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Updated daily. All values annualized from Jan. 2008.

Coming in at #4 in our Magic Formula Business Sector Rankings is the Industrial Materials sector. This sector accounted for 491 stock days tallied by 25 different stocks. As you can tell by the name, Industrial Materials is a pretty wide classification, and Morningstar has quite a few industries grouped underneath it:

Morningstar Industry	Stock Days	Unique Stocks
Aerospace & Defense	98	5
Agriculture	51	2
Construction Machinery	48	2
Auto Parts	46	1
Machinery	38	3
Electric Equipment	37	3
Mining (Nonferrous & Nonmetals)	34	2
Transport Equipment	28	1
Metal Products	28	1
Steel/Iron	28	1
Office Equipment	28	1
Truck Makers	14	2
Chemicals	13	1

Obviously, it would take up too much time to dive into each of these industries, and in any case the exercise would probably be repetitive. Let's group these down further as so:

• Aerospace & Defense: we'll leave this one be, as it's the top ranked industry and doesn't combine well with the others.
• Materials: Steel/Iron, Chemicals, Mining, Metal Products
• Heavy Machinery: Agriculture, Construction Machinery, Machinery, Truck Makers
• Equipment: Auto Parts, Electric Equipment, Transport Equipment, Office Equipment

When combining industries in this manner, the breakdown is as follows:

Morningstar Industry	Stock Days	Unique Stocks
Heavy Machinery	151	9
Equipment	139	6
Materials	103	5
Aerospace & Defense	98	5

Heavy Machinery

It is somewhat surprising that a business as capital intensive as heavy machinery production should have such a strong presence on a screen that prioritizes high return on capital. Magic Formula stocks here included specialty truck outfitter Oshkosh (OSK), RV and Bus maker Thor Industries (THO), and Crane Co. (CR), which makes everything from electronics for aerospace applications to vending machines.

So why so popular? I believe it boils down to one simple factor: lack of competition due to the very niche nature of these products. For example, very few companies are interested in competing in small markets such as fire and trash trucks like Oshkosh does. This is great, because Oshkosh can basically charge whatever the market will bear. Also, the company doesn't have to spend heavily on marketing or development to fend off competition. However, heavy equipment is a cyclical business. When customers are facing recessionary conditions, they tend to hold back on capital expenditures. The perfect storm of a cyclical bottom and low competition brings these firms to the top of the screen, where they represent some attractive buying opportunities.

Equipment

The Equipment segment consists of companies that produce somewhat smaller products than our Heavy Machinery group. In this area, the Magic Formula dug up such stocks as Pitney Bowes (PBI), the leader in mailing and shipping equipment; FreightCar America (RAIL), which incidentally produces rail cars; and Acuity Brands (AYI), a manufacturer of lighting fixtures.

The Equipment segment in general is quite a bit less niche than Heavy Machinery. These products have a wider addressable market (for the most part). Acuity, for example, has several direct competitors such as Cooper (CBE - another MFI stock), and Genlyte. The Magic Formula screened some of these guys in due to the fears of recession, sending stock prices south. Sticking with Acuity, their products are primarily used in home lighting, and everyone knows how bad the housing markets have been for nearly a year now. Equipment stocks magnify the overall business cycle. Do they make good MFI purchases? Probably not as good as heavy machinery. With lots of competition and practically no switching costs, these businesses do not lend themselves to natural moats. Still, using MFI to time a cycle is a valid way to play an expected recovery in the short term.

Materials

Some Magic Formula stocks in the Materials segment were Southern Copper (PCU) and Allegheny Technologies (ATI). Those who read MagicDiligence regularly know that one of the weaknesses of the MFI screen is selecting commodity stocks at the top of their cycles. At this point, returns look great looking back at the trailing cycle, but looking forward we could be going downhill as the cycle bottoms. Also, copper and steel is copper and steel regardless of who supplies it. Buyers can often get these materials from a variety of providers, so there is no intrinsic moat qualities to these businesses.

The one exception would be those firms that own a very unique property or have the market for a particular commodity cornered (no other competitor can get access to it). These situations are rare, but I'm always on the lookout for them as they can be lucrative opportunities.

Aerospace & Defense

Finally, we come to Aerospace and Defense companies. Aircraft maker Boeing (BA), and defense contractor Lockheed Martin (LMT) are examples in this segment.

Aerospace and Defense is an interesting business. A large portion of revenues for these companies comes from government contracts for supply to the military. This, combined with the fairly limited competitive characteristics of these markets, give companies in this segment some decent moat potential. Boeing, for example, operates in an effective duopoly with European competitor Airbus. Lockheed is known as the biggest of the "big 5" defense contractors the government turns to for the majority of it's contracts. However, one needs to be aware that the reliance on government business is a double edged sword. When defense budgets expand, as they have for most of this decade, these companies do well. When defense budgets stagnate, as in the 1990's, business for these guys contract.

Industrial Materials - Summary

When I first compiled the list of Magic Formula business sectors, I was a bit surprised that Industrial Materials ranked so highly. You would think that industries that require large amounts of capital to build things like naval ships, satellites, and fire trucks would have difficulty maintaining high returns on capital. I was not surprised that some mining and materials companies showed up - commodity stocks will always be a zit on the Magic Formula lists. However, it all boils down to competition here, or the lack of it. Many of these niche products have limited markets, which discourages new entrants. This allows the incumbents to maintain profitability and grasp the market even tighter.

Magic Formula Business Sector Countdown

#9 - Energy

#8 - Software

#7 - Media

#6 - Consumer Services

#5 - Hardware

#4 - Industrial Materials

#3 - Consumer Goods

#2 - Healthcare

#1 - Business Services

MFI Business Sector Project

Steve owns no position in any stocks discussed in this article.

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