Industrials Sector Report

Sector report by Ed Collins, 27 November 2020

EXECUTIVE SUMMARY

In this investment report, I recommend that the Fund invests in three ETFs, two of which have exposure to the Building & Construction sub-sector, and one with exposure to the Transportation sector.

The report breaks down the Industrials sector and dives in depth into three specific sub-sectors, in order to provide sufficient qualitative and quantitative backgrounds to make accurate investment decisions.

On the back of lockdowns and people spending more time at home, with this likely to carry on in the near- and medium-term in regards to working from home and lockdown measures, I predict that home improvement will continue to be a big trend.

As a result, I have picked two ETFs with exposure to the Building & Construction industries: the SPDR S&P Homebuilders ETF (XHB) and the Invesco Dynamic Building & Construction ETF (PKB).

I have also recommended that the Fund goes long on the Transportation industry, due to the increasing importance that efficient transportation has in the world. This has been boosted by the ongoing pandemic and lockdowns, with online shopping increasing is one example of why transportation is becoming increasingly important.

However, I have picked an ETF with minimal exposure to airlines, as their recovery post-COVID may be delayed.

I have picked the iShares Transportation Average ETF (IYT), which only has a 10.54% exposure to airlines; the majority of its weighting is in Railroads (35.24%) and Air Freight & Logistics (30.98%).

I also mention throughout this report the potential growth that the aerospace and defence sub-sector may experience in the near future. However, I deemed it too risky an investment due to government spending qualms and worries about future aircraft demand due to a potentially very slow rebound in flights.

OVERVIEW OF SECTOR

Sub-Sectors:

Chart, sunburst chart

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Figure 1: Bloomberg Breakdown of Industrials Sector into Sub-Sectors (size of segments correlates to market cap of each sub-sector)

The Industrials Sector can be divided further, with sub-sectors defined as Aerospace & Defence, General Industrials, Electronic Equipment, Transportation, Industrial Engineering, Construction, Support Services, and more.

For a further breakdown of the Industrials sector under the GICS, please click here.

Trends, Themes and Key Sector Drivers:

Performance in the sector is largely driven by supply and demand for building construction in the residential, commercial, and industrial real estate segments, as well as the demand for manufacturing services.

Historically and currently, the biggest driver of activity in the Industrials sector is the health of the wider economy. When the economy contracts during recessions, as we have seen recently, activity in the industrials sector drops since all companies postpone expansion and investment plans, hence require less of the manufacturing goods and services that the companies in the Industrials sector provides.

Monetary and fiscal policy are also key drivers: if there is a lot of government spending on infrastructure projects, for example, this boosts industrials companies. Additionally, low interest rates encourage capital spending and investment, which is particularly good for the Capital Goods sub-sector.

General Recent News:

One of the biggest news stories, focused on the Aerospace sub-sector, has been the ongoing debacle surrounding Boeing 737-Max aircraft. After two fatal crashes, the Federal Aviation Administration grounded the jet 20-months ago. This week it was announced that the jet would be cleared to fly again as soon as the start of 2021.

The Airbus vs. Boeing competition has been a focus of many of my Friday Wrap-Ups recently, and it seems Airbus is very much winning in 2020. This may have been what prompted the US government to provide illegal state aid to Boeing, which has led recently to the EU placing extra tariffs of 15% on US aircraft.

Other general news tends to just be analysis of how well different Industrials companies are faring to the challenges 2020 has posed: Aerospace & Defence companies have fared badly whilst Industrial Transportation companies, such as FedEx, have done incredibly well this year.

Products/Services and Key Business Models within the Sector:

Due to the range of companies that are found within the Industrials sector, there is an unbelievable range of products and services offered, and there are not any such business models that are utilised by multiple companies.

Products offered range from capital goods like manufacturing machinery to defence goods like missiles.

However, not to be overlooked are the key service offerings provided by many Industrials companies. This can include companies where services are their main revenue source, e.g. FedEx with its transportation and delivery services, but services still provide a huge income stream for companies like Boeing and Rolls Royce, who provide maintenance services for their customers.

Historical Price Action of Sector Indices:

Figure 2: Price Graph YTD of the S&P 500 Industrials Sector Index (Please click for data)

As we can see, and as is the case with most sectors this year, the Industrials sector started off the year healthy, with the S&P 500 index hovering around the $700 mark. This changed towards the end of February and start of March, when stocks worldwide tanked due to the growing severity of the COVID-19 pandemic leading to many national lockdowns.

Industrials stocks bottomed out on the 23rd March and have since improved steadily. This recovery has come as fiscal stimulus measures were agreed, monetary policy started to take hold and economies started to open up more and more out of their virus-induced lockdowns.

You will also notice that since approx. the 30th October, the Industrials sector has been on an upward trajectory, breaking above the $700 mark that it was averaging before the pandemic at the start of this year. This is due to investors’ optimism following the US election result, since Democrats historically spend more on infrastructure projects, which benefit industrial companies greatly. It is also due to optimism following vaccine results.

FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS

Due to the varied nature of the Industrials sector, the analysis will be broken down by sub-sectors. I have also been selective with the sub-sectors, focusing on a few in detail rather than all of the Industrials sub-sectors.

Sub-Sector 1 – Aerospace and Defence

As mentioned earlier, 2020 has not been kind for Aerospace and Defence companies. The iShares US Aerospace and Defence ETF (ITA), the largest ETF for this sub-sector, has fallen by 17% since the start of the year. These depressed price points could potentially be an opportunity of entry for investors, and I personally see plenty of opportunity for a rebound, particularly from more defence-focused companies.

Besides from commercial airlines, who buy commercials jets from essentially just Boeing and Airbus, the main customers when it comes to the Aerospace and Defence sub-sector are governments.

It is true that many governments’ budgets have been squeezed due to funding COVID-19 responses, however, this will unlikely impact countries’ military spending. This is because governments will want to continue to stimulate economies and provide industrial jobs.

Take the UK, for example: last week, Boris Johnson promised the biggest defence investment since the end of the cold war with a £16.5bn military spending boost. The funding includes £1.5bn in new money for research and development, including a tranche for Tempest.

Many analysts are predicting that other nations will now follow suit, with defence spending increases of their own.

With this, defence companies worldwide should benefit greatly from greater R&D spending and greater demand for weapons.

The key players in this subsector include Raytheon, Lockheed Martin and Boeing. Another one to keep an eye on is BAE systems, who may benefit greatly from the UK’s Tempest R&D funding.

Of course, the downside of this is the commercial aircraft part of the sub-sector. This has taken a huge hit during the pandemic. Boeing’s Q3 earnings report reflected this: in the nine months to September 30th 2020, Boeing’s revenue for commercial airplanes was 53.8% lower than in the same period for 2019. In this same period of comparison, Airbus’ revenue from its commercial aircraft sector fell 43.5%.

This was due to many commercial airlines cancelling or delaying orders for jets due to the impacts of the pandemic limiting the flights that individuals were taking.

However, there is still hope for a strong rebound in air travel after the pandemic: following positive vaccine news recently, we saw stronger stock market performances from both airlines and manufacturers.

In my personal opinion, it will be short-haul and domestic flights that are the first to recover. This will include businesspeople carrying out short business trips in North America, as well as people going on continental holidays in Europe, for example.

This means that aerospace companies with exposure to short-haul travel will be the first to rebound. The biggest player in this game is Airbus, with its A320neo aircraft.

As for long-haul travel, the flight industry as a whole will likely not be back to pre-pandemic levels until 2023 or even the start of 2024, according to latest forecasts.

There is also the risk that the vaccine rollout worldwide is not a smooth operation, in which case we may see some countries stay in lockdowns and keep travel restrictions for longer. If this does indeed become the case, the rebound in air travel might be delayed and have even more bumps in the road.

Sub-Sector 2 – Industrial Transportation

The Transportation sub-sector deals with the movement of people and products. This includes air freight & logistics, airlines, road & rail, marine and transportation infrastructure companies.

The customer base for this sub-sector varies massively. Both the private and public sector utilise Transportation companies heavily.

The pandemic has had a mixed impact on the Transportation sub-sector: firms that tend to transport humans have fared a lot worse than firms that transport goods.

Take, for example, airlines. The number of flights taken by people dropped drastically due to the pandemic and travel restrictions. This has led to 2020 being a bad year for airline stocks: the U.S. Global Jets ETF (JETS), the largest airline-focused, has fallen 29.1% since the start of 2020.

Contrastingly, all of the other industries within the transportation sub-sector have done really well throughout 2020. A shining star is FedEx (FDX), the multinational delivery services company. Their stock is up 85.7% since the beginning of the year. This is due to numerous factors, but mainly due to the fact that whilst people have been stuck at home, delivery has become so much more essential for delivery of online orders and more.

Because the importance of the delivery of goods, both consumer and capital, has become so much more important since the pandemic, most transportation companies have fared very well. This has been shown by the iShares Transportation Average ETF (IYT), which has grown 12.9% since the beginning of the year (despite having a 10.42% weighting to airlines stocks).

Key risks to the future performance of the Transportation sub-sector include the price of oil. Oil makes up a large cost for transportation companies. If oil continues to hover at around the $40-45 dollar per barrel mark for the medium-term, this is good news for the profitability of these firms. However, there is a risk that oil prices could continue to creep back upwards towards the $70 per barrel mark that we saw before the pandemic. If oil prices do rebound going into 2021, this may add additional pressures to transportation companies.

Sub-Sector 3 – Building Products, Construction & Engineering

It is difficult to assess any one of these industries individually. This is because, when it comes to building anything, a lot of components go into it. Take an infrastructure project, for example, materials, the engineering and construction services, and utilities are all required.

Due to this, many construction or infrastructure ETFs contain a lot of Materials and Utilities companies alongside Industrials.

2021 could be a good year for such companies involved with infrastructure. The incoming Biden administration is expected to be very positive for renewable energy and this is likely to drive electrical infrastructure spending over the next 4 years.

Combine this with the increasing amounts of outsourcing we are seeing for infrastructure and engineering projects globally, and there is plenty of growth potential for the industry over the coming years.

The other thing that contributes to the good performance of many construction and building product ETFs this year is the amount of home-improvement projects that have been undertaken as individuals have spent time during lockdowns sprucing up their homes. With working from home looking to continue for the medium term, home improvement projects may continue going into 2021.

 FUNDAMENTAL QUANTITATIVE ANALYSIS

Using the S&P 500 Industrials Sector Index as a benchmark for the industry, we see the index having these Fundamentals.

S&P 500 Industrials SectorTicker: S5INDU / SPLRCI
P/E (Trailing)P/E (Projected)Price/Cash FlowP/BIndicated Dividend YieldP/Sales
28.9223.5123.994.511.88%1.69
P/E (Projected) and Dividend Yield are as of October 30, 2020; P/E (Trailing), P/B, P/Sales and P/Cash Flow are as of June 30, 2020.

We can also see the Fundamentals of the overall S&P 500 index as a benchmark.

S&P 500Ticker: SPX
P/E (Trailing)P/E (Projected)Price/Cash FlowP/BIndicated Dividend YieldP/Sales
31.2420.8622.652.261.76%2.26
P/E (Projected) and Dividend Yield are as of October 30, 2020; P/E (Trailing), P/B, P/Sales and P/Cash Flow are as of June 30, 2020.

MACRO OUTLOOK

Impacts of COVID-19

Throughout this report, the impacts of the COVID-19 pandemic on the Industrials sector, both positive and negative, have been highlighted. Here, I want to focus on the outlook going forward.

Firstly, air travel. So long as travel restrictions between countries exist, air travel will not pick up. The best hope for the airline industry is a successful vaccine rollout internationally. If this occurs, people will be able to start travelling again as international travel restrictions fade. The rebound in flights will not be an overnight process – it may take years for air travel, both short-haul and long-haul, to be back at pre-pandemic levels: most estimates place 2024 as the date.

Secondly, even with vaccines on the horizon, loose lockdowns may still continue in the medium term. Working from home as a trend is also likely to continue for the next year or two: firms like Google have already confirmed that their workers will be working from home until Summer 2021 and that might continue even further. Due to this, delivery and transportation companies will continue to be important going forward, not to mention the lingering impacts of people now being a lot more likely to shop online due to habits formed during lockdown. Similarly, with people continuing working from home, home improvement will continue to be a big trend, benefitting construction companies.

Impacts of the Economic Outlook

The Federal Reserve will continue to adopt accommodative monetary policy, including no rates hikes until 2023 at the earliest. With firms having this guarantee of low interest rates for the next few years, capital investment projects may be undertaken by many companies. Capital investment picking up would be incredibly beneficial for all Industrials firms, considering that capital investment involves capital goods and transportation firms.

On a similar note, fiscal spending can often sway the investment performance of Industrials companies. If governments choose to use fiscal stimulus as a way to bring economies out of the COVID-19-induced slump, this could bring big benefits. Governments are often big customers of Industrials companies. For example, if governments choose to invest in new infrastructure projects, this will lead to some big contracts and outsourcing opportunities for construction, engineering and professional services firms. As mentioned previously in this report, we have already seen Boris Johnson commit to greater defence spending, which should benefit aerospace and defence firms, and Joe Biden has promised numerous infrastructure projects during his campaign.

Finally, oil prices. Oil makes up a large cost for many firms in the Industrials sector, but mainly transportation companies. The pandemic has caused oil prices to fall to historic lows, with futures even turning negative at one point. Due to numerous measures undertaken by OPEC+ and others, the oil price has rebounded and is staying relatively constant around the $45 per barrel mark for Brent crude. Many analysts are suggesting that vaccines will not affect demand or supply for oil in the short term. This suggests that, going into 2021 at least, oil prices will continue to operate at this depressed price, which is good news for transportation firms, who will have deflated costs. Looking further forward, analysts have very conflicting opinions on how the price of oil will behave. The situation is veryu fluid so it is hard to predict what the impact of oil prices on the Industrials sector will be in the medium-to-long run.

PRICE TARGETS

Personally, I believe that there is plenty of opportunity for growth for the Industrials sector going into 2021, however this is not spread evenly between the sub-sectors. This is reflected in my recommended ETFs.

Despite having focused on aerospace and defence quite significantly in this report, I cannot provide an investment recommendation for the sub-sector. Many ETFs in this sector have a large exposure to Boeing and Airbus, both of which will continue to struggle as airlines are strapped for cash in the future. Additionally, it is not a guarantee that all countries will increase defence spending: some may cut it through austerity measures.

Recommended ETFs

ETF 1 – SPDR S&P Homebuilders ETF

TickerStock ExchangePrevious Closing Price (26/11/2020)Target Price Range for 12-months’ timeGross Expense RatioP/E TTM
XHBNYSE Arca$58.03$63.57 – $65.960.35%19.47

ETF 2 – Invesco Dynamic Building & Construction ETF

TickerStock ExchangePrevious Closing Price (26/11/2020)Target Price Range for 12-months’ timeGross Expense RatioP/E TTM
PKBNYSE Arca$40.51$42.96 – $47.330.59%17.28

ETF 3 – iShares Transportation Average ETF

TickerStock ExchangePrevious Closing Price (26/11/2020)Target Price for 12-months’ timeGross Expense RatioP/E TTM
IYTBATS Global Markets$222.98$239.370.42%20.26

All three of these ETFs are Growth opportunities due to their larger P/E ratios.

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