5 stocks for the next spending wave - Jubak's Journal

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Posted 4/5/2006

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Jubak's Journal
5 stocks for the next spending wave

If the consumer is tapped, what will keep the economy humming? Business spending. And these companies stand to profit as corporations open their wallets.

By Jim Jubak

Here's the current consensus on the U.S. economy: Growth will taper off in the second half of 2006 as the Federal Reserve's interest rate increases gradually take the wind out of the red-hot housing market and consumer spending.

But the drop in growth will be very slight -- to 3.2% for all of 2006 from 3.5% for all of 2005 -- because an increase in capital spending by corporations will pick up the slack. Companies, flush with record profits, will spend more on new plants and equipment in the year ahead. According to a recent survey by Duke University's Fuqua School of Business, CEOs plan to increase capital spending by 6.5% in 2006. That's a big jump from September, when the same survey showed plans to increase spending by 4.7%.

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And here's how investors in the stock market have acted on that consensus: They've driven up the share price of companies that sell the building materials and equipment that companies need to expand production. So, for example, shares of Florida Rock (FRK, news, msgs), a company that makes building aggregates and cement products essential for the building new plants, are up 18.5% so far in 2006, and shares of Wabtec (WAB, news, msgs), a maker of electronic systems for railcars, is up 25%.

Riding an aging cycle
But investing in stocks like these can be very tricky, especially after they've had a big run like this. These companies are all cyclicals, meaning that they belong to industries where revenue, and even more so profits, go through boom and bust cycles. In the railcar industry, the market that Wabtec sells into, the time between peaks has averaged five to seven years. At a peak, rail companies, looking at all their traffic and extrapolating future growth, order so many new cars that they create a glut. As the new cars are actually delivered, the supply outstrips demand, driving down the prices that rail companies get for their services and leading them to first gradually and then rapidly cancel future orders. That finally results in a trough, when no one orders cars. That ends when, thanks to the shortfall in the supply of cars, growing demand drives up the price of rail services again.

The time to buy cyclicals is near the trough, if you can figure out when that is. And the time to sell is when the cycle is nearing a peak. The last thing you want to do is to buy at the peak and then see the cycle go south on you and your investment.

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That's why once the cycle starts to reach the length of earlier cycles investors start to worry. Cyclical stocks at this point face a constant demand from investors of "Show me we haven't reached the peak yet" before they're willing to buy. And that's where we are in the stock market these days: Many cyclical sectors are getting long in the tooth by historical standards, but investors continue to find reasons to believe that the peak is still a way away.

I think those arguments are largely correct. It is different this time in many cyclical sectors in that it's taking longer to reach the peak than it has in earlier cycles. The reasons for that range from the macro- to the microeconomic.

On the macro level (the level of the economy as a whole) first, companies have only reluctantly invested in new equipment this time around because they were so badly burnt by the supply glut in technology sectors in 2000. So it's taken longer to get CEOs to open their purse strings in this cycle, and they're still sitting on plenty of cash that already would have been re-invested in a more "normal" cycle. And, second, because so many basic industries, such as mining and railroads, have seen depressed profits for so long, there is a huge backlog of deferred capital investment to make up. Some on Wall Street say, for example, that the mining industry is just now making up for 20-30 years of under-investment.

For investors in basic industries and capital equipment, this extended macro cycle is good news. It means that winners still have longer to run.

But, I'd argue, the way to get the most out of this capital investment story -- and to get an extra margin of safety, too -- should look for individual cyclicals with their own micro-economic stories. That puts the economywide and company-specific trends both at your back.
In my regular Wednesday appearance on CNBC's "Morning Call," I recommended three capital investment stocks that have the macro and micro winds blowing in their favor.

Wabtec (WAB, news, msgs). Yes, the average railcar cycle lasts five to seven years from peak to peak. And yes, at the end of the fourth quarter of 2005, the last peak was 7.25 years ago. But there's good reason to believe that the peak is still ahead. Demand last peaked with an order backlog of 69,858 cars in the third quarter of 1998. The bottom came in the first quarter of 2002, when the backlog fell to 6,443. The backlog now stands at 69,408 cars but new orders continued to out pace new car deliveries in the fourth quarter of 2005 and look like they'll do the same in the first quarter of 2006. Trends point to a peak backlog near the end of 2006 near 80,000, a level last seen in the 1970s, according to Morgan Keegan. And even that might be a conservative projection, as the average age of the U.S. railcar fleet has been climbing for the last 20 years and railroads retired 40,000 cars last year. An end-of-2006 peak, however, is more than far enough out to keep this six-month pick moving up -- especially because the company has micro trends in the rail industry to help out. Wabtec's electronic systems for railcars enable railroads to improve productivity by substituting technology for labor. And it pays a railroad to add that technology to existing cars, as well as in the new cars it buys. About 54% of the company's revenue comes from systems sold to railroads for installation in cars they already own. Our StockScouter rates these shares a 4 out of a possible 10.

Florida Rock (FRK, news, msgs). Cement prices have been hotter than a lime kiln in July since 2004, when they climbed, according to the Department of Labor, by 10% and then added another 12% in 2005. In most cyclical industries price climbs like that would lead to an industrywide binge on new plant construction with devastating effects on future prices as supply overwhelmed demand. But the cement business in the United States doesn't work that way because it is just so unbelievably hard to build a new plant in this country. Total planned domestic expansion would add just about 17% to current domestic production of 104 million short tons by 2010. But that would leave the U.S. industry well short of the 140 million short tons consumed in the United States in 2005, let alone the 160 million short tons projected to be consumed in 2010. The gap between constrained production and growing demand is met in the cement market by imports. Because cement is so bulky, imports are generally more costly than domestic cement, when domestic supply increases, imports drop. Florida Rock's management recent told Wall Street that January price increases of 8% or more have held with customers and that markets are likely to support another round of price increases this summer. Our StockScouter rates these shares a 5 out of a possible 10.

Crane (CR, news, msgs). Two divisions, Fluid Handling and Controls, which account for 50% of Crane's revenues, give this diversified manufacturer of everything from specialty chemicals to electronics its exposure to an up-tick in corporate capital spending. Management recently told Wall Street to expect 4% revenue growth in 2006, but most analysts feel that estimate is far too low. Sales could grow by 7% (Standard & Poor's projection) in 2006 after 9% growth in 2005. The big opportunity is in the fluid division, where internal efficiencies and the ability to spread fixed costs over a larger volume of sales could push margins to as high as 12%, according to management, from the current 8% level. Crane is traditionally a late-stage cyclical with about 50% of its sales, according to Bear Stearns, coming from late-cycle businesses in aerospace, chemicals, commercial construction, power, and vending markets. Our StockScouter rates these shares a 7 out of a possible 10.

And as always I have two "exclusive" picks for readers of CNBC.com on MSN Money.

Pentair (PNR, news, msgs). Fluid is the story here, too. The company's water products group, especially its specialty pumps and filtration products, should be enough to drive organic growth at a 7% rate in 2006. With margin improvements as the company continues to digest its acquisition of WICOR and to drive up profits in the acquired business, earnings per share are projected by Wall Street to grow by 12% in 2006 and 14% in 2007. Besides benefiting from the pick-up in capital spending, Pentair has been doing some investment of its own. Pentair has doubled its headcount in China and now has 100 engineers in India. Our StockScouter rates these shares a 5 out of a possible 10.

Columbus McKinnon (CMCO, news, msgs). Got to move it around your factory floor? Columbus McKinnon has a hoist, crane, conveyor, lift table or material handling system to do the job. And, if its customers are to be believed, Columbus McKinnon does it well: The company has a No. 1 market share in 65% of its business lines. For the December quarter, the company reported a 6% increase in sales and a jump in operating margin to 9.8% from 7.5% in the year-earlier quarter. Company management has set a target of a 11% to 12% operating margin. Wall Street analysts are projecting 88% earnings growth for the fiscal 2006 year that ends in March 2006. Our StockScouter rates these shares a 4 out of a possible 10.

Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Pentair. He doesn't own short positions in any stock mentioned in this column.

MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.