Morningstar - Q4 2020 - 82

Investors

Building Optimism
Many industrial companies are thriving,
and opportunities are ahead.

There are reasons to be optimistic for other end
markets, too. In terms of utilities spending, we're
still in a capital expenditure cycle, and there's
still an overarching need to make the grid
harder and smarter, particularly given the secular
trend toward renewable power generation.
Lallos: Josh, you've written about how multi-industry

industrials are well positioned today.

SECTOR RAP

Laura Lallos

The industrials sector was hit extra hard when
the COVID-19 pandemic tanked the market earlier
this year; these largely cyclical companies
are particularly vulnerable to economic downturns.
But when the market rebounded, many
of these names recovered quickly and even
raced ahead.
I spoke with Brian Bernard, who leads
Morningstar's industrials equity coverage, and
analyst Joshua Aguilar about trends to watch.
Our conversation took place on Aug. 20
and reflects performance and valuations as of
that date.
Laura Lallos: Broadly, how is the industrials sector

doing this year?
Brian Bernard, CFA, CPA, is
director of equity research,
industrials, with Morningstar
Research Services.

Bernard: It's rallied since the March 23 low,
more than the market. Most of the sectors here
are performing quite well, and only about 25%
of our industrials coverage now looks undervalued,
in our view.
Lallos: Which industries remain down?

Bernard: Aerospace and defense-the airlines,
Airbus EADSY, Boeing BA. Obviously, Boeing
was having problems before this with the 737 MAX,
and that's still unresolved. With the airlines,
no one ever thought we'd have a scenario where
basically they had no revenue. There's a lot

82

Morningstar Q4 2020

of operating leverage there, a lot of fixed cost.
They've done a good job trying to defend their
cash flow, but it's tough with almost no demand.
And autos-that's a very cyclical industry.
A lot of the auto names were underperforming
anyway because of a fear that some of them may
not be positioned as well for electric vehicles.
Tesla TSLA has been the outlier. In our coverage
list, that one is by far the best-performing stock.
Lallos: Do you see signs of life for some of these
hard-hit industries?

Bernard: The virus is very uncertain,
but Morningstar has expectations that might
differentiate us from other analysts. For
the airlines, there's been some positive data points
from the Transportation Security Administration,
which tracks volumes through airports.
We've had a few months of at least moving in the
right direction, though we don't think things
will get back to normal until there's a vaccine.
Then the question is, does business travel
ever come back? We don't think that Zoom will
replace all business travel. Maybe in that regard,
we're more optimistic.
Joshua Aguilar is an equity
analyst with Morningstar
Research Services.

Aguilar: According to the International
Air Transport Association, about two thirds of
passengers surveyed would be willing
to travel here in one to six months. That's a pretty
positive development. Defense is a little bit
of a countercyclical, because it's tied to defense
budgets. Some of the businesses I cover still have
double-digit order growth.

Aguilar: Some of these businesses are just less
cyclical inherently. There's only so much
maintenance that can be deferred on industrial
equipment, which is why these businesses
tend to have decent pricing power that can offset
inflation. They compete in their niches,
and there are few alternatives in that space.

There are a number of trends worth looking at.
There's reshoring of customer supply chains-
that is, localizing supply chains closer to where
sales take place. Rockwell Automation
ROK disproportionately benefits from that trend,
particularly in the hybrid space, combining
discrete and process manufacturing. Medical, life
sciences, and food and beverage companies
are strong end markets here and 20% of
Rockwell's end markets are exposed to food and
beverage and 5% to life sciences.
Technology is also becoming a meaningful
business for some of the companies I cover. If you
have mission-critical software with recurring
revenue, that's a good place to be. Roper
Technologies ROP sells ERP, or enterprise resource
planning, solutions in a very niche, complex, and
highly regulated market-property and
casualty insurance. Their customers are highly
dependent on this type of software for workflow
automation and benchmark analytics. Like
Rockwell Automation, Roper's been a beneficiary
of multiple expansion; the company hasn't skipped
a beat, even with pandemic-related headwinds.
But these are names that are worth watching.
Lallos: HVAC names stand to benefit directly from

the pandemic, given an increasing focus on air quality.
Brian, can you talk about the names you cover here?

Bernard: We cover the four major U.S.-based
HVAC companies: Carrier CARR, Johnson Controls
JCI, Lennox LII, and Trane Technologies TT.
They do residential and commercial HVAC-
Morningstar - Q4 2020

Table of Contents for the Digital Edition of Morningstar - Q4 2020
