Deere stock trades at 14.7 times its next 12 months’ expected free cash flow per share.
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Even the Fed admits it—inflation will be part of our lives longer than most imagined. That could be good news for industrial stocks.
This past week, Federal Reserve Chairman Powell shocked the market when he said that it was time to stop using the word “transitory” to describe inflation and warned the central bank could speed up the end of its bond-buying program.
In some ways, he was acknowledging the obvious: The consumer price index reading rose 6.2% year over year in November, though no one expects inflation to remain that high. Average annual inflation expectations for the next five years are at 2.8%, according to the St. Louis Fed, but that’s still well above 2019’s prepandemic level of 1.8%.
“Transitory is dead,” observes Tom Porcelli, economist at RBC Capital Markets.
Industrial stocks usually aren’t the first companies to benefit from higher inflation. Manufacturers often have contracts with their customers that must expire before they can raise prices. Commodity producers usually benefit right away, which is why energy stocks performed so well when prices started rising. But after a while, industrial companies can raise prices to protect their profits from higher material costs. That’s particularly true when inflation is persistent, says James Camp, managing director of strategic income at Eagle Asset Management.
Yet investors haven’t been very interested in industrial stocks. The Industrial Select Sector SPDR exchange-traded fund (ticker: XLI) has gained 18% in 2021, underperforming the S&P 500’s 23% gain. The sector has seen just over $225 billion flow into global ETFs since September 2019, according to Citigroup data. That’s well below the $325 billion that flowed into ETFs loaded with oil producers and basic material manufacturers. “Investors should be turning to more diversified economic-sensitive exposures like…financials and industrials, versus the near-term inflation beneficiaries,” writes Scott Chronert, global head of ETF research at Citigroup.
That means industrial stocks are trading at relatively undemanding multiples. The Industrial Select Sector SPDR ETF trades at 20.5 times expected free cash flow, below the S&P 500’s 23.5 times, according to FactSet. Industrial stocks have historically traded at valuations in line with the broader index. The sector’s cash flow is expected to rise 28% in 2022 and 17% in 2023.
The recent selloff in industrial stocks has left some names looking particularly cheap. Deere (DE), for instance, trades at 14.7 times its next 12 months’ expected free cash flow per share, below its five-year average of 20.7 times. That’s despite the fact that the $107 billion agriculture and construction equipment manufacturer is expected to grow free cash flow in the high teens over the next two years.
That valuation likely doesn’t reflect Deere’s growth, argues Edward Jones analyst Matt Arnold. “You don’t necessarily have to buy [the stock] and have the company crush expectations,” he says.
Deere could beat those expectations anyway. In recent weeks, the company has been charging its customers prices that are 7% to 8% higher than they were a year ago, Arnold says, which has helped drive analyst sales estimates higher. With Deere’s stock down 10.3% over the past three months—the S&P 500 has gained 0.1% during the same period—it may just be time to buy the dip.
Write to Jacob Sonenshine at [email protected]
