Samuel Oubadia is a portfolio manager at Lorne Steinberg Wealth Management in Montreal.
With global growth expected to slow, let's scrape beneath the surface of the heavy-machinery sector.
These machinery companies sell their products to the energy and transportation, construction, agriculture and mining sectors. However, the prospects for these companies may not be as bright as previously expected.
Given that many of the customers of these equipment manufacturers are mining and energy companies, the demand for certain types of machinery has been affected by lower commodity prices. Put differently, a company that mines iron ore, for example, is less likely to invest in new mining equipment when iron ore prices have fallen to their lowest levels in several years.
At Lorne Steinberg Wealth Management, we set out to find machinery stocks that are trading at attractive valuations but that are still providing investors with reasonable returns.
Using S&P Capital IQ, we screened for machinery companies based in North America and developed countries in Europe. We only included companies that had a market capitalization of $1-billion (U.S.) or higher. To screen on valuation, we looked for stocks that had a forward price-to-earnings ratio (P/E) of less than 15.
We also only included companies with a trailing enterprise value to earnings before interest, taxes, depreciation and amortization ratio (EV/EBITDA) of less than 12. In order to screen on profitability, we screened for companies that had a trailing return on equity (ROE) of more than 12 per cent. Finally, we also wanted the screen to display the dividend yield, the debt-to-equity ratio and the free cash flow yield of all the companies on our list.
The machinery sector is dominated by a few larger players that serve most of the markets mentioned above, with several other smaller companies that are more specialized. This is reflected in the accompanying table. The list includes a few of the sector's heavyweights such as Caterpillar Inc., Deere & Co. and Cummins Inc. The valuation of these three companies looks similar based on forward P/E and EV/EBITDA. However, Deere leads the pack with a healthy ROE of more than 34 per cent.
One feature that stands out among Caterpillar and Deere is that both appear to have hefty debt-equity ratios. However, it should be pointed out that these ratios are overstated as both companies have finance divisions that lend money to customers to buy their equipment, which is often very expensive. These divisions borrow money to lend it out to customers at a higher rate. Excluding the debt in these divisions would leave their debt ratios significantly lower.
On the other end of the debt spectrum is Cummins. The company's conservative balance sheet may appeal to some investors.
As machinery companies operate in a capital-intensive industry, it is also worthwhile looking at their free cash flow generation. This looks at their ability to generate cash after their capital expenditures and other ongoing costs, and may be more representative of a firm's situation than accounting-based earnings. One measure of this is the free cash flow yield formula, which expresses free cash flow as a percentage of the company's market capitalization.
Generally, the higher the free cash flow yield, the more attractive the investment. One company on our list that ranks highly on this basis is IMI, with a free cash flow yield of more than 11 per cent. The Britain-based firm provides engineering services for the control and movement of fluids to a number of different industries such as oil and gas, petrochemical, commercial vehicle and food and beverage.
Investors are advised do their own research before purchasing any of the stocks listed here.