If you're wondering how to find the best industrial stocks, there's good news and bad news. The bad news is that, like so many parts of Wall Street, the industrial sector doesn't have a magic metric that readily separates good stocks from bad stocks. On the bright side, with a little bit of know-how and some discipline, investors can find the industrial stocks that are more likely to succeed.
Industrial stocks typically represent companies that handle production and distribution. Their businesses are straightforward – they manufacture goods, for instance – but their balance sheets are usually more complicated than what you'd find with early stage tech start-ups. Industrial stocks also hold material assets like assembly plants, real estate and heavy equipment and machinery, and they sometimes have large workforces. All to say: industrial stocks involve capital-intensive ventures.
These cost centers make it harder to find the breakneck growth or huge profit margins you might find at a software start-up or a biotech company researching the next generation of cancer drugs. But, because companies classified as industrial stocks require more staff and more raw materials than just a few computers in an R&D department, it's harder for new competition to disrupt them given the massive up-front investment required to establish a business in the space.
In 1999, analysts at Morgan Stanley Capital International (MSCI) and Standard & Poor's put together the Global Industry Classification Standard taxonomy to divide up the entire universe of stocks. While there are increasingly granular ways to categorize the companies listed on Wall Street, the most basic involves 11 main sectors – "industrial" is one of them.
Industrial stocks can vary widely when you dig deeper into the sector as a group, however. They include logistics stocks like airlines, railroads and trucking firms, along with construction firms and traditional manufacturers of machinery.
Industrials are admittedly not the largest or most prominent grouping of Wall Street stocks. Right now, the S&P 500 Index is dominated by tech stocks at 31.5% of assets in the benchmark, followed by financial services at 12.5% and healthcare at about 12%. In contrast, industrial stocks only make up about 8% of assets. Other indexes are different, but almost all have industrials playing a minor role; the Nasdaq-100 has a mere 4.2% in industrial stocks and even the Dow Jones Industrial Average has under 12% in these companies despite having the sector as part of its name.
Given the secondary role that industrial stocks play in most portfolios, it's important to look beyond mainstream commentary to find greater detail on the sector's trends.
When you're looking for the best stocks to buy in the industrial sector, make sure you're not comparing companies that don't operate the same way. It's a good rule of thumb to always use an apples-to-apples comparison, but the capital-intensive nature of this sector means it's particularly important.
Generally, high-level metrics like price-to-earnings (P/E) ratios and price-to-sales (P/S) ratios are helpful. But keep in mind that each sector trades in a different range. For instance, the S&P 500 as a group has a P/E ratio of 24.8 and a P/S ratio of 2.9 right now. S&P 500 components that are solely in the industrial sector have a P/E ratio of about 25.6 as a group and a P/S ratio of 2.2 at present. The tech-heavy Nasdaq-100 index is even more elevated, with a P/E ratio of 31.9 and a P/S ratio of 5.1 right now.
Let's look at how comparisons, P/E ratios and P/S ratios can make a difference. Consider American Airlines Group (AAL), which has P/E ratio of 18.4 and a P/S ratio of 0.1 as of this writing. That sounds like a bargain until you compare it to the current valuation metrics of United Airlines (UAL), which has a P/E ratio of 6.0 and a P/S ratio of about 0.3.
That example illustrates the importance of comparisons within the sector as well as within industry subgroups.
Specific to industrial stocks, however, metrics like enterprise value (an equation that starts with market value but includes debt and cash on its balance sheet) and EBITDA (earnings before interest, taxes, depreciation and amortization) can be useful. These measures are "all-in" numbers that include financing quirks that some companies just gloss over but that are incredibly important to capital-intensive industrial stocks.
It's also critical to acknowledge that many industrial stocks are cyclical in nature, meaning they rise and fall along with the broader U.S. economy. In other words: When times are good, manufacturers fill more orders and shipping firms make more deliveries, but when times are bad, these firms see their business dip as customers pull back. As a result, investors in industrial stocks must be aware of broad macroeconomic trends as well as the factors that might impact individual companies on a more case-by-case basis.
