Stocks to Buy as Manufacturing Revives

Smokestack industries are staging a revival, and you can still get in at a good price.
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Editor's Note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on

TheStreet.com.

It ain't real fancy, it ain't real pretty, and it ain't gonna make the cover of too many magazines, but the evidence is undeniable: U.S. factories are back in business not too long after they had been left for dead by skeptics, doomsayers and political opportunists.

As a result, familiar names out of the American heartland, such as

Ford

(F) - Get Report

,

Ingersoll-Rand

(IR) - Get Report

,

Caterpillar

(CAT) - Get Report

,

U.S. Steel

(X) - Get Report

,

Alcoa

(AA) - Get Report

and

Goodyear Tire and Rubber

(GT) - Get Report

are the unlikely first-half heroes of the stock market in 2007, racking up grease-stained gains of 25% to 65%.

And after so many years in the wilderness, most are still so cheap that they look like strong prospects to keep on muscling forward during the rest of the year.

Amid the fearful pause on Wall Street precipitated by a few greedy mortgage bankers and hedge-fund types this month, you might be excused if you believe that stocks are on their last legs.

But that's unlikely to be the case. Leaders this year are not the dot-com clickin', real-estate flippin' yahoos of years gone by. This is a steak-and-potatoes, eat-your-spinach kind of market, in which investors have rolled up their sleeves to research and buy shares of companies that are focused on the hardworking underbelly of industrial manufacturing.

Cheshire CAT

Despite recent GDP growth numbers that bordered on the zero line in the first quarter, U.S. makers of things have beaten out their flashier services-providing kin to win the hearts of real customers -- not just investors.

April, May and June data produced by the U.S. Department of Commerce show that factories are experiencing a material rebound in durable-goods orders, capital expenditures, capacity utilization and expansion after several years of drift. GDP growth in the second quarter is going to shock a lot of people as it inches back toward 3%.

It's not just domestic demand that's kicking up the numbers. America is making high-quality things that the rest of the world wants -- from motion sensors and conveyer belts to diesel engines, truck tires and jet aircraft -- and we are selling bundles of them. Consider Caterpillar, whose shares are up 31% this year after dozing all of 2006.

Now in the low $80s, Caterpillar will steam toward $100 over the next year, I believe, even if not a single new house is built in the U.S. Revenue growth and earnings growth are unlikely to top much more than 7% and 13%, respectively, so the key to a higher valuation for Caterpillar will be an expansion of its

price/earnings multiple as investors get increasingly comfortable with its vital role in the long-term build-out of the Asian economy.

This isn't because China is important to Caterpillar as an end market, but because Asia is the main market for most of the companies to which Caterpillar sells. In other words, all the world's energy explorers and producers, miners, electric power generators, heavy construction providers and industrial manufacturers that sell things in or to Asia are the most important customers for Caterpillar today -- not U.S. homebuilders, as in years past. Almost 60% of the company's total revenue comes from customers for whom China is the principal customer, and India isn't too far behind.

Put another way, strength in global industrialization and urbanization are trumping any softness in U.S. end markets for industrial manufacturers like Caterpillar. I estimate the company will haul in $48 billion in revenue next year, and I believe investors will be willing to pay up to 1.5 times that amount for shares.

Doubts Abound

This type of

multiple expansion showed up big-time in the 200% recovery in

Boeing

(BA) - Get Report

shares that has transpired over the past four years. People were skeptical that Boeing would survive its political scandals, management behavior embarrassments and Sept. 11-related commercial setbacks, but its U.S. engineering and sales teams have proved the skeptics wrong, quarter after quarter.

Now I believe we see, again, a situation where there are a tremendous number of skeptics on the Caterpillar, Ingersoll-Rand and Goodyear stories, as most American analysts just cannot seem to look beyond the U.S. home-construction part of their business and see the sales they're winning in the Middle East, Latin America and Asia.

And it's not just the big companies that are racking up sales. A lot of smaller manufacturers are finding favor with applications ranging from new ethanol-processing plants to steel mills. Take, for instance, a small Wisconsin company called

Magnetek

(MAG) - Get Report

. It makes digital power control systems for material-handling applications, such as overhead cranes in factories, as well as for elevators.

Magnetek, like many others, is seeing sales advances on the widespread modernization of U.S. factories. Where plants used to have workers hauling heavy or dangerous materials from place to place on the floor, and later used hoists on long cables operated by a guy in a booth, they are now using computer-programmed cranes fitted with wireless sensors operated by remote control.

Although these plants save money by hiring fewer workers, the jobs move to a company such as Magnetek that is making the electronics. Magnetek sells to 600 of these crane contractors that are retrofitting power, auto, chemical and steel plants.

Robert Murray, vice president at Magnetek, told me that the factory modernization business is growing at double-digit rates with 30% margins. Another division of the company is automating coal mines by providing small electric motors and motion sensors for underground haulage carts -- replacing diesel and gas engines, making the business not just more efficient but also safer. A second division makes motors for coal-gasification plants run by utilities such as

FPL Group

(FPL) - Get Report

, which crush the hard carbon into a fine dust that can be ignited to turn turbines with less toxic emissions.

Energy From Gravity

However, the biggest growth opportunity for Magnetek, which was spun out of the great old electronics conglomerate Litton Industries two decades ago, is in making digital-power inverters for the wind- and solar-power industries. Its products turn the DC power created by clean energy producers into highly controlled AC currents that can be fed efficiently into the utility power grid.

The same devices are sold to hydrogen fuel-cell makers, whose products are fully out of labs and into heavy industrial use. Customer

United Technologies

uses them in large-scale hydrogen fuel cells sold as backup generators to telecom giant

Verizon Communications

(VZ) - Get Report

.

One more division makes "regenerative" control motors for elevators in skyscrapers that actually turn the descending energy into AC current that can be stored in batteries or fed out to the power grid.

Multiply the heavy industrial progress made by Caterpillar and Magnetek across the country, and you can see why there's a real revival of interest in these companies by prescient, patient value investors. Magnetek, which is now restructuring, should return to full profitability next year with double-digit growth and 30% margins. My 18-month target is $8, or 60% higher than the current quote.

The industrial recovery may not be the sexiest story in the market, but it should persist for some time. So look for ways to get in on the factory floor with these stocks amid any broad-market weakness sometime over the summer.

At the time of publication, Jon Markman did not own or control shares of companies mentioned in this column.

Jon D. Markman is editor of the independent investment newsletter The Daily Advantage. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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to send him an email.