Long-Term Investments in the Global Economy

Alvin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The global economy is struggling. France, in an aggressive effort to reduce its deficit, is implementing a 75% tax on earnings of over one million Euros (CNBC). Spain’s and Greece’s unemployment rates are at 25.1% (Irish Examiner) and 24.4% (Bloomberg), respectively. Meanwhile, the US unemployment rate has been hovering above 8% (Ycharts) and had a record 46.7 million people on food stamps in June.

Caterpillar (NYSE: CAT), whose large global operations make it a good barometer for the health of the global economy, recently lowered its earnings guidance for year 2015. Caterpillar CEO Doug Oberhelman said, “There are a number of geopolitical and economic factors driving uncertainty in the world today, but our base case scenario calls for modest global economic growth over the next few years.”

The global economy is bad. However, investors should keep a long term view. Over the last century, people endured the Great Depression, WWI, WWII with the dropping of two atomic bombs on Japan, the Cold War, and the 1973 Oil Crisis. Still, from year 1900 to year 2008, the S&P 500 grew at a 9.21% compounded annual rate (The Ivy Portfolio). It is an impressive return.

One of the best ways to invest in the long-term growth of the global economy is through the industrial goods sector. Industrial goods companies produce essential products that are mainly used by other companies for construction, manufacturing, mining, etc. Keeping a long term view and taking into account the weakness of the global economy, a return on assets (ROA) of at least 10% and a PE ratio below of 10 were used to filter through the companies in the industrial goods sector.

An ROA screen of at least 10% is used to find companies with strong assets and good management. A PE screen of less than 10 is used to minimize risks. Due to the current global economic problems, companies with a high PE will have a very hard time justifying their valuation through growth. The following table sums up the four companies that passed the screens (note: stocks that are thinly traded were ignored and Caterpillar is included as a benchmark).

<table> <tbody> <tr> <td> </td> <td><span><span>ROA</span> (<span>ttm</span> %)</span></td> <td>5 Year Avg Sales Growth (%)</td> <td>PE Ratio</td> </tr> <tr> <td><strong><span><span>Cummins</span></span></strong> <span class="ticker" data-id="203143">(NYSE: <a href="http://caps.fool.com/Ticker/CMI.aspx">CMI</a>)</span></td> <td>17.15</td> <td>9.7</td> <td>9.2</td> </tr> <tr> <td><strong>Joy Global</strong> <span class="ticker" data-id="204148">(NYSE: <a href="http://caps.fool.com/Ticker/JOY.aspx">JOY</a>)</span></td> <td>13.35</td> <td>12.89</td> <td>8.0</td> </tr> <tr> <td><strong><span><span>Timken</span></span></strong> </td> <td>13.05</td> <td>0.78</td> <td>6.6</td> </tr> <tr> <td><strong><span><span>Kennametal</span></span></strong> </td> <td>10.74</td> <td>3.85</td> <td>9.8</td> </tr> <tr> <td>Caterpillar</td> <td>7.43</td> <td>7.69</td> <td>9.6</td> </tr> </tbody> </table>

Cummins produces diesel engines, Timken produces friction and power transmission products, Joy Global produces mining machinery, and Kennametal produces products used in production processes. Of the four companies that passed the filters, the best long term investments look to be Cummins and Joy Global because of their size, growth, and strong free cash flow.

Joy Global produces surface and underground mining equipment for the mining of coal, copper, iron ore, oil sands, and other minerals. Over two-thirds of the company’s revenue comes from coal mining companies. Recently, the coal mining industry has been facing downward pressures from a slow economy and the natural gas boom in the US. In its Q3 FY 2012 earnings release, Joy Global stated, “As noted, U.S. coal has experienced the most severe decline, driven primarily by lower electricity demand and electricity generators switching to natural gas.” However, coal is the most abundant fossil fuel on Earth and in the US. The US has 25% of global coal reserves and has the largest coal reserves in the world (US DOE). Thus, despite current problems and environmental concerns, the long term prospects of the coal industry and Joy Global are good because of the sheer amount of coal available for energy use. The biggest knock on Joy Global is its sky high price to tangible book value ratio of 11.5. Thus, Joy Global is the riskier investment.

On the other hand, Cummins is a big manufacturer of engines. The company operates in four business segments: Engine, Components, Power Generation, and Distribution. The Engine segment manufactures diesel and natural gas engines, Components produces products that are related to the engines (e.g. fuel, intake, and exhaust systems), Power Generation produces components that are used in power generation systems, and Distribution distributes products to customers. Overall, the company is performing well despite the weak global economy. In its Q2 report, the company reported a decrease of four percent in revenue year over year, but delivered record gross margin.

In summary, the global economy is facing serious problems. However, investors should keep a long term view and one of the best ways to invest in the long term growth of the global economy is through industrial goods stocks. Two companies that stand out from its peers are Joy Global and Cummins. The two companies produce products that are essential to the modern world. Joy Global produces mining machinery and Cummins produces diesel and natural gas engines and power generation components. The companies have ROA’s above 10%, PE ratios below 10, strong growth, large global presences, and strong free cash flows. A PE ratio of below 10 provides a good protection against a drop in earnings. Of the two, Joy Global carries more risk because it has a high price to tangible book value of 11.5. Regardless, Joy Global and Cummins should be good long term investments in the global economy.

Dig Deeper

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Alvin has no positions in the stocks mentioned above. The Motley Fool owns shares of Cummins. Motley Fool newsletter services recommend Cummins and Kennametal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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