The Northern Trust’s Signature Stock Investment

There are very few firms that have a reputation anywhere close to the Northern Trust when it comes to the management of trust funds and family wealth over generations. You pay a premium price for their services, but if you want to create a sophisticated trust, a trust fund that will be put in use for a long time, or just want assistance with your investment selection, this is where you go. They trace their origins back to the 19th century, have served over 20 sitting U.S. presidents, and currently run the trust funds that President Obama has set up for his daughters.

One of Northern Trust’s big investments is Illinois Tool Works (ITW). They own 38 million out of the corporation’s 345 million shares of stock, or about 11.2%. Since 1987, Illinois Tool Works has returned a little over 14%.

It is an industrial firm with a market niche for creating original equipment manufacturing (OEM) products. This just means that you sell a product to another manufacturer that is turned into an end product. If you sell laces to a manufacturer of footballs, the lace seller is considered an original equipment manufacturer.

Illinois Tool Works makes the pistons, starters, flywheels, belts, chains, fuel pumps, air filters, steering wheels, and so on that get used to create new cars. Because of their enormous economies of scale–they earn about $2 billion in profits–they are able to earn 14% net profit margins.

By all accounts, this is a dream business to own. Each item is highly profitable, and the network is so large and complex that it serves as a high barrier to entry for competitors because the relationships that Illinois Tool Works has formed are so entrenched and it would be difficult to beat Illinois Tool Works on price.

Beneficiaries of trust funds at Northern Trust have benefited immensely from this decision to make Illinois Tool Works a common portfolio component over the decades.

However, I am curious as to how the Illinois Tool Works investment will play out going forward because the valuation has gotten so high. At a price of $114 per share, Illinois Tool Works is trading like a non cyclical.

In the late 1990s, Illinois Tool Works was earning about $2 per share. That figure climbed to $33.36 before the financial crisis before slamming down to $1.93 abruptly in 2009. The stock price fell by over 60%, and the previous seven years of earnings growth were no longer visible before you.

If you were a diversified fundamental investor, the storm wasn’t so bad because the dividend held steady and Illinois Tool Works was still generating $1 billion in net profits during the worst of the economic conditions.

However, I’m not sure that people who have Illinois Tool Works stock purchased on their behalf remain calm and cool when they see the value of the stock component fall from $100,000 to $60,000 in a matter of months. It takes some understanding of the business, balance sheet analysis, and the firm’s track record to make peace with the high volatility.

Given how few new cars get purchased during a recession, it is not unusual to see Illinois Tool Works’ earnings fall quickly and the stock price fall even more. It would not surprise me to see Illinois Tool Works’ stock price fall below $100 at some point in the next five years. This is not a criticism of the firm’s business model, but rather, a repudiation of its current valuation levels and a recognition of the stock’s historical volatility during economic conditions that dampen the demand for new car purchases. The Northern Trust has invested into a great asset on behalf of the beneficiaries whose funds they manage, but the beneficiaries may not recognize it as such a few years from now.