There are many wide-ranging engineering companies, quoted and private, so trying to pigeon hole them is like herding cats.
‘Industrial engineering’ is an umbrella term covering aeroplanes, satellites, engines, generators and missiles, with middle to small sized firms representing downstream industry linked to metal manufacturing, bearings, sprockets, gas turbines, machine tools, and more.
The ‘metal bashing’ side of engineering is about the manufacture of a metal item to be used with another metal item and was central to the industrial revolution of the 19th century into the 20th.
Today the old style metal bashing has shrunk, the companies are now more diverse, often connected in various ways with the aerospace, avionics and defence sectors. They lap over with chemical, electrical, automotive and civil engineering companies.
Companies in industrial engineering span the earth from Malaysia’s heavy engineering and shipbuilding firm MMHE Engineering to huge conglomerate, Siemens, from Germany.
Siemens is a good example of an evolving old style engineering firm that has broadened out into interests from process industries and drives, steam turbos, power generation, to wind power and financial services.
All this century heavy engineering has been trying, like Siemens, to morph its core businesses into something less cyclical, more versatile, more ecological and sustainable – and more profitable.
In the US heavy engineers include General Electric, General Dynamics, Boeing and Lockheed Martin. Lockheed is the world’s largest defence contractor on revenue. In 2013 the Pentagon paid out nearly 10% of its revenue to Lockheed.
In Europe there is the multi-national aerospace and defence Airbus Group. In the UK industrial sector big names includes ammunition, artillery systems and missile launchers made by BAE Systems (BA LON).
There is also diversified engineer Smiths Group (SMIN LON), aerospace and automobile components firm GKN(GKN LON), and QinetQ (QQ LON) which is exclusively defence.
Tapping into defence
Defence is a big chunk of heavy engineering, where contracts, information and intentions are probably the least transparent of all stock market sectors.
But as with all heavy engineering, defence contractors have had to become more imaginative about what they pitch for and undertake, and they are looking for new customers from the emerging markets, moving away from their historic links like NATO.
PWC’s Engineering Trends - Aerospace & Defence 2017 shows that spending in North America and Europe defence budgets declined in 2014. The Middle East, India, South Korea and Japan saw an increase in spending, topped by Saudi Araba (54%) and UAE (23.9%).
Getting that contract
In global business successful trading is all about building relationships and adding value with strong emphasis on fine tuning sales, programmes and joint ventures.
Engineering is also trying to meet the demands of many countries which have complicated histories, politics, economies, agendas and an unfamiliar way of doing business and awarding contracts.
An example of involving importing technologies and using local capability is a joint venture in India between Boeing and Tata Advanced Systems where they will produce together Boeing AH-64 Apache helicopter fuselages.
Long term service agreements
Engineering has also been trying to get away from its hardcore business to boost income, and general stock market credibility.
This is characterised in terms of devising contracts with long term service agreements. The idea is to generated much needed income and support the lean years.
Rolls Royce (LON RR) is the world’s second largest aircraft engine maker after the US’s General Electric, with global reach for its Trent jet engines.
RR was a pioneer in the business of persuading principals to buy service contracts that lasted the life time of the engine, and many firms have followed this successful approach, including GEC.
Another way for heavy engineering
Another trend is for industrial engineers to diversify further down the industrial supply line, buying smaller, niche and complementary industries which could provide cash flow.
An example of the current fashion to regroup is the French locomotive manufacturer Alstom’s decision to sell its power generation and electrical transmission business to General Electric in 2015.
Smaller industrial UK engineering companies to watch out for include classic aerospace equipment firm Meggitt (LON MGGT), based in Bournemouth. Also machine tool and precision components firm 600 Group (SIXH LON).
There is also high precision engineer Renold (LON RNO), and world reputation in the fluid power industry, Fenner(LSE FENR).
They are all in the business of arranging their products competitively, while keeping a weather eye on predators.
Should I go for this sector?
Heavy engineering is not an easy sector to try and imagine, unlike retail or computer software. The sector is keen to re position itself and many firms want to make intelligent purchases and joint ventures to achieve contracts.
There are constraints as to how defence markets win projects. One analyst deplored the fact that the sector was too reliant on government financing, so assessment of share value was not easy.
With a global mood of heightened security against terrorism, defence contracts are in rising demand in emerging markets. Greater civil aircraft demand is also thought to be upcoming among economies with a growing middle class who can afford travel.
Rather than look at the growth of share prices in the sector over the last six months, mirroring the current bull markets, investors should think in terms of value.
Does a company have quality earnings? How much debt does it have? What about its ecology and social responsibility record? Heavy engineering is under pressure to improve here?
Beware over pricing
Even when these boxes are ticked, a company with demonstrable sound fundamentals could in fact be just plain over-priced.
For example, fund manager at Jupiter, James Clooney said, "The UK’s industrial fluids specialist Spirax Sarco Engineering (SPX LSE) is now over-priced." He said the same of specialist safety health and environment technologies firm Halma.
Spirax saw its share price jump recently when it made an acquisition, but some analysts saw this as an over-reaction and have said take profits.
Fund managers think a lot about ‘management incentives’ when considering a company. Assessing what motivates managers is central – why and how do they wish to improve earnings per share, how do they research a particular project and whether they provide better data and insights.
The markets have helped share prices
There are many US, UK and European engineering stocks that have appreciated in tandem with current bull markets. Another contributor to strong share prices has been President Trump’s election.
The hope is that there will be a green light for major US infrastructure spending, not least the Mexican wall. Note that trading in US aerospace and defence ETFs has been busy of late.
What could affect the share price?
Bribery in a word. Again and again the defence industry is caught making bribes. Companies bribe the buyer to clinch a sale. Take Lockheed Martin, it recently paid huge sums in legal settlements for corruption.
A suggestion of a bribery scandal can hit the share price and can depress a company’s standing, sometimes for years while investigations and hearings take place.
How can a share buck the trend?
A value, quality contract or acquisition for an engineering firm often lifts the shares, regardless of what other shares in the sector are doing (Spirax-Sarco). A rumour can also send a share price sky high, exciting for the investor, but for how long?
What to look for in the accounts
- The Beneish M-Score. Relevant and very useful, particularly in defence manufacture, this is a statistical model using financial ratios plus accounting data. It tests whether a company has manipulated its earnings.
- Rapid asset growth - be aware of signs in the balance sheet of rapid asset growth. Investors get excited if there is asset growth, and enjoy the share price rises, but it has to be quality asset growth and not a short term, poor value purchase.
What else to look out for?
This sector is particularly full of diverse information about complex products and systems involving many different scientific disciplines, around the world. As with any investment it makes sense to keep in touch with sector news, monitor share performance.
It takes time to be able to assess whether these big and small engineering firms have potential to make money in a highly competitive market. There is a lot to look out for.