Manufacturing is the process of turning raw materials into finished goods. Manufacturing can take the form of tools, machinery, chemical processing, and/or human labor. Manufacturing is considered a sub-sector for investors because the list of companies that manufacture goods and services overlaps several sectors of the economy.
For example, Hershey’s (NYSE: HSY) is a manufacturing stock because of the company’s automated process for making its signature confectionary products. But investors will also note that Tesla (NASDAQ: TSLA) is a manufacturing stock. However, the electric vehicle sector and the consumer discretionary sector behave very differently at different times.
What Do Manufacturing Stocks Say About the Economy?
Perhaps no industry illustrates the relationship between supply and demand like manufacturing. Manufacturing added to the cost of the raw materials used to calculate a company’s cost of goods sold (COGS). This additional value allows the company to charge a higher price for its finished products.
Best-in-class manufacturing companies seek ways to utilize the most efficient manufacturing techniques. These investments allow companies to produce more goods at a lower cost.
The manufacturing sector is one of the key drivers of job creation in a country’s economy. When activity is slowing down, it is typically a harbinger that the economy is weakening. It is also usually marked by companies issuing layoffs or hiring freezes. By contrast, when manufacturing activity picks up, it is generally a sign that the economy is growing. In these cycles, manufacturing companies typically contribute to that growth by hiring more workers.
What Economic Reports Track Manufacturing Activity?
Monthly economic reports give investors clues about the strength of the manufacturing sector. One of the most closely watched reports is the Institute for Supply Management (ISM) Manufacturing Index, this is known as the purchasing managers’ index (PMI). This is a monthly forecast of manufacturing sentiment based on a survey of purchasing managers at over 300 companies. A related survey is the S&P Manufacturing and Services PMI.
Both reports give investors a sense of the economy’s direction. A reading above 50 generally signals that the economy is expanding. A number below 50 signals an economy that’s contracting. However, there are a couple of things that investors need to consider when assigning significance to this monthly reading
Look for Context - It’s always important to look at the reading in context with prior numbers. This is because these surveys are reporting on ordering activity that’s already taken place.
That makes these reports lagging indicators, meaning they give investors information about what’s already happened in the economy. So if the index shows a month-over-month decline it may not be showing up in the broader economy. The opposite is also true. If the index shows a month-over-month gain, it may not be reflected in the prices that consumers pay.
However, the stock market is always forward-looking. So lagging indicators such as manufacturing data can help confirm trends in the economy.
Look for Correlation - Another way to make sense of the monthly manufacturing data is to ensure it correlates with other economic reports. For example, if the Producers’ Price Index (PPI) is climbing you would expect manufacturing activity to slow down.
That’s because if it costs businesses more to get their raw materials, it will be more expensive for them to manufacture their goods. Although they will try to pass this cost along their supply chain to the end consumer, ultimately they may have to cut their output if consumer demand drops.
On the other hand, if manufacturing output remain steady or growing even in the face of rising producer costs, it can signal that consumer demand remains strong even as they are facing higher prices.
When Do Manufacturing Stocks Perform Well?
Like many sectors, manufacturing stocks tend to do when the economy is performing well. When consumer demand is high, manufacturing activity tends to increase.
Also, when the economy is expanding, interest rates are generally stable, and perhaps falling. Lower borrowing costs allow companies to invest in the equipment necessary to upgrade their manufacturing infrastructure. This can make stocks such as Caterpillar (NYSE: CAT) more attractive.
However, that doesn’t mean that manufacturing stocks are bad investments when the economy is in decline. Some manufacturers are in more defensive sectors that can help them outperform the market because their products and services remain in demand. An example of this could be found in the agriculture sector. Regardless of what is happening in the broader economy, crops need to be planted, cultivated, and harvested on a regular schedule.
Defensive manufacturing stocks offer the additional benefit of pricing power. For example in the Covid-19 pandemic, commodity prices rose due to supply chain disruptions. As producer prices rose, the manufacturing stocks that performed the best were ones that were able to pass along its higher production costs.
Are Manufacturing Stocks Good Dividend Stocks?
As you might expect, many manufacturing stocks pay a dividend. A dividend is simply a portion of a company’s profits that it pays out to shareholders in the form of a direct cash payment per share. Companies that pay dividends are typically in mature industries and manufacturing companies certainly fit that description.
That’s not to say that manufacturing companies don’t offer share price growth. And when the economy is sluggish, the dividend payment these companies offer will boost an investor’s total return to the point that they outperform growth stocks. But it’s fair to say that many of these stocks will not outperform the market when the economy is going well.
The qualities that investors should look for in manufacturing stocks that pay a dividend are the same as with any other sector. First, look at companies that have a strong balance sheet. Investors should also look for healthy cash flow and the potential for some growth.
All of these factor into a company’s ability to issue a dividend and, in the best-case scenario, increase its dividend on an annual basis. And that is far more important to an investor than a company’s dividend yield or even its dividend payout.
Two Examples of Great Dividend Stocks
3M (NYSE: MMM) is considered one of the best dividend stocks among manufacturing companies. The company has paid a dividend in each of the last 98 years and has increased its dividend the last 56 years. This puts the company in the select group of companies known as Dividend Kings. When you consider everything that has happened in the economy over the past 98 years, an investor can’t help but be impressed with the fact that 3M has not failed to pay a dividend in every single quarter.
Caterpillar (NYSE: CAT) is an example of where upside matters. In 2020 and 2021, the company’s business was curtailed due to the Covid-19 pandemic. However, the passage of the infrastructure bill in late 2021 is spurring growth in revenue and earnings. As of August 2022, Caterpillar’s dividend yield is just above 2% which isn’t all that attractive. However, the company continued to increase its dividend throughout the pandemic which means investors can expect the dividend to continue to grow and perhaps by a higher percentage over the next several years.
Can You Find Good Small-Cap Manufacturing Stocks?
Large-cap and mid-cap manufacturing companies do offer investors the benefit of being well established and financially stable. However, investors can find good small-cap manufacturing stocks. To begin with, many of today’s most iconic companies such as Amazon (NASDAQ: AMZN) started as small-cap stocks. And second, these stocks often sell for a lower price per share which can make them appealing for risk-tolerant investors.
The key to finding a quality small-cap manufacturing stock is to find companies that have a product that will continue to be in demand. There are many small-cap stocks that are considered manufacturing companies but they are in niche markets where they have limited hope for revenue growth. The dot-com bubble of the late 1990s and early 2000s showed the problem of investing in manufacturing companies simply because they checked one box no matter how enticing that box was.
Another problem may be company may be in the early stages of the manufacturing cycle and be losing money. This was the case in 2020 and 2021 as many companies in the electric vehicle sector went public despite being several years away from having meaningful revenue.
How to Invest in Manufacturing Stocks
As you can see, manufacturing stocks come in different sizes and sectors. This means one of the best ways to invest in manufacturing stocks is to start with your investment objective. If you’re a growth-oriented investor, you will probably be more interested in technology stocks.
That doesn’t mean that you won’t get exposure to a manufacturing stock. For example, Apple (NASDAQ:AAPL) is, technically, a manufacturing stock. But investors who are buying AAPL stock are not doing so for that reason.
On the other hand income-oriented investors may look for utilities and real estate investment trusts (REITs). Neither of these sectors would include manufacturing stocks. However, as noted earlier in this article, investors can find great income-generating stocks such as 3M, also great manufacturing stocks.
Manufacturing Stocks ETFs
Many investors prefer to invest in exchange-traded funds (ETFs) for all or a portion of their portfolio. ETFs offer the benefit of buying a basket of companies within a sector while spreading the risk that comes from owning any individual stock.
Because manufacturing stocks can be found in almost any sector, investors need to be a bit discerning when it comes to finding ETFs that provide exposure to manufacturing stocks.
One of the largest ETFs for investors looking for exposure to manufacturing stocks is the Industrial Select Sector SPDR Fund (NYSEARCA:XLI) which has over $13 billion in assets. Industrial companies typically have strong balance sheets and steady demand.
Another way to be a fund investor in the manufacturing sector is by focusing on specific sectors. For example, investors can still find manufacturing stocks in the technology sector. One such choice is the Technology Select Sector SPRD ETF (NYSEARCA:XLK).