Evidence is mounting that the economy and the industrial distribution industry are both bottoming out. Stabilizing and improving industry conditions should create a favorable backdrop for industrial distribution stocks well into the future.

Historically, industrial distribution stocks have generally performed well when the ISM Index (formerly NAPM) is 50+ and/or rising. Over the last 12 months, the ISM Index has risen from the low- to mid- 40s to 49.9 in January (its highest reading since August 2000). Although October and November dropped following the September 11 attacks, the index rebounded quickly and resumed its upward journey.

Industrial distribution stocks, too, have performed well. Airgas' stock price, for example, has increased 120 percent over the past 12 months. In addition, Noland has seen 66 percent price appreciation, while Hughes Supply and Grainger are +65 percent and +50 percent, respectively, in the past year.

Our analysis of the past four recessions indicates that industrial distribution stocks underperformed the Dow Jones Industrial Average during those recessions, but have outperformed the Dow at most other points in the cycle. We believe this is because the companies are not cyclicals, but "growth cyclicals." The bottom line is that investors should avoid these stocks during recessions, but should own them selectively at most other points in the economic cycle.

Our top-rated stocks for this market are MSC Industrial, Fastenal, Hughes Supply and Watsco (an HVAC distributor not included in the ID/Baird Index).

We think MSC and Fastenal will be prime beneficiaries of higher sales and higher profitability that should follow a stronger economy. We like Hughes based on re-energized leadership and potential for improvement. And we are encouraged by Watsco's new agreement with Whirlpool.

Industrial distribution stocks should perform well early in the economic cycle. In addition, they should continue to perform well later in the cycle as the economy recovers and provides a more favorable business environment.