Anyone contemplating investing in UK engineering stocks should be warned. Publicly quoted engineering firms have performed consistently badly over the past 30 years, both in terms of earnings and share prices. In that time the sector has lost more than half its relative value.
Firms have continued to lose value. The sector performed badly during the 1960s and early 1970s, the last so-called ‘Goldilocks’ period before the oil crisis of 1973, when economic conditions were ‘neither too hot nor too cold’.
Thus most engineering stocks should be avoided or sold, especially those with excessive market exposure in the UK and those in mature markets. These stocks should then only be bought near the bottom of the cycle in anticipation of their recovery, albeit from a low base. They should not be held for long.
Engineering firms tend to perform well in the period a couple of quarters before the bottom of the recession to about a year after. For the rest of the cycle, the next five or six years, their shares under-perform.
Although there is some evidence of an improvement in the performance of engineering shares in the past five years, it is largely confined to a few high-performing companies which have moved into high-growth, high-return businesses. But even these firms will need to keep selling their maturing businesses and buying growth to stay ahead of maturity in their main activities.
Recently, because of the benign economic conditions in the West, some investors have been suggesting that Western economies may have become less cyclical. They argue that stocks such as engineering, which have large cycle variations, might be revalued upwards.
Because engineering is more volatile than the market as a whole, they suggest that the sector could be re-rated over a longer, flatter cycle. On average it might have more to gain from reduced variability in earnings than the rest of the market.
But our analysis of long-term earnings growth suggests that engineering stocks are not systematically undervalued. If anything, they are overvalued and there is little reason to expect any upgrading.
The engineering sector is cyclical. But even with the recent strong performance by some large firms, overall performance of the sector in the last cycle has been poor. And its relative share price has struggled to regain its pre-recession levels of 1986-89.
Despite variations in economic conditions since 1964, including a long phase of good conditions, the relative value of the sector has barely changed. A basic measure of share valuation the price-earnings ratio has averaged for engineering stocks about 10% below that of the rest of the market. If the current growth cycle continues for longer than expected, the earnings of cyclical stocks will reach higher peaks than forecast.
However, engineering earnings grow rapidly early in the cycle because companies are coming out of recession and because restocking by customers boosts demand. But towards the end of the cycle earnings slow when demand falls as customers avoid overstocking.
In other words, it seems unlikely that the classic supply and demand cycle has gone away. The engineering sector cannot outgrow the markets it supplies and so is unlikely to benefit more than other sectors from an extended economic cycle.
Nevertheless, there are a few, genuine, long-term growth stocks in engineering. They all demonstrate good geographical spread, strong cash flows, and strong market positions in growth markets. They share another common factor as well.
All have been subject to drastic changes in management which has then found the one critical deal which has transformed the group concerned and given it momentum.
Nick Cunningham is vice-president engineering sector analysis at stockbroker Salomon Smith Barney.