FTSE 350: All about earnings for engineers in 2014

For us, a number of long-standing buy tips proved dependable once more. GKN (GKN) had an incredible year as its £633m acquisition of Volvo's aerospace division began to deliver the goods. Big-money purchases beefed up earnings at paper and packaging giants DS Smith (SMDS) and Mondi (MNDI), too. And despite conglomerate Smiths Group's (SMIN) failure to sell its medical division for a second time, its share price, like the others, is near a record high.

Repeating last year's feat will not be easy. Then, a dramatic re-rating proved a huge tailwind, driving average sector valuation multiples up by almost 20 per cent. The FTSE All-Share industrial engineering sector currently trades on a forward PE ratio of 17, compared with nearer 14 a year ago. That's close to peak levels, which suggests to us that the re-rating cycle is over and that share prices will keep rising only if the pace of earnings growth picks up.

What, then, are the chances? Well, the economic recovery both here and in the US certainly appears credible, and while anticipated growth of 1 per cent in Europe might not seem much, it is growth nonetheless, the first since 2011. Recent data has been positive. The eurozone manufacturing PMI reading was at its strongest in two and a half years last month, which bodes well for the first quarter of 2014.

But even if a global recovery is under way, concerns remain. "End markets remain tricky, capital is tightly controlled and management teams continue to strike a cautious tone given the range of potential economic and political risks," says broker Investec. "For the most part, our forecasts assume modest revenue growth on flat margins, consistent with this."

We'll find out more when the results season kicks off in mid-February. Investec doesn't expect much. "We do not expect to upgrade forecasts for the majority of stocks we cover before the summer at the earliest," it says. The implication is that much has already been priced in. But there is always the chance of a surprise. Number crunchers at Numis admit their forecasts for earnings growth to more than double to 7 per cent this year could prove conservative.

Auto demand and commercial aircraft growth is already tipped to drive double-digit EPS growth at GKN this year, and at 2013 laggard Weir Group (WEIR), where key indicators are improving. However, sterling strength, particularly against the US and Australian dollars, continues to put pressure on overseas earners' profits. True, it benefits groups with dollar-denominated debt, but a recent warning from Fenner (FENR), which implies no growth for the company this year, is a reminder that the currency problem remains. Any re-rating there will have to wait.

Of course, earnings growth can be acquired, too, and acquisitions remain high on the agenda. Weir, Rotork (ROR), Bodycote (BOY) and Spirax-Sarco (SPX) all have both the fire-power and inclination to do deals, and GKN is apparently mulling a $250m (£153m) bid for two of Spirit AeroSystems' US factories, which make wing parts for Boeing jets. But British companies could face stiffer competition from cash-rich American heavyweights in 2014. After a quiet year for takeovers in 2013, activity is expected to pick up in the months ahead, especially if the eurozone recovery becomes more established.

One company that excels in deal-making is Melrose Industries (MRO). Having offloaded four businesses last year, the engineering turnaround specialist is returning £600m, or 47p per share, to shareholders. Management is hotly tipped to make another big buy in 2014. We're tracking this one closely. IMI (IMI) has been selling, too, and will hand back £620m, or 200p per share, in March. Of more interest is what new chief executive Mark Selway, who took over from long-serving Martin Lamb just weeks ago, has planned. We're keeping our powder dry until we hear more, given an already full valuation.

FAVOURITES:

GKN has the clearest catalysts and remains our pick of the bunch. DS Smith is up there, too, and Weir should have a stronger year. US oil rig count, gas prices and other key data is on an improving trend, and speculation about possible bid interest from General Electric as recently as December should dissuade the short-sellers. Shares in both GKN and Weir trade at a discount to the sector.

OUTSIDERS:

Rotork and Vesuvius (VSVS) remain vulnerable on valuation grounds. While Rotork's consistency through economic cycles deserves recognition, a premium to peers of 40 per cent looks overly generous; there's clearly better value elsewhere. The same can be said of Vesuvius's shares, which have rocketed since the Cookson split over 13 months ago, narrowing the historic discount to the sector dramatically.