Industrials: Sector Outperformance Led by Aerospace and Defense

The Morningstar US Industrials Index has solidly outperformed the US Market Index this year, as investors have brushed aside trade policy concerns. We believe the market has become more optimistic that Trump administration policies could revitalize the US manufacturing base, which would be a favorable development for industrials. Furthermore, the US economy remains resilient, industrial production has been steady, and new orders for durable goods have trended higher, with May new orders up nearly 20% year over year, aided by a surge in commercial aircraft orders.

Industrials Index Has Solidly Outperformed the Market This Year

While the aerospace and defense industry has had the strongest performance this year, we still see value in the space, particularly in defense contractors, though those stocks had some upward price movement due to the Iran conflict. We saw that rally as an exaggerated reaction, because in our view, the dots between military combat and the profit of a defense contractor do not connect nearly as directly as investors seem to imagine.

We See Compelling Investment Opportunities in Aerospace and Heavy Machinery

In the short term, munition resupply orders can contribute to sales, although these are typically small relative to total revenue. However, a drawn-out conflict could sap military budgets and divert funds to operations and logistics, away from research, development, and procurement, where defense contractors generate the bulk of their revenue. Nevertheless, we see upside for our defense coverage. Over the longer term, the Pentagon has prioritized modernization of the military’s ability to counter aggression from multiple so-called great power rivals, namely China and Russia, while managing threats from terrorism and hot spots like Iran and North Korea. We think defense procurement budgets will continue to grow with modernization, around a low-single-digit percentage over the next five years.

The Industrials Sector Has Benefited From Solid Manufacturing Production

Farming is in the early innings of “precision agriculture” technology adoption. Agricultural equipment will increasingly include digital technologies to enhance crop yields and drive other efficiencies. We expect growing market penetration of this technology will lead to structurally higher profit margins for the ag equipment industry and damp the industry’s cyclicality. The North American ag market remains very challenging, but we believe 2025 will mark the trough of the cycle.

Precision Ag Tech and a Market Upturn Will Drive Ag Equipment Earnings Growth

Top Industrial Sector Picks

CNH Industrial

• Fair Value Estimate: $21.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: Medium

CNH CNH is a global manufacturer of agricultural and construction equipment. In the long run, the firm will face steady, if not increasing, demand for its solutions to help feed a growing global population. Moreover, margin-rich technology add-ons to its product portfolio will continue improving returns and its through-cycle financial profile. Though the performance gap versus Deere remains wide, CNH has earned its seat at the table, and it will benefit from favorable, long-term dynamics in global agriculture markets.

Huntington Ingalls Industries

• Fair Value Estimate: $316.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

Huntington Ingalls HII is the largest independent military shipbuilder in the United States, generating most of its profits from building ships for the US Navy. The major value drivers for are nuclear-powered submarines and large surface warships. We see meaningful growth from the Columbia-class submarine program. Though Huntington Ingalls delivers roughly 23% of this boat, each one costs nearly $9 billion to build. We expect relatively steady long-term demand for amphibious assault ships, as Huntington Ingalls is their sole provider and there is not much room for additional capacity.

Fortune Brands Innovation

• Fair Value Estimate: $82.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: Medium

Fortune Brands FBIN is a competitively advantaged building products manufacturer with a portfolio of well-established brands, including Moen (plumbing fixtures), Master Lock (security), Therma-Tru (doors), and Fiberon (composite decking). We think Fortune Brands will grow faster than the US residential repair and remodel and new construction markets (weighted for the firm’s exposure to these two markets), especially with its growing mix of connected products (smart plumbing fixtures, leak detection devices, and home security products).