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The stock market is focused closely on the fiscal chaos in Washington, but below the surface the economy has shown strength. The ISM Manufacturing Production Index has been hot in recent months and above 60 the past three months.  This type of strength has not happened since 2011 and bodes well for industrial shares.  Further Alcoa (AA - Analyst Report) and RPM International (RPM - Snapshot Report) recorded stronger than expected Q3 profits confirming healthy industrial activity.

The economy is expanding solidly:

The graphic following displays the relationship between the year over year change in the ISM Manufacturing Production Index and the year over year change in the price of the Zacks Machinery Sector Index.  Notice the two series tend to track each other.  Strong growth is a plus for the price of machinery stocks.

The year ago comparison for the ISM Production index is easy over the next few months and should help to promote strength in the year over year growth rate to the benefit of machinery stocks.  The ISM Production Index averaged 53.0 in Q4 2012 and 54.5 in Q1 2013, but this was helped by a quirky 57.6 in February 2013.

The next chart displays the relationship between the Machinery Index and an index of the ISM based on growth.  The ISM index was based at a value of 100 in December of 1997 and the difference between the Production Index and 50 was added to the index value over time.  As a result, the index shows a level of “growth”.  Notice that growth has shown some acceleration in recent months, but the trend has been positive since the trough of the Great Recession.  Weakness in the machinery stocks in 2011 and 2012 seemed linked into credit stress in Europe and not the trend in U.S. growth. 

Machinery stocks to think about:

The table below displays a number of industrial machinery related stocks.  The table contains the name, ticker symbol, Zacks Rank, earnings per share revisions, and EPS levels for this year and next.  

(click table to enlarge)

Zacks Rank:

The two Zacks Rank #1 (Strong Buy) stocks are Manitex International (MNTX - Snapshot Report) and Middleby (MIDD - Analyst Report).  These stocks are seeing the strongest upward revisions to their earnings estimates based on the Zacks Rank methodology.   At the same time, there are five Zacks Rank #2 (Buy), one Zacks Rank #3 (Hold), and one Zacks Rank #4 (Sell).   There are no Zacks Rank #5 (Strong Sell).

Generally, a number of stocks in the sector are seeing upward revisions to their earnings estimates given the number of Rank #1 and Rank #2 companies.  This is consistent with the strength in the ISM Production Index which has been arguing for vibrant economic growth.  Signs of improved growth in China, Japan, and Europe add to the constructive backdrop.

Earnings Estimate Revisions:

Earnings estimates for the sector have not been revised materially over the past 30 days for either 2013 or 2014.  The largest increases in 2014 EPS estimates have come at Colfax (CFX - Analyst Report) followed by Ingersoll Rand (IR - Analyst Report), while the Illinois Tool Works (ITW - Analyst Report) and Parker Hannifin (PH - Analyst Report) have seen their 2014 estimates cut.   Looking at 2013, EPS estimates for ITW and Xylem (XYL - Analyst Report) have increased, while numbers were reduced for PH.    

Valuation:

The table below displays three metrics of valuation for each company – the 12 month forward PE ratio, the PEG ratio, and the price to sales ratio.  

(click table to enlarge)

Usually, a stock with a low PE ratio is seen consistent with attractive valuation and a stock with a high PE ratio is consistent with poor value.  The table indicates that MNTX and Babcock and Wilcox (BWC - Snapshot Report) have the lowest PE ratios, while MIDD and CFX have the largest PE ratios.   Relative to the median, MNTX and Dover (DOV - Analyst Report) are trading at a discount to their median.  MNTX appears to be the cheapest stock out right and relative to its median

Like the PE ratio, a low PEG ratio is seen as a sign of value and a high PEG ratio is viewed as an indication of poor value.  The PEG ratio is the price to earnings ratio relative to the growth rate in earnings per share.   When the PEG ratio is above 1.0, the market is paying more for earnings than the growth rate, while when the PEG ratio is below 1.0, the market is paying less for earnings than the growth rate.  It is a way to filter out high growth stocks, which may have a high PE ratio because of their earnings prospects.  MNTX and BWC have the lowest PEG ratios, while XYL and PH have the highest PEG ratios.  Only BWC is trading at a discount to its median value. Based on the peer group, MNTX and BWC appear to be the most inexpensive stocks.

Most traders view a low price to sales ratio as a sign of value and a high price to sale ratio as expensive.  MNTX and BWC have the lowest price to sales ratios, while MIDD and ITW hold the highest price to sales ratios.  Again MTNX and BWC are the cheapest relative to the peer group.  ITW has the narrowest premium to its median in terms of the price to sales ratio.

Trying to summarize value, each stock was ranked by its position based on the value metrics. A one was given to the company with the lowest value metric, while a nine was given to the company with the highest value metric.  An average was taken across the three measures.  The company with the lowest average was MNTX followed by BWC. The most expensive shares were ITW, XYL, and MIDD. 

Mixing value and the Zacks Rank:

The analysis suggests that MNTX is the most inexpensive stock followed by BWC.  When these are combined with Zacks Rank, it appears that MNTX is the best candidate for purchase.  MNTX is a Zacks Rank #1 (Strong Buy) and combines inexpensive valuation with upward earnings estimate revisions.  BWC may also be worth a look.  It is a Zacks Rank #2 (Buy), and also offers attractive valuation.   MIDD is a Zacks Rank #1, but is richly priced to its peer group.  The market is paying up for its earnings outlook. 

IR may be of special interest.  It was on the inexpensive side of its peer group and is a Zacks Rank #2.  Going deeper, it is expected to spin off its security unit, Allegion, by the end of this year.  Spin off stocks have a tendency to outperform the market and have been a hot investment idea this year.   A purchase of IR may provide a play on the spin off investing strategy and provide an additional catalyst for price strength.  IR was trading below the median valuation of the peer group in all three of the classifications.

More details on names of interest:

For those who are not familiar with MNTX, it is a leading provider of engineered lifting solutions.  The stock has traded sideways through 2013.  From a chart perspective, a rally over $13 would suggest a new leg higher.  It is a very small $134 mln market cap.  MNTX has not missed an earnings estimate in the past 10 quarters. It matched three times and beat seven times.

BWC provides advanced engineering, manufacturing, and construction solutions related to the energy industry.  The stock has been stair stepping higher this year, but has stalled recently in the face of the government shutdown and debt ceiling controversy.  It is a $3.6 bln market cap.  Although BWC has value and strong earnings estimate revisions, it has only beaten earnings estimates seven out of the past ten quarters.   Technical traders may examine the old set of highs from early August between $31.50 and $32.00 for support. Over $34.50, momentum buyers will likely take a look.

IR provides products, services and solutions for air quality, transportation and protection for food and perishables, security for homes and commercial properties, and increased industrial productivity and efficiency.  Like BWC, it has been trending higher through the year, but run into a soft patch with the recent turmoil in Washington.  The $59 area has been pivotal in recent months.

Conclusion:

Manitex, Babcock and Wilcox, and Ingersoll Rand are candidates to lift your portfolio.  Look for these machinery stocks to flex their muscles after the fiscal fiasco in Washington ends.

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