Industrials: The sector continues to benefit from the robust US economy, but is now overvalued

Industrials posted solid gains in the first quarter of 2024 thanks to a robust U.S. economy, and the group is now trading, on average, moderately above our fair value estimates. Nevertheless, the Morningstar US Industrials Index has underperformed the broader US market so far this year. The sector's best-performing industries were waste management, construction and business services. In contrast, aerospace and defense, transportation and logistics, and conglomerates were notable laggards.

Source: Morningstar. Data as of March 22, 2024.

Waste management is a defensive industry. The largest players enjoy strong competitive advantages and predictable free cash flow. We believe investors have been encouraged by record price increases, continued margin expansion and greater investments in potentially lucrative sustainability projects such as renewable natural gas and recycling infrastructure. Although we expect margins to continue to increase over the next few years, we believe that market expectations for the industry have become too optimistic.

Source: Morningstar. Data as of March 22, 2024.

Construction stocks posted strong gains during the quarter. We believe the market is now taking a more constructive view of U.S. housing, even as mortgage rates remain high. By offering more sales incentives, lowering home prices and building smaller homes with fewer amenities, home builders are creating more affordable homes that attract more buyers. There is some debate about the future path for multifamily construction, but we see an undersupply of affordable housing, potentially increased immigration, and lower interest rates as catalysts for more multifamily construction in the next decade.

Source: US Bureau of Economic Analysis, Morningstar. Data status: March 2024.

We expect GDP growth to slow to 2.1% in 2024 and 1.4% in 2025 as we assume the economy has not yet fully felt the impact of higher interest rates. Some industrial companies with short-cycle exposure have already felt some pressure, and this trend could continue in 2024. Nevertheless, we expect GDP growth to pick up again in 2026, which bodes well for the sector in the longer term. General Electric has split into GE Aerospace GE and GE Vernova GEV, continuing the trend we have seen in recent years of companies moving away from the conglomerate structure. We wouldn't be surprised to see more announcements like this in the coming years.

Source: US Census Bureau, Morningstar. Data status: March 2024.

Top tips for the industrial sector

Wesco International

Wesco International WCC is an industrial distributor with three reportable segments: Electrical and Electronics Solutions, Communications and Security Solutions, and Utility and Broadband Solutions. Shares plunged on disappointing Q4 results as the company grapples with near-term challenges such as destocking and weaker end-market demand. However, we believe Wesco's long-term prospects remain strong, supported by higher US infrastructure spending, and therefore believe the sell-off was overdone and investors have a buying opportunity.

Stericycle

Stericycle SRCL is the largest provider of medical waste disposal and data destruction (primarily paper shredding) services in the United States. The company is in the midst of an operational turnaround led by a refreshed management team committed to investing in its core businesses while divesting its lower-margin non-core businesses. The company has experienced solid organic growth since 2021 and its consolidated gross profit margin has improved significantly. We believe Stericycle is at a margin inflection point and we expect adjusted EBITDA margin to increase to approximately 23.5% by 2027/28 from an average of 17% in 2019/23.

Sealed air

Sealed Air's two SEE segments, Food and Protective, provide customers with protective packaging materials and the equipment necessary to use them in manufacturing facilities. By integrating into the manufacturing process, Sealed Air has greater consumables pricing power than its more traditional competitors. The company posted disappointing profits for much of 2023 due to destocking and changes in consumer spending, and shares underperformed. Given Sealed Air's competitive position and favorable long-term outlook, we continue to view the stock as attractive.