Best industrial shares to buy now

Business has been worse than expected for global industrial firms. Spending cuts in the oil industry and less demand from the Chinese means fewer orders placed with suppliers of high-tech seals, pumps, gears, switches and other specialist parts. Despite a 10% bounce over the past week, the FTSE 350 Industrial Engineering index is down 30% in the past 15 months to levels last seen in the summer of 2012. Cuts to earnings estimates are coming thick and fast, but among the carnage there are some first-class British manufacturers whose shares are still worth buying.

"For most companies, trading in September will have been weak, not terrible, just weaker than consensus expectations, we believe," says Investec Securities. We'll get confirmation over the next few weeks as engineers release trading updates, but the number of profits warnings has prepped the market for further bad news.

Last month, we said an anticipated hit to profits at valve control systems expert Rotork was a "warning to others".  Results from industrial conglomerate Smiths Group shortly after confirmed its mechanical seals division John Crane remained under pressure. Rolls-Royce had already issued its third profits warning earlier this summer (a fourth is widely anticipated), Caterpillar disappointed and international names like steel giant TimkenSteel, German engine manufacturer Deutz and Finnish cranes firm Konecranes.

"In our view, this is not specifically Oil & Gas or China related, although they are contributory factors," says Investec. "Instead, it illustrates a general economic slowdown. However, the indiscriminate market sell-off has started to create opportunities - where trading proves to be more resilient, strong balance sheets provide upside and cash generation is good. For us, IMI, Bodycote, Melrose, DS Smith and e2v exemplify this."

With a slew of updates still to come, the broker downgrades earnings per share (EPS) expectations for almost its entire coverage, for all years, although it says the extent varies considerably.

It admits that gauging the accuracy of its new estimates, even for this year, is proving difficult, but says, quite rightly, that it's "better to react early as directionally we have clarity". EPS cuts for 2016 are biggest at Weir (17%) and Vesuvius (14%) - both are downgraded from 'hold' to 'sell' - Rotork (10%) and Spectris (10%), which goes down to 'hold' from 'buy'. De La Rue, Hill & Smith and Halma, a company with a history of riding out recessions and paying dividends, should be the most resilient.

"We believe the stockmarket has been overly negative on the prospects for a number of stocks - where history will not provide a particularly accurate guide to future performance," writes Investec. "For us, this is typified by Bodycote which has robust cash generation, a strong balance sheet and a management team who know how to cope in tough times. We expect this period to enhance their reputation. The share price is down c.18% in the last 3 months, but the cumulative FY15 downgrades are only 12.5%, hence a significant and somewhat unjustified de-rating, in our view. We believe the stockmarket is assuming greater downgrades than are likely.

"On reflection, we think most shares are still not cheap enough to appropriately reflect the high degree of uncertainty, but are closer to being of interest given the market sell-off over the summer. Valuations remain above historical levels, which we are comfortable with - given a better business mix, better run businesses, better balance sheets - however, a lack of growth and margin pressure will likely restrict re-ratings."

For the record, Investec's favourites are: DS Smith, Melrose, IMI, Bodycote and e2v technologies.

Avoid for now: Smiths Group, Weir, Rotork, Vesuvius and Fenner.

Clearly, we're into the historically more optimistic quarter for equities, and there are some fantastic manufacturers here which will weather the storm. And, after one of the worst summers in years for many investors, there is still a wave of institutional cash in need of a home. What's more, and despite some rich valuations and mediocre earnings growth, shares are still seen as the only show in town by many of the City's big swingers.

The rally since 28 September demonstrates perfectly how a turn in sentiment has a hugely positive effect on these highly cyclical stocks (see second chart, above). Investors, then, are faced with the dilemma of whether to stay fully invested for the anticipated seasonal rally, or sell into any upturn in case things turn ugly again. There's no easy answer I'm afraid, but our latest market report may give some clues as to whether it's time for investors to breathe out, or not.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.