On a regular and routine basis we evaluate positions held within clients’ accounts. We call it “creative de-construction”, where we figuratively remove positions held in a client's account and rebuild it.
Each position should provide a combination of diversification, safety, and growth. We evaluate positions and make adjustments as needed while keeping a client’s capital gains and risk tolerance in mind. We also consider whether additions should be made to the portfolio.
During this “de-construction”, we took a deep dive into clients’ industrial holdings. Companies such as Honeywell, Boeing, Caterpillar, Ford, and FedEx (examples, not recommendations). These are companies in the construction, aerospace, electrical equipment, machinery, and transportation arenas.
In general, industrials are cyclical and sensitive to changing economic conditions because they build large products that require healthy economic demand, long lead times and large financial investment (usually financed with debt).
During our initial screening, 68 companies peaked our interest. However, we ultimately settled on 8-12 depending on the size of the account. Through these we are seeking adequate exposure to solid holdings while balancing the need for diversification.
We spent quite a bit of time digging into each company’s financials to understand what goes on behind the scenes and how they did during past recessions. If we saw too much volatility or stress, they were removed from consideration.
In our selection process, we prefer companies that use technology to enhance their products and offer complimentary product lines to serve a broad range of customers. Multiple product lines provide the opportunity for growth and safety. For example, we like to see companies that can combine two of their existing products to create a third and serve a new market.
Honeywell tends to be one of our larger holdings in this sector and it has been a steady performer for years. They have broad product lines and a broad customer base, just what we like to see. They have a good story with great prospects for the future. When we evaluated their financials, it’s hard to see anything that could derail the company. They will continue to use technology to innovate their products and potentially improve their profit margin.
An interesting side note for Honeywell is the income they earn through servicing and providing maintenance for their products. Servicing and maintenance income will help provide cash flow during a downturn when customers are slower to purchase new products.
On the other hand, we are not interested in Boeing. Not because of the tragic plane crashes in 2018 and 2019 but because of the nature of their business. They have a slim product line which limits them and can make them vulnerable.
There are limited buyers for their products within a given year. Their products are expensive to build and require long lead times. If an issue arises during the plane’s assembly (such as a recession or plane crash), the buyer could cancel their order. If they cancel, Boeing is left with heavy debt, limited alternative buyers and expensive idle equipment sitting on the shop floor.
Hopefully Boeing resolves the problems that grounded the 737Max. If it does, the stock could have a nice recovery. However, the nature of the business will not change and we don’t see their business as a desirable investment for clients.
The low interest rate environment has benefitted industrials because most companies use debt to finance large purchase orders (contracts) before payment is received from the buyer. If the level of debt is too high, a company’s stock can be extremely volatile during an economic downturn because debt payments still need to be paid even though sales have declined. We believe it’s ok to have some debt but avoid those who have significant debt on their books.
Other areas we seek to avoid are “dinosaurs” (companies that have struggled to innovate and adapt to changing market conditions), heavy equipment companies, and the auto industry as we don’t see anything to get excited about.
We added a few names to our holdings, mostly in the “electronics” space. This area is particularly noteworthy because of their wide adaption capabilities. Areas such as environmental solutions, motion detection, and digital imaging should continue to be used in new and interesting ways.
Periodically, you should expect to see this type of communication from us as we to go through the sectors. Once completed, we plan to go back through them again and again. As we go through each sector, we identify companies that we want to invest more, hold, avoid, and those that could be future additions (if they reach our standards for investment).
We want to be the absolute best we can be, and it’s through feedback that we accomplish this. If you have questions or if there is anything we can help you with, please don’t hesitate to let us know.
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