Goldman Sachs Thinks You Should Sell These 3 Industrial Stocks

By Lee

In a recent quarterly chartbook,Goldman Sachs analysts recommended 40 stocks to buy and 40 to sell. The only major industrial company on the buy list is Johnson Controls, but there are a plethora of industrials on the sell list. Of course, that doesn't mean you should sell; in fact, sometimes it's a good idea to buy stocks the investment community has given up on.

Let's take a look at some of them and examine what you need to know before buying into these stocks unloved by Goldman Sachs analysts.

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Unloved industrial stocksThe following chart shows the performance of the Industrial Select Sector SPDR ETF versus the S&P 500 year to date. As you can see, the industrial sector has underperformed the broader market in 2015 because of a combination of issues. Weaker oil-and-gas-based capital spending, tough mining markets, a stronger U.S. dollar, and slowing growth in industrializing emerging markets like China and Brazil have combined to hold back prospects in the sector.

XLI data by YCharts.

Therefore, it's unsurprising to see so many industrial names on Goldman Sachs' sell list. At the time the report was published, the bank's analysts had sell ratings on The Boeing Company , pumps and valves supplier Flowserve, industrial supply company W.W. Grainger, Inc , engineering consultancy Jacobs Engineering, mining equipment manufacturer Joy Global Inc, industrial automation Rockwell Collins, and Emerson Electric .

Commodities and heavy process industriesThe specter of lower energy and mining commodity prices looms large on this list. Joy Global is directly exposed to mining capital investment, and the stock's prospects are unlikely to brighten until mining commodity prices start to recover.

However, lower commodity prices have other effects. For example, when oil and gas prices start to fall, pressure builds up on heavy process industries to curtail capital spending -- not good news for a pump manufacturer like Flowserve, or an engineering consultancy like Jacobs Engineering. In fact, the latter's management was talking about caution within its energy processing customers back in October 2014.

If spending on process engineering is going to slow, then Emerson Electric is surely going to suffer. In fact, it's been a tough year for the company. Management has cut its underlying sales guidance three times this year. Full-year underlying sales are now expected to decline 2% in 2015. Moreover, 4 out of 5 of Emerson Electric's segments reported declines in underlying sales in the company's recent third quarter.

Simply put, all three companies need higher energy prices in order to spur capital spending from the process engineering industry down the line.

A weak industrial capital spending environmentEmerson Electric is also heavily exposed to the industrial automation market and, therefore, capital spending programs. Unfortunately, other industrial bellwethers are reporting a weak capital spending environmentamid revenue declines in some cyclically exposed areas. Clearly, this will hurt industrial automation equipment manufacturers like Emerson Electric and Rockwell Collins, but it will also hit the industrial equipment wholesalers like W.W. Grainger.

In a nutshell, the industrial equipment wholesale market is highly cyclical and also tends to be led by short-cycle demand. In plain English, the latter means companies like Grainger tend to see a short period of time between customers' need for a product and their order. In other words, they have limited visibility over their sales. Therefore, it's hardly surprising that Grainger's management downgraded its full-year sales guidance in July to growth of 0% to 2% from the previous guidance of 1% to 4% given in April.

Grainger and other industrial supply companies are the canaries in the coal mines of the industrial sector, so they could see conditions pick up before other companies, but buying them requires a belief that industrial end markets will recover in due course.

To Boeing or not to BoeingBoeing is the most high-profile name on the list -- and also the most idiosyncratic. Unlike the others, its end market of commercial aviation continues to perform strongly this year. However, Goldman Sachs analysts are concerned that the decline in fuel prices could cause airlines to curtail replacement demand for new aircraft, as fuel efficiency may not be as important to airlines when oil is at $50 rather than $100.

Against this argument, aircraft demand tends to correlate with airline profitability, which the International Air Transport Association, or IATA, believes will increase strongly in 2015. For example, in its midyear update in July, the IATA predicted that net post-tax profits for the worldwide airline industry would be $29.3 billion in 2015, up from $16.4 billion in 2014 and $10.6 billion in 2013.

Moreover, there are concerns about cost overruns with the 787. The following chart shows how deferred production costs -- the difference between the average cost of the 787 program and its current costs -- have increased over time. For reference, in 2013, Boeing expected deferred production cost to peak at approximately $25 billion.

Data source: The Boeing Company presentations. Chart by author. Figures in millions of U.S. dollars.

The takeawayAll told, the three stocks focused on different earnings drivers. Grainger is attractive if you think the manufacturing sector in the U.S. is going to pick up, while Emerson Electric really needs energy prices to stabilize and emerging market infrastructural spending to increase.

Boeing is probably the most intriguing of the sells. There is no doubt that costs on the 787 have overrun, but the debate over whether low energy prices will reduce new airplane demand has not yet been resolved.

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Lee Samaha has no position in any stocks mentioned. The Motley Fool owns shares of Johnson Controls, Inc.. The Motley Fool recommends Emerson Electric. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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