Retrieving the Babies From the Mid-Cap Bathwater

In their rush to spurn medium-sized industrials, investors are missing out.

By
DAVE S. GILREATH, CFP®
February 17, 2015, 6:19 AM ET
2 min read

— -- When the market throws out the baby with the bathwater, there are sometimes value opportunities for investors alert enough to retrieve the baby.

Midcap (midsize) industrial stocks have underperformed over the past year, as investors have rejected their potential based on poor showings among the entire industrial sector, including large companies. One concern for the sector as a whole is that a largely depressed global economy will hurt sales.

Yet most midcap companies, many industrials among them, get most of their revenues domestically, thus avoiding both the global slump and currency swings (currently, a strong dollar) that negatively affect export revenues. As the U.S. economy is the engine driving the world’s economy right now — only 12 percent of the U.S. gross domestic product is from exports — some midcap industrials are in a good place.

As economic growth slows globally, it’s chugging along in the U.S., creating fertile ground for companies that do most of their business domestically, including midcap industrials. The U.S. economy is what economist Brian Westbury of First Trust Advisors calls a “plow-horse economy,” delivering slow but steady growth. This augurs well for companies whose revenues are largely generated on American soil.

Yet, myopic to this distinction, much of the market has tarred all industrials, including the domestic midcaps, with the same brush. Money managers have turned an indifferent eye toward these stocks, fleeing the category and rendering some of these companies greatly undervalued relative to analysts’ projections of their sales and profit.

They throw some fine babies out with the bathwater, so the idea is to identify these. Of course, there are nevertheless many ways to choose the wrong representatives of this category for your portfolio. As always, the key to a winning batting average is to look for strong signs of undervaluation, indicated by a likelihood of sustained growth fueled by the health of the sectors these companies serve.

Here are two examples of midcap industrials that may be undervalued:

  • Steel Dynamics (STLD). This manufacturer of flat roll steel had revenues of $8.8 billion in 2014. The company’s year low is $15.80 per share and its year high, $25.51.  Early this month, the share price was only about $1 off the low. Last year, in discussing the company’s 2014 performance, its best ever, CEO Mark Millet said: "We achieved record annual revenues, net income improved 70 percent and operating income increased 58 percent. We also achieved record 2014 shipments.” The company’s undervaluation comes not just from being a midcap industrial, but from being in steel, an industry that gets no love from the market, which keeps punishing its share price, despite a dividend yield of 2.75 percent(a stock’s ultimate return on investment).

    And, according to about 20 analysts, Steel Dynamics shares will rise 70 percent over the next year. The median price target of 16 analysts covering the company is $25 per share. This may be the best-run steel company in America, but the market has a distaste for even a thriving example of an industry generally dismissed as being entirely undesirable.

  • United Rentals (URI). This construction-rental company is coming off a record year for sales and profits. The stock price hit a record high of $120 per share last year, but market fears stemming from the herky-jerky nature of the housing recovery have pushed the price down to recent levels of around $90, compared with analysts’ price targets of $112.

    Yet, the gap between market perception and the actual value of United Rentals is even wider than these numbers suggest. Although construction activity is nowhere near what it was before the housing bubble burst, it’s doing a lot better than earlier in the recovery. The industry can only be helped by the reality that, as the job market improves, millennials living with Mom and Dad will get homes of their own. And using rental equipment is a flexible way to manage project costs, especially in a somewhat spotty market that may not assure steady work volume to justify purchasing.

    Thus thrive just two examples of midcap industrials. Their performance and prospects, relative to their treatment by the market, demonstrate a time-honored investing maxim:  When the market is tarring well-performing companies with an indiscriminate brush, there can be significant opportunities for investors who think for themselves.

    Any opinions expressed are solely those of the author and not of ABC News.

    Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.

    • And, according to about 20 analysts, Steel Dynamics shares will rise 70 percent over the next year. The median price target of 16 analysts covering the company is $25 per share. This may be the best-run steel company in America, but the market has a distaste for even a thriving example of an industry generally dismissed as being entirely undesirable.

  • United Rentals (URI). This construction-rental company is coming off a record year for sales and profits. The stock price hit a record high of $120 per share last year, but market fears stemming from the herky-jerky nature of the housing recovery have pushed the price down to recent levels of around $90, compared with analysts’ price targets of $112.

    Yet, the gap between market perception and the actual value of United Rentals is even wider than these numbers suggest. Although construction activity is nowhere near what it was before the housing bubble burst, it’s doing a lot better than earlier in the recovery. The industry can only be helped by the reality that, as the job market improves, millennials living with Mom and Dad will get homes of their own. And using rental equipment is a flexible way to manage project costs, especially in a somewhat spotty market that may not assure steady work volume to justify purchasing.

    Thus thrive just two examples of midcap industrials. Their performance and prospects, relative to their treatment by the market, demonstrate a time-honored investing maxim:  When the market is tarring well-performing companies with an indiscriminate brush, there can be significant opportunities for investors who think for themselves.

    Any opinions expressed are solely those of the author and not of ABC News.

    Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.