FTSE 350 Review: The best manufacturing stocks

The divergence in the share price performance of FTSE 350 engineering companies last year was due in part to the state of end markets. The continued recovery in the aerospace sector, where demand for new planes is strong despite Boeing’s (US:BA) recent travails, means that companies with the greatest exposure, such as Melrose (MRO), have outperformed – its share price rose by over 80 per cent last year. The automotive sector, too, rebounded after the global shortage in semiconductors eased, allowing carmakers to ramp up production to meet demand backlogs.

It's been more of a struggle for the broader manufacturing sector, though, with the FTSE 350 Industrial Engineering Index down 9 per cent over the past 12 months. Companies have been faced with customer destocking as supply chains normalised and end-user demand waned.

Purchasing managers’ index data on both sides of the Atlantic remained firmly in negative territory at the end of 2023, but survey respondents were more positive about prospects for this year. Although “pockets of destocking will likely persist” in the first half of the year, more companies will move towards restocking as 2024 progresses, RBC Capital Markets analysts argue.

For FTSE-listed companies, too, Peel Hunt’s analysts suggest that this year has started “with the sense that the cycle is through the worst”.

Companies are reporting “early green shoots in terms of order intake in Europe”, while the North American market remains robust, backed by billions of dollars being poured into infrastructure investments.

Overall, this translates into a forecast of “flat-to-low” single-digit organic growth. But with pricing levels holding up and cost bases remaining lean, any increase in volumes should feed through to companies’ bottom lines, the broker thinks.

Moreover, falling interest rates and the low valuations attached to many smaller, or financially weaker, companies in the sector also provide scope for consolidation, according to Deutsche Bank analysts.

Others are not so optimistic. JPMorgan points out that manufacturers’ margins look “stretched” compared with pre-pandemic levels, with forward earnings per share for Europe’s capital goods companies now approaching 8 per cent of sales, compared with a long-run average of 6 per cent.

UBS analysts expect UK industrials companies to face “difficult” trading in the first two quarters. Its “short cycle indicator”, which tracks near-term demand, remained in negative territory for the 19th month in succession in December, meaning new orders were still coming in lower than the level of inventories being produced.

Taking a longer-term view, there are plenty of opportunities in the drive towards a greener economy. Although there’s been “a lot of rollback” on consumer-focused parts of the energy transition, particularly in the UK, there is still a need to overhaul electricity networks, says Bernie Ahkong, co-chief information officer of hedge fund UBS O’Connor.

Ahkong said one US-based utility to which the fund recently spoke had 100,000 transformers on its grid that were built to last for 30 years. The average age of these is now 40 years, and "a third of those transformers were built before 1950”, he notes. Adding lots of EVs to a grid whose components were built so long ago is “clearly not tenable”.

Factor in the revenue benefits already starting to filter through from higher North American infrastructure spend, as well as favourable dynamics in aerospace and automotive supply chains, and current valuations “do not reflect these opportunities, in our view", Peel Hunt’s analysts assert. According to the broker, the aggregate valuation of all the FTSE-listed industrial engineers is 15 times forecast earnings, well below the five-year average of 24 times.