Investment: Should you invest in... engineering?

ENGINEERING FIRMS have had a torrid time over the past two years, as a strong pound and high interest rates battered the export-led sector. But this does not mean investors should ignore these companies.

"We are reasonably positive about engineering stocks for the long-term," says Geoff Miller, head of research at Brewin Dolphin Securities. "We are actually looking for greater exposure to companies in these cyclical sectors."

But you have to be selective.

Hugh Priestley, investment director at stockbrokers Rathbones, says: "It is a very disparate sector. There are lots of small companies looking for M&A activity and we have seen some bids.

"But investing on that basis is like playing the lottery. You might get lucky and find a company or two that might be bid for, but there is a high probability you will not."

Miller suggests investors concentrate on firms with identifiable product niches. "There are very solid businesses, such as GKN, Senior and Bodycote, that are generally supplying products that are being outsourced, particularly to the automotive industry," he says.

"This means such companies can continue to grow their businesses because the demand for their outsourced products is growing."

Vicky Wong, an analyst at stockbrokers Killik & Co, says: "The attractive stocks are the makers of niche products, such as Rolls-Royce engines.

"If they can establish such a niche, companies are in a winning situation because it means they have the best technology and are making products needed by their customers. If not, they're in trouble. There's still a handful of small companies just producing traditional tools. Manufacturing is declining so there's no demand for these products."

The problem is there are not many of these paragons around.

"Many companies are still suffering the aftermath of having multiple non-core businesses," adds Wong

Priestley says: "There is a distinction between aerospace and defence companies and the rest of the sector.

"I have reservations over British Aerospace because of problems with its Saudi deal. But if the oil price recovers and payments are received on time British Aerospace will look a lot better."

Priestley sees this as a relatively resilient section of the market, but Vicky Wong is not so sure. "The problem for European companies in the defence sector is that defence budgets are being cut and most defence technology is based in the US," she says.

"In Europe, companies know they have to consolidate, but there is a lot of resistance to this because it would mean job losses."

Wong sees this consolidation process as a major factor across much of the engineering sector.

"It is still a good idea, in the long term, to put money behind a company like British Aerospace despite the rumours about the Saudis not paying up, because it is a company with a lot of political clout, which puts it in a strong position with regard to consolidation." The same arguments apply in the automotive sector. "The engineers we are buying are companies such as the vehicle parts supplier, Mayflower, which is well run and is in all the right markets with the right products," Wong says.

"Component manufacturers need to have worldwide distribution and be able to supply a complete design solution, not just a few specialist parts."

Geoff Miller also feels some of the problems confronting exporters are overdone. "Companies such as Rolls-Royce, which the market always marks down when the currency goes against them, can be seriously undervalued as a result.

"If you look at the figures, you find that a strong pound doesn't necessarily affect their revenues. But you have to wait for the figures to be published to see that."

Hugh Priestley says: "We are quite keen on Rolls-Royce and Cobham in the sector.

"We are keen on any company which is a market leader in its field. Anybody looking at engineering stocks must look for market leaders. But even then it's easy to get it wrong."

He adds: "We thought Morgan Crucible was one because it does dominate in a number of markets around the world, but it came in with a fairly heavy downgrade and its share price has suffered.

"One day, things will turn round and we'll start selling off the IT stocks and start buying them instead.

"But I don't think we're there yet. There are a lot of very tempting yields out there, but many companies will simply maintain these or even start to cut them. Unless you are very lucky and pick a stock that is bid for, it is a very tough sector."

Vicky Wong agrees. "A lot of engineering stocks are very cheap, but we're not buying many because there are simply better opportunities elsewhere."

"One we have been buying is TI Group, because it has very good management and an attractive yield. It is more into industrial production, which does not sound a very exciting niche, but it does have the best products."

Not all market watchers share this view. Geoff Miller says: "Given the current economic background, you're going to have to look at all those companies you would have turned your nose up at six months ago. Engineers are a prime example of an area where you may suffer if you are underweight. But you have to be a bit cautious."