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Insider Buying Leading Us to the Industrials Sector

Have we seen the peak of the great capital spending cycle here in the U.S. that has played out during the past decade?

Over the past year, the Industrials sector has been one of the most severely impacted with the slowdown in global economic growth.  Exacerbating the hit to fundamentals for these companies has been the concurrent weakness in the price of crude oil.  Many industrial companies sell equipment that is used in the exploration and production of oil, so as the commodity price has fallen, so too has purchases of capital equipment.  A third factor that has negatively impacted sales of industrial equipment has been the relative weak pricing environment for commodities in general as the U.S. dollar has strengthened.  Most commodities and materials such as copper, iron ore and metals are priced in U.S. dollars, so when we go through a period where the dollar strengthens, the commodities become more expensive for buyers in countries where the local currency has weakened, such as China.

On a year-to-date basis through October 5th, the average performance for industrial stocks in the Russell 2000 Index is roughly -13%, and only two sectors posted worse declines – Materials -15% and Energy -29%.  Our investment process here at 1492 Capital Management often discovers investment themes that seem contrarian to the prevailing sentiment on Wall Street.  Following the most recent market correction that was most acute at the end of August and then continued through the end of September, we began to see a potential silver lining as it relates to some of these industrial stocks.

We are initially focused on industrial stocks rather than materials- or energy-related companies, despite these two sectors having posted worse performance.  The primary reason is we believe that there could be a longer-term weak demand environment for materials and commodities that stems from the continued slowing of economic trends in all of the largest emerging markets, namely China, Russia and Brazil.  While some of the industrial companies have exposure to these commodity markets, there are also other demand drivers that continue to have a strong fundamental outlook such as construction, housing and automotive end markets.

Anecdotally, we have identified several industrial companies that are once again trading at attractive valuations on an enterprise value to EBITDA basis.  During the bull market run it was common to see stocks in this sector trading at 10 to 12 times EV/EBITDA, but with the recent market sell-off, many of these same stocks are now trading at five to seven times.  We generally do not quantitatively screen for low multiple stocks.  We do, however, screen for companies where insiders, such as corporate officers and directors, are making purchases of their stock in the open market.  Based on our experience, this screening method has been one of the most effective determinants of future stock price performance.  Working with Evercore ISI, we put together the following table that shows insider purchases and sales for the major economic sectors during the week of September 28th .  As you can see, there has been a recent spate of large insider buys in the Industrials sector, an over 2:1 ratio to sales.  Interestingly, see that insider sales in the Health care sector over buys is 36:1!  Generally we believe insiders at companies know their businesses better than any outside investor could; therefore, when they are buying stock in the open market it is usually a good time for us to evaluate if we should follow their lead.

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