Can Industrials Keep the Dow Rally Going?

The Dow Jones Industrial Average is knocking on its all-time highs, but is U.S. industry really recovering? As the Dow nears the barrier, traditional manufacturers are lagging. But the year ahead could see industrials catching up.

"The industrial story is a great story, it's a global story," says John Fox, manager of FAM Value Fund. "The U.S. industrials hit bottom in 2009 and it's been a slow recovery, but now these companies are doing well and earning record profits."

The recovery has indeed been a long time coming. While headlines during the collapse of 2008 mostly belonged to the housing and financial industries, the manufacturing sector fell into its steepest decline since the Great Depression as well. Factory shipments slumped by $1 trillion in a year, showing a 20 percent plunge in output that was far worse than the 5 percent contraction in the overall economy.

What made things worse for the manufacturers was that they were already in a long slide nearly a decade in the making. Indeed, the losses stretched so far back that some economists thought the sector might never recover.

But fund managers are seeing surprising gains as new technology is applied to old industries like energy and car manufacturing. Still, like the gradual decline in the years before the 2008 collapse, the recovery is less obvious.

[Read: Why Dow 14,000 Is One of the Market's Toughest Milestones.]

Value-oriented fund managers are finding areas in which technological innovations are slowly transforming the manufacturing sector, and they often have been overlooked in a market dominated by speed trading and short-term bets. These companies, broadly lumped into the "producer durables" category, are small-to-midsized manufacturers of tools used by other manufacturers. The Russell 3000 Producer Durables index, a kind of business-to-business version of the Dow industrials, lists many of these companies. The index has jumped 20 percent in the past two months as investors have started to notice the sector's potential.

"These companies are a little confusing and they tend to be 'cross-industry' focused and not covered much by analysts," says Seth Reicher, president of Snyder Capital Management, a private $1.9 billion asset management firm.

For investors seeking exposure to industrials, this is a much purer play than the Dow "industrials," many of which don't make anything tangible at all. Some of the biggest Dow-30 names--Bank of America, Microsoft, American Express, JPMorgan, and United Health--don't own a smelter or a fabricating machine among them. The Dow Industrials are spread across service, finance, and other broad industries. Remaining manufacturers like Caterpillar and Alcoa have been struggling to keep pace in the Dow's recent rally amid concerns over sagging commodity prices and doubts about the strength of China's economy. Boeing, another Dow manufacturing stock, has been struggling with industry and plane-specific problems. All of the heavy industrials have fallen behind.

Automakers, meanwhile, are recovering, albeit in fits and starts. Long-time Dow industrial standard-bearer General Motors was completely dropped from the average in 2009 after nearly a century. But with the help of a U.S. bailout, GM has shaken off some of its rust and has accelerated the use of technology in making and equipping its cars. Ford, on its own, has also revamped as a high-tech company. In a 2010 study by high-tech job service, Detroit was rated the fastest-growing U.S. high-tech center. The First Trust NASDAQ Global Auto Index ETF is up nearly 27 percent over the past three months, compared to 11 percent for the S&P 500.

Reicher says the automakers' profit-generating transformation is an example of the tech-infused recovery, but he avoids investing in them because they are highly leveraged and could be hit hard by any pullback. In a sense, they take on the attributes of a financial-services company to finance the cost of their vast dealer networks.

[Read: Is It Too Late to Buy Stocks?]

The companies he invests in are using high-tech enhancements, as carmakers have done, but operating in smaller markets where they are dominant and shielded from competition. Their technology investments of the past decade have created barriers for others to enter, so they are poised to grow strongly as the economy expands.

Reicher's Snyder fund also looks for companies that are generating cash flow as the best indicator of value. They are spread across sectors like transportation, energy, environmental services, food processing, and mining.

Some of his favorites are Clean Harbors, a hazardous-waste incineration company that is among the relatively few U.S. companies operating such facilities; Covanta, which produces energy from waste materials; Entegris, which outsources manufacturing from semiconductor makers; and Ingredion, a technology company that processes corn for sugar and other uses. The Snyder fund is a long-only fund for high net-worth and institutional investors, and Reicher says he has the luxury of finding cash-rich companies with long-term growth potential.

[See Emerging Markets to Consider in 2013.]

Fox's FAM Value Fund is also focused on value and cash flow. About a quarter of the fund's investments are in industrials. Fox cites Joy Global, a maker of mining equipment, as the kind of U.S. company "that sells to the world" and will fare well as the global economy recovers. Illinois Tool Works is another heartland company that holds value as a global seller of high-tech tools. Its erratic recent performance has made its shares relatively inexpensive.

"These companies tend to languish at low prices until somebody notices--that's what value investing is about," says Fox.

The fund managers say industrials with strong cash generation are being overlooked in favor of growth companies that have higher risk and less cash flow. "The market is so short-term oriented it is dominated by high-frequency trading and hedge funds and people using quantitative trading," says Reicher. "But it's not very good at finding long-term value, and that leaves room for people to make money by investing in good fundamentals of cash flow and earnings."

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