An end-of-year rally in 2013 spurred hope that industrials were finally set to return to pre-recession form in 2014, yet currency headwinds and sagging economic growth in Europe, China and the US, wreaked havoc across the sector. Sterling strength, in particular, significantly slashed operating profits for an industry full of exporters, and played a crucial role in pushing down share prices.
Sterling, buoyed by the strengthening economic picture here in the UK, emerged as the world's strongest currency for large periods of 2014, which in turn put pressure on overseas earners' profits. But the US dollar has started to rally hard in the past few months, providing some breathing space for companies with business interests across the pond.
Economic meltdown
On the other hand, those with large client bases in Europe will not be pleased to see the euro continue to depreciate, or that second-quarter output in the eurozone was flat. Worse still, output in Germany, the continent's economic powerhouse, has contracted after restrictions were placed on Russia - one of its main trading partners.
As an indicator of the ongoing gloom facing the troubled eurozone, the latest Purchasing Managers' Index (PMI), which is based on surveys of thousands of companies across the region, slumped to a nine-month low of 52.3 in September. Such dreary news could prove costly for box maker DS Smith (SMDS), which makes two-thirds of its profits in the eurozone, and Mondi (MNDI), whose packaging business is relying on structural demand in Europe to improve.
A large number of players in this sector are also reeling after China's continued slowdown. Triggered by a slumping property market, China recently posted its weakest industrial-output expansion since the global financial crisis and shows no signs of displaying the growth potential of a few years ago. This could have implications for GKN (GKN), which has benefited from car market growth in China, and Spirax-Sarco (SPX), whose first-half reports showed flat sales and lower profits in the country previously renowned for its booming industrial sector.
On a more positive note, US growth finally appears to be back on track after contracting in the first quarter of this year. The latest outlook from the National Association for Business Economics forecasts that the economy will grow at a rate of 3 per cent in the second half of this year and the same in 2015, giving the country its strongest annual growth rate in a decade.
These encouraging figures were no doubt aided by the news that the Federal Reserve will continue to pursue its ultra-low interest rate policies for the foreseeable future, which should ensure that stronger growth is not suddenly derailed by rising borrowing costs. Some, like Weir Group (WEIR) and RPC Group (RPC), have already started to reap the benefits of improving US markets, while both Smiths Group (SMIN) and Bodycote (BOY) will be praying that defence spending there picks up as a result.
Mixed end-market fortunes
Geographical growth disparity aside, the sector's various end-markets also yielded very different results. Most damaging of all was the mining sector, where weaker metal prices and an investor backlash forced miners to slash spending.
Fenner (FENR) has been the biggest casualty of waning demand, with weak sentiment in the US coal industry hurting its core conveyor belt division and leading to a profit warning in May. Weir also suffered weak demand for its mining kit, although buoyant oil and gas markets helped compensate.
Many anticipated that oil and gas would falter like the mining sector yet, to date, quite the opposite has happened. With brent crude still trading around the $100 (£62) mark per barrel, and interest in shale gas growing, the likes of Weir have every right to be optimistic. Bodycote also benefited from strong demand in this sector, which helped offset its weaker aerospace division, while Smiths Group's defence and medical woes were eased by the solid performance of its oil equipment supplier, John Crane.
Re-rating sparks takeover hope
Given the obstacles faced by most in the sector, share prices have fallen significantly from their lofty heights earlier in the year. Share prices in the general industrials and industrial engineering sectors, for example, are down 9 per cent and 13 per cent, respectively, from levels reached in mid-May.
This re-rating could serve as an ideal entry point for investors and reinvigorate a fairly stagnant period of M&A activity. Some brokers continue to predict imminent market movement, but David Larkam at Numis reckons that unrealistic valuations and low market visibility continue to hinder hopes of corporate takeovers." There have not been many corporate takeovers in the past 18 months because the sector is relatively well valued and when people put a premium on top of what they want it doesn't work out for them," he notes.
Nonetheless, one company that could spring into action is Weir, which is reported to be looking for acquisitions to boost its growing shale gas operations. Furthermore, Mark Selway's bold strategic review has factored in bolt-on acquisitions to expand IMI's (IMI) product range, while Melrose Industries (MRO) recently acquired Eclipse, a manufacturer of gas combustion components, to integrate with its highly profitable Elster business. Rotork (ROR), too, has made shrewd, small-scale acquisitions of late, including the purchase of a Korean maker of valve positioners in March, which contributed £10.7m of revenue to its latest half-year results.
Outperformance indicators
According to analysts, M&A activity could be key to improving lacklustre capital expenditure, with most agreeing that companies should be spending more on research and development (R&D) to improve their fortunes. Ben Bourne at Liberum says that a capex recovery is now due, and seems to be on the mend again after years of investment drought. In fact, following some fairly disappointing results in August, the likes of Fenner and Smiths Group both outlined plans to invest more in product innovation, while Mr Selway at IMI has been very vocal in his plans to spend more revenues on R&D.
Mr Bourne is particularly impressed by IMI's new leader, and feels shares have adjusted since he brought in a "clear medium-term plan". In a period of low growth and margin pressures, the Liberum analyst reckons outperformance will be linked to structural growth and self-help strategies.
Nick Wilson, senior analyst at Espirito Santo Investment Bank, meanwhile, sees no room for positives and predicts that 2015 will fare no better than this year. "The current pace of slowdown in both China and Europe could easily continue into the first half of 2015. Also, we have price deflationary pressures and a lack of capex spend recovery," he notes.
"My concerns are that, both within the sector and also more in general across the cyclicals space, analysts still have far too optimistic assumptions in their models for FY15 potential top-line organic growth."
Favourites
Widespread de-ratings means there are some bargains amid the rubble of troubled stocks. GKN (GKN) remains our pick of the bunch (Buy, 380p, 24 April 2014) as it is profiting nicely from aerospace demand and a booming global car market, yet surprisingly trades on a sector low of 11 times forward earnings. Another favourite is RPC Group (RPC) (Buy, 610p, 29 May 2014), whose shares also appear undervalued, given its solid first-half results, shrewd, margin-boosting acquisitions and growth in the economically improving US.
Outsiders
With the mining sector showing no clear signs of a turnaround, Fenner (FNR) will have to follow through on its plans to invest more in oil and gas if it is to have any chance of offsetting flat US coal markets and pricing pressures in Australia. Smiths Group (SMIN), too, could face another difficult year in its medical and defence divisions, even if a strengthening dollar should translate into lower currency headwinds for the engineering conglomerate.
