks and valleys of their cycles aren’t all at the same time. For investors, this means that there are always a few industrial stocks that are good deals.

Many industrial companies are 50 years old or more. It’s one of the few sectors where you can find many companies that have survived through a whole century. Many of these old companies are of the “GDP+” type of businesses, meaning they normally generate a bit more in returns than the economic growth of the market where they operate (a country or, for the bigger ones, the world). Due to their long-standing existence, they have built solid core businesses and commensurate brand recognition. Those who survived the passage of time and found ways to evolve often make solid dividend payers.

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Industrials sub-sectors (Industries)

Here are the sub-sectors found in the industrials sector. Quite a lot of diversification for investors; flight transportation, waste management, manufacturing electrical equipment, and construction are all very different activities.

• Aerospace & Defense
• Airlines
• Airports & Air Services
• Building Products & Equipment
• Business Equipment & Supplies
• Conglomerates
• Consulting Services
• Electrical Equipment & Parts
• Engineering & Construction
• Farm & Heavy Construction Machinery
• Industrial Distribution
• Infrastructure Operations
• Integrated Freight & Logistics
• Marine Shipping
• Metal Fabrication
• Pollution & Treatment Controls
• Railroads
• Rental & Leasing Services
• Security & Protection Services
• Specialty Business Services
• Specialty Industrial Machinery
• Staffing & Employment Services
• Tools & Accessories
• Trucking
• Waste Management

Sector strengths

Barriers to entry are legion in most industries in this sector. It’s quite difficult for a new, inexperienced business to secure military contracts or build railways. Most industrials spend massively in research and development and operate enormous facilities around the world. Since many are old companies, you can often pick a business that has survived the last three recessions while keeping its dividend alive. Surviving and thriving in such challenging periods in the market is proof of timelessness and sustainability.

Many industries enjoy repetitive contracts or sales. While the overall demand fluctuates to follow the economy, they can often count on solid core demand from their customers. Many of them operate sticky business models; it’s complicated, costly, or both, for their customers to switch to another supplier. The reason for this is that they develop extensive expertise in niche domains and offer customized solutions to their customers. When an entire business is tied to the services or products that it co-developed with its industrial suppliers, the costs to switch are high.

Finally, as mentioned earlier, there’s always a thriving industry among the industrials. This means you can surf several tailwinds if you follow macroeconomic data carefully.

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Sector weaknesses

A problem with industrial companies is that they often become too large to be managed effectively. Many remember the multiple problems at General Electric (GE), which had to cut its dividend twice between 2008 and 2018. When facing legal issues, 3M decided to spin off a portion of its activities to “simplify” its business, and hopefully mitigate legal ramifications. In other words, the longevity of a company is not necessarily an accurate predictor of its likelihood of paying or increasing its dividend in the future.

The other potential problems can arise due to the companies’ complexity and debt levels. Over time, companies tend to grow by adding new segments and divisions to the point where it’s difficult to understand where their true expertise resides. That’s what happened with GE.

Industrial companies usually need to invest substantially in machinery, equipment, and infrastructure to operate. They often finance these capital expenditures through debt to preserve cash flow for day-to-day operations. They also take on debt to fund expansion projects, such as building new facilities, acquiring other companies, or investing in R&D. When they experience fluctuations and demand slows down, they’re left with unused machinery and resources, which is costly. Some might have to rely on debt to bridge financial gaps or cover operating expenses until business improves. With higher interest rates, industrial companies can run into trouble.

Inflation increasing the cost of raw materials is another risk for industrial companies. There is a limit as to how much of the cost increases they can pass on to their customers.

Getting the best of the Industrials sector

Most industrials follow cycles. Railroads, construction equipment companies, and truck manufacturing are busy during economic booms but suffer during recessions. If you follow a specific industry closely, you’ll be able to catch great businesses when their stock price is devalued by the market.

There are several fragmented markets in which a leading company makes acquisitions to increase its market share. You can either target smaller players with low debt or go for the major player that wants to consolidate its position.

The industrial sector is very well suited to growth investors, but income investors will also find solid candidates. Depending on the diversification of industries you select within the sector, you could have between 5% and 25% of your portfolio in industrials.

Favorite Picks

Here are some of my favorites in this sector:

• S.: Lockheed Martin (LMT), A.O. Smith (AOS), Honeywell (HON), Automatic Data Processing (ADP)
• Canada: Toromont Industries (TIH.TO)TFI International (TFII.TO / TFII), Canadian National Railway (CNR.TO / CNI), Richelieu Hardware (RCH.TO).