Sector Rotation

  • 06 Jun
    PH is a very interesting value play

    PH is a very interesting value play

    Finding good investment opportunities can be a pretty hard thing to do, no matter how much knowledge or experience you have in the market. Part of the problem, I think comes from the nature of the (social) media-driven, instant-information society we live in today. If you pay attention to media news outlets for market information, you’ll usually find that a lot of what gets talked about doesn’t change a whole lot from one day to the next. Politics, monetary policy and interest rates are three primary themes from which the talking heads never really seem to move very far afield.

    One of the methods that I have learned is useful as a tool to stay abreast of current market events and to identify pockets of opportunity is called sector analysis. That might sound pretty complicated, but it really just means taking time to pay attention to the different industries that make up our economy. As business flows back and forth from one economic segment to another, you can begin to see specific industries rise into and fall out of favor in the stock market. That ebb and flow creates opportunities within the broader scope of overall market movement to pick industries, and therefore stocks that might be trading at discounted levels but that have a reasonable basis to be trading higher.

    The last day or so has given me an opportunity to go through my sector analysis, and I wasn’t really all that surprised to see a few sectors, like Consumer Staples, Real Estate, Financials and Industrials lagging the market. It’s true that since the broad market hit a new all-time high in late January, most sectors are down, or only marginally higher for the year. However, these three sectors have stood out from the crowd. The reasons for that are interesting, and can provide some good insight about where the greatest risks, and best opportunities in these areas are.



    The Real Estate and Financial sectors are both being weighed down by the prospect of higher interest rates. While the Fed has generally maintained the posture and attitude towards rates that it has been telegraphing to the market for some time now, there is still speculation that the economy could start heating up more than expected and force the Fed to accelerate the timing and size of rate increases moving forward. I also believe that Real Estate, which has generally seen big gains in property values over the last year nationwide, is starting to reflect some investor uncertainty. At what point does the strength in the economy translate to an overbuilt housing market that will force property values to drop? At what point does the surge in property values reach a tipping point, where average Americans looking to buy a home simply can’t afford it? To what extent will higher interest rates translate to higher mortgage costs that frustrate and stymie home buyers? I think Real Estate right now is acting as an early indicator of much broader economic uncertainty and concerns that have yet to be fully realized or refuted.

    Consumer Staples companies include well-known and long-established names like General Mills (GIS), Kraft-Heinz (KHC), and Campbell Soup (CPB). This is a sector that a lot of analysts, myself included, like to think of as a defensive segment of the market; it generally performs well when the market is showing signs of strength, and is usually less sensitive in nature than other sectors, whose cyclic nature leaves them vulnerable to broader economic weakness. If there are signs of economic uncertainty starting to show, defensive stocks like those in this industry should hold up pretty well. That hasn’t been the case for the last few months, as most of names you and I think of immediately when we think about things grocery shopping have been under pressure by shifting consumer trends away from processed and packaged foods to generally healthier, more organic alternatives. This is a trend that I’m not sure is done playing itself out, despite the fact that many of the companies in this sector have terrific balance sheets and overall fundamental strength.

    Industrials have been showing some very attractive earnings growth, fueled in part by the Tax Reform Act from December of last year, but for the last couple of months have been under pressure by the looming threat of a trade war that is starting to shows signs of increased costs on a lot of basic materials besides the steel and aluminum imports that recently imposed tariffs on Mexico, Canada and the European Union targeted. Trade tensions with these countries and with China are still playing themselves out, and so making a play in this space could be risky. I think it’s useful to remember that tariffs on imports, while deemed by market analysts and political wags as bad, misguided policy, have also been applauded by a lot of American companies as necessary steps to assure a level playing field on a global scale. I think the opportunities in this sector lie in targeting industries that tariffs are designed to protect, and among those are companies that work in aerospace and defense. PH is a great example of that, with a very solid fundamental profile, and a depressed market price that offers a nice opportunity if you’re willing to take a long-term view.



    Fundamental and Value Profile

    Parker-Hannifin Corporation (PH) is a manufacturer of motion and control technologies and systems, providing precision engineered solutions for a range of mobile, industrial and aerospace markets. The Company operates through segments: Diversified Industrial and Aerospace Systems. The Diversified Industrial Segment is an aggregation of several business units, which manufacture motion-control and fluid power system components for builders and users of various types of manufacturing, packaging, processing, transportation, agricultural, construction, and military vehicles and equipment. The Diversified Industrial Segment consists of Automation Group, Engineered Materials Group, Filtration Group, Fluid Connectors Group, Hydraulics Group and Instrumentation Group. The Aerospace Systems Segment produces hydraulic, fuel, pneumatic and electro-mechanical systems and components, which are utilized on domestic commercial, military and general aviation aircrafts. PH has a current market cap of $23 billion.

    • Earnings and Sales Growth: Over the last twelve months, earnings increased by more than 30, while sales grew a little over 20%. It’s hard for a company to grow earnings faster than sales, and generally not sustainable over time. Initially, however it is a good sign that management is doing a good job of maximizing their business operations.
    • Free Cash Flow: Free Cash Flow has shown strong improvement dating back to the fourth quarter of 2015, when the company reversed a two-year trend of negative Free Cash Flow growth. As of their last earnings report, PH’s Free Cash Flow was more than $1.2 billion.
    • Debt to Equity: the company’s debt to equity ratio is .82, a number that is generally manageable. Their debt has also declined by a little more than 10% over the past year.
    • Dividend: PH pays an annual dividend of $3.04 per share, which translates to an annual yield of 1.76% at the stock’s current price.
    • Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods uses the stock’s Book Value, which for PH is $44.20 per share. At the stock’s current price, that translates to a Price/Book Ratio of 3.9. I usually like to see this ratio closer to 1, or even better, below that level, but higher ratios in certain industries aren’t uncommon. The Machinery industry’s average is 5.13, putting PH quite a bit below its counterparts. The stock’s historical Price/Book Ratio is 3.2, which is below its current level and could be a sign the stock is fairly valued right now. The stock would have to move about 24% higher to reach par with its industry average, however, which translates to a long-term target price above $210 per share.



    Technical Profile

    Here’s a look at the stock’s latest technical chart.

    • Current Price Action: Over the last week or so, the stock has been dropping from a pivot high at around $184 per share (which I’ve marked B on the chart). The stock does appear to be showing some signs of stabilization over the last few days between $170 and its current price, which I’ve marked with a C on the chart.
    • Trends: I’ve highlighted the stock’s intermediate-term downward trend, which dates back to its high near $213 in mid-January with the red diagonal line. The stock’s recent decline has been following that line, meaning that the trend is acting as resistance for the stock’s price right now. The dotted green line on the chart traces the intermediate trend’s low point at about $161 along with the stock’s recent stabilization around $170 per share. If the stock’s current support holds, the difference between the short-term upward trend line and the intermediate-term downward trend line will continue to decrease. You think of that like the tightening compression of a coiled spring; the longer that lasts, the more likely there will be a significant move, or release of tension out of that range. If it breaks higher, the stock should see little near-term resistance until it reaches about $184 per share. In the longer-term, and given the stock’s underlying fundamental strength, I think there is a good basis to suggest the stock could revisit the highs it approached at the beginning of the year.
    • Near-term Keys: Watch the stock’s movement carefully over the next few days. A break above $175 would likely mark a reversal the downward trend and could mark a good bullish trade, either by buying the stock or working with call options. On the other hand, a break below $170 could offer an attractive bearish trade, either by shorting the stock or using put options.


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