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Defensive Growth Plays for a Manic-Depressive Market

Jimi Hendrix’s 1967 song “Manic Depression” should be the anthem of this stock market. After plunging last week, the markets sharply rebounded on Monday as investors shrugged off political tensions at home and abroad.

The bull market still shows life but beneath the ebullience runs an undercurrent of anxiety, as traders contend with excessive valuations, war drums in the Korean peninsula, and the spectacle of neo-Nazis killing protestors on American streets.

Below, I highlight two basic materials stocks that offer both portfolio protection and growth. These companies are “picks-and-shovels” plays that provide the essential building blocks for sectors that are thriving right now. As such, these stocks are defensive growth plays well suited for a moody market.

Geopolitical and domestic worries have weighed on the broad indices in recent days and yet stocks remain in a secular bull market. Despite mounting anxieties and rising interest rates, better-than-expected corporate earnings are keeping stocks aloft.

The markets plummeted on Thursday and recovered only slightly on Friday, racking up the second worst week of the year. But Wall Street acted giddy again on Monday, with the Dow Jones Industrial Average and the S&P 500 closing out the day with gains of 0.62% and 1.00%, respectively. Helping restore confidence on Monday were robust corporate operating results across the board, as well as statements from U.S. military leaders that emphasized a diplomatic solution with North Korea over its nuclear missile program.

Crisis? What Crisis?

It begs the question: how long before another crisis sends traders reaching for the Xanax? The Trump administration is likely to create uncertainty for as long as it holds power. That’s why investors are smart to focus on certain key sectors, notably aerospace/defense, high technology and automobile manufacturing, which are positioned to provide steady growth this year regardless of the market’s ups and downs.

A surer and safer way to leverage the durability of these segments is to invest in companies that provide them with basic materials.

Two salient opportunities now are Hexcel (NYSE: HXL), the leading producer of carbon composites, and Allegheny Technologies (NYSE: ATI), the dominant maker of titanium.

Two of the strongest and most valuable materials in existence are carbon composites and titanium. They’re crucial in the manufacture of a wide range of products, in both the military and commercial sectors.

These specialty materials are vital to various manufacturing processes, but they’re in limited supply and susceptible to disruption. As opposed to precious metals such as gold, these substances are so crucial that many major industries would grind to a halt without them. The time to invest in specialty materials is now, as global recovery boosts demand for them.

To be sure, the recovery remains wobbly. In the U.S., the immediate fear is that rising interest rates and declining investment in the energy patch due to falling oil prices will impede the American expansion and pull down overseas markets.

However, Hexcel and Allegheny offer defensive growth that should persist even in the face of market pullbacks. I also like them because they’re mid-cap stocks with greater room for capital appreciation than the overvalued behemoths that have been disproportionately sustaining the bull run. Let’s examine each.

Hexcel: In The Driver’s Seat

Composites are the most important materials to be adapted for aerospace since the use of aluminum in the 1920s. The application of these materials is sweeping all sectors of aerospace and a host of other major industries as well.

Broadly defined, composite materials represent the combination of inherently dissimilar materials, usually involving carbon, to form a strengthened combination. These hybrid materials yield remarkable results in weight reduction, strength and flexibility. Composites also are key components in automobiles, alternative energy devices (e.g., windmills), sports equipment, luxury consumer goods, and other products.

With a market cap of $4.7 billion, Hexcel is the largest U.S.-based producer of carbon fiber and the number one producer of aerospace composite materials. The commercial and military aviation sectors are soaring, providing multi-year tailwinds for Hexcel.

As the chart below shows, the forecasted five-year (2015-2020) compounded annual growth rate for carbon composite demand is 9.21%.

Global Demand for Carbon Composites

Source: Statista; Hexcel (*estimated)

Hexcel is the chief composite supplier for aerospace giant Boeing (NYSE: BA), manufacturer of the game-changing Dreamliner 787, a composite-built passenger aircraft. Aircraft made from composites enjoy reduced weight, improved fuel burn, and better resistance against corrosion and damage. Hexcel customer Boeing has been on a tear, enjoying a flood of new commercial and defense orders. BA shares have risen 52.2% year to date and the aircraft maker’s order book should remain healthy for years, which is great news for its supplier Hexcel.

Hexcel reported second-quarter earnings per share (EPS) of 67 cents, compared to prior year EPS of 70 cents. Revenue of $491.3 million came in 6% lower than the same quarter a year ago. However, the revenue and earnings shortfalls were largely due to delayed orders that are on course to perk up in coming quarters.

The average analyst expectation is that Hexcel’s year-over-year earnings growth will reach 12.5% next quarter, 3.9% in the current year, and 12.3% next year. My calculations show that the company’s five-year earnings growth over the next five years should come in at 9.1% on an annualized basis.

With a forward 12-month price-to-earnings ratio (P/E) of 19.6, Hexcel’s valuation is roughly in line with its sector of industrial goods.

Breaking the Sales Barrier

Named after the Titans of Greek mythology, titanium boasts the highest strength-to-weight ratio of any metal. In its unalloyed form, it’s as strong as some steels but almost 50% lighter.

The resurgent aerospace sector is especially hungry for titanium. As noted above, carbon fiber composites are in great demand for aircraft construction and represent a promising investment theme, but today’s advanced flying machines also require titanium — lots of it.

Despite its name, Allegheny Technologies isn’t a technology stock (and this fact makes it less volatile). The company operates in three segments: High Performance Metals, Flat-Rolled Products and Engineered Products.

The High Performance Metals segment provides various alloys, including those based on titanium, nickel, cobalt, and zirconium, primarily in the form of ingots, bars, rods, wires, seamless tubes, precision castings, and machined parts.

The Flat-Rolled Products segment provides most of the same alloys, in the form of plates, sheets, engineered strips, and precision rolled strip products. The Engineered Products segment offers tungsten in the form of powders, carbide materials and carbide cutting tools.

In the U.S., the aerospace industry accounts for more than 70% of titanium demand, while industrial applications predominate in other countries, such as China.

Oil and gas engineering applications also pose a major growth opportunity for Allegheny. Energy prices are currently more than 50% off their highs of mid-summer 2014, but they’ll inevitably bounce back. Regardless, energy producers will always need the company’s super-strong products.

The search for hydrocarbon reserves is going deeper and farther, into remote areas far beneath the ocean surface that were once considered impossible to tap for oil and gas production. Titanium alloy materials are crucial for the construction of oil pipelines and well tubing, which are the key elements of offshore platform equipment and sub-sea wellheads.

Titanium materials for energy applications are not only tough but also corrosion resistant and able to withstand virtually any natural environment, with no service life restrictions. This makes them ideal for the frequently harsh operating conditions of the energy patch.

Allegheny reported second-quarter revenue of $880.2 million, a 9% increase compared to the same quarter a year ago. Earnings in the second quarter came in at $10.1 million, or EPS of 9 cents, compared to a net loss of $18.8 million or a per-share loss of 18 cents in the same year-ago quarter.

A major driver of growth for Allegheny in the second quarter was demand for materials used in jet engines, especially for combat fighters. Aerospace/defense sales in the quarter posted a year-over-year jump of 5%. This demand should remain robust, as Pentagon spending soars under the hawkish Trump administration.

With a forward P/E of 45.9, ATI shares are a bit pricey compared to peers. However, as a mid-cap stock (market valuation: $1.9 billion), Allegheny should outperform its larger cap brethren this year.

If you’re looking for peace-of-mind growth plays in a crazy market, these two stocks fit the bill.

 

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