MARKET COMMENTARY

Full Steam Ahead? Why We Think Industrials Are On The Right Track

03.01.2017 - Kenneth Siegel

Our outlook for Industrials has improved in recent months, and President Trump’s promise to rebuild America’s transportation infrastructure is just one reason why. In this Q&A, portfolio manager Kenneth J. Siegel explains how broad macroeconomic trends, rising corporate profits and a shifting political landscape have sparked what could be the beginning of a new growth cycle for Industrials (and a new opportunity for long-term investors).

Q: What are you seeing in the economy that makes you more upbeat about Industrials?

KENNETH: We see a number of developments in the US and global economies that look encouraging for Industrials over the next several years. One of the most important trends is an improvement in global manufacturing volume that started late last year, not only in the US but also across the Eurozone and in some emerging markets (see Chart).

Another is energy prices, which bounced back from multi-year lows in early 2016 and appear to have stabilized. That’s important because when energy companies can command higher prices they are more likely to allocate capital toward new drilling equipment, pipelines and other types of machinery supplied by the Industrial sector. On a broader scale, market sentiment is also improving noticeably. Confidence among small business owners spiked in December, reaching its highest point since 2004, according to the National Federation of Independent Business. Small businesses are an integral part of the manufacturing supply chain, so the fact that small business owners expect demand to pick up is a positive sign for Industrials.

Q: In that case, would you recommend investing broadly across the Industrials sector?

KENNETH: Not at all. It’s important to remember that the Industrial sector is diverse, ranging from manufacturers of heavy construction equipment to transportation businesses and defense contractors. It’s true that we are more optimistic about the sector as a whole, and that economic growth could stimulate the Industrials market (including the slow-growing automotive and construction industries). But we would caution against investing across the board because we expect to see a clear separation of winners and losers in this sector over the next several years.

Q: Will the winners be companies involved in infrastructure?

KENNETH: Everybody is talking about President Trump’s proposal to spend $1 trillion on transportation infrastructure over the next decade. But nobody is really sure where infrastructure falls on his list of priorities, how it might be financed, which areas of our transportation network might be targeted or what the timeline for implementation might be. We are certainly keeping our eyes open for opportunities, but our sense is that it could be another year or two before an infrastructure package is approved and starts filtering through the US economy. We also think an infrastructure package would be more likely to provide the economy with a quick lift than a sustained tailwind.

But regardless of what happens in Washington, we continue to find attractive investments in the transportation category, ranging from traditional railroads to companies that are pioneering “intelligent transportation grids” and computerized safety systems for cars, trucks and busses. In this brighter economic environment, we are also attracted to a select group of shipping and delivery companies, which usually see a pickup in demand when the economy is expanding and budgets improve. Shipping and delivery companies also benefit from the growth of e-commerce, a long-term trend.

Q: You also like the defense industry. Why?

KENNETH: After years of government belt-tightening, both in the US and overseas, it seems clear that defense spending will increase over the next several years. President Trump has already encouraged the Defense Department to request an additional $14 billion in emergency funding to supplement its 2017 budget. That budget request could offer valuable insights into specific areas of the defense industry that might offer rewarding investment opportunities. Defense stocks are usually long-term investments because military spending rises and falls along with prevailing attitudes in Washington. So, the defense industry’s expansion and contraction cycles tend to run much longer than they do for industries like aerospace, for example. We believe the defense industry could be entering the early stages of another protracted period of growth, possibly extending for the next five or ten years.

Q: Will President Trump’s pro-growth policies also benefit Industrials?

KENNETH: Deregulation is already paving the way for energy infrastructure projects like the Keystone XL and Dakota Access pipelines. Environmental concerns are likely to persist, but companies that manufacture energy-related equipment and supplies could see activity pick up. Tax reform and repatriation of cash held by US companies in offshore accounts could offer significant benefits for Industrials, possibly triggering a flurry of mergers and acquisitions. As companies look for ways to put their newfound cash to work, they will be looking for investments that generate the most attractive return on capital for their shareholders.

With this in mind, we have been scouring corporate balance sheets for expanding profit margins, cash reserves (free cash flow) and other metrics that might indicate a company has the ability to become a buyer. Strong corporate leadership is especially important. We look for management teams that have made smart acquisitions, buying companies that improve their operational efficiencies in the short term and their profit margins over the longer term. And we are also interested in management-led turnarounds that could lead to better-than-expected financial results.

Q: Where do you see the most prominent risks for Industrials?

KENNETH: For now, our main concern is that the sector looks expensive. P/E multiples are relatively high compared to their historic averages and top-line sales growth has been modest. But keep in mind that today’s valuations reflect investor expectations for corporate performance six or twelve months down the road, not current performance. So a market correction or pullback could provide us with more attractive entry points.

There are several macroeconomic trends that could also influence corporate performance in one direction or another. As the global economy strengthens, manufacturers are likely to enjoy more pricing power and stronger sales. But a spike in commodity prices could make production more expensive and erode their profit margins. Companies with a strong international presence could be hurt by a stronger US dollar or by President Trump’s protectionist trade policies. Of course, it is impossible to shield our portfolios from these threats completely. But our investment process has always focused on finding companies that are taking precautions to mitigate the effects of any unanticipated volatility.

CHART: Manufacturing Activity Has Improved Across the Globe (Purchasing Managers Indexes for 2016)

Source: Bloomberg as of 12/31/16.





This communication is intended solely to provide general information. The information and opinions stated are as of March 1, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.
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