We discuss promising relative-value scenarios.
Key Points
- In our view, there are positive changes in medium-to-longer term fundamentals in the industrials sector yet there is enough skepticism toward this outlook to create attractive relative valuations.
- Within industrials, we are watching companies that can grow alongside increased electricity demand and infrastructure, and businesses that stand to benefit from a long-overdue upswing in capital expenditures.
- Defense contractors present a strong value proposition due to rising geopolitical risks, signs of higher defense spending, and the industry’s resilience during economic downturns.
- We also see opportunities in companies that have realigned their business profile and sought to add to shareholder value through mergers, acquisitions, and divestitures.
In our July blog, we identified industrials as a sector where we saw pockets of value. In this blog, we update and expand our thoughts about the sector. The compelling value opportunities can be categorized into three buckets: 1) cyclicals with attractive structural tailwinds; 2) earnings stability during economic uncertainty; and 3) emerging best-in-class industrial capital allocators.
Cyclicals with Attractive Structural Tailwinds
Current valuations suggest that investors expect the last decade’s fundamentals to carry forward to the next decade. We see positive change in the longer-term fundamental profile for industrials that are favorably exposed to the structural tailwind of electrification and/or the next strong multi-year capital-expenditure (capex) cycle.
Electricity demand should experience growth through a variety of structural drivers, including rising data-center use, a higher prevalence of connected devices, and further growth in electric vehicles (EVs). As the transportation landscape evolves—with an increasing percentage of EV sales—there is a need for a more expansive charging infrastructure. Also, the higher EV and electricity demand increases the strain on the electric grid. Businesses that manufacture electrical equipment look well positioned to benefit from utility companies’ long-term investment in transmission and distribution, as they provide solutions for connecting new sources of renewable electricity to the grid while also hardening the grid. The Infrastructure Bill passed by Congress in late 2021 will provide funds to companies that enhance the EV charging network and upgrade power infrastructure to meet the electrification boom. Increased electrical content density in data centers, industrial warehouses and commercial buildings are further secular tailwinds. Upgrading the existing installed equipment base to more energy-efficient models could provide compelling returns on investment and payback periods for manufacturers.
The broader capex cycle also portends well for industrials. Plant, property, and equipment investment has been below the long-term average since the mid-2010s, and the last capex cycle globally goes back over 20 years. With a decade of underinvestment, aging US fixed asset and supply constraints need to be addressed through higher capex investment. Inflationary pressures also drive home the need for more supply and therefore capex investment. Tangible examples include factory automation to manage the wage inflation pressure and increase productivity and supply constraints in natural resources. Furthermore, the reshoring push is driving increased capex needs with new factory builds and related equipment.
Stability During Economic Uncertainty
Our value strategies pursue sources of free cash-flow stability and seek to obtain these companies at attractive valuations. We find these attributes present among defense contractors. While there have been concerns of lower US defense spending under the Biden administration, the actual budget outlays have not been materially lower. We expect US defense spending to have an upward skew irrespective of the outcome of November’s mid-term elections. Furthermore, with the unfortune war in Ukraine, there appears to be a new urgency in Europe to increase defense spending. NATO countries have reaffirmed their commitment to spend at least 2% of GDP on defense, a level that has not been achieved due to austerity measures and divergent threat perceptions.
The resilience of defense spending even amid an economic slowdown, coupled with a higher medium-term, free-cash-flow growth profile, is a compelling combination in our view. Importantly, there remains enough debate about supply-chain impacts and sustainability of the durable growth outlook, that in our view valuations still provide attractive risk/reward scenarios.
Emerging Best-in-Class Capital Allocators
We are also closely watching companies whose portfolio has changed through divestitures and mergers and acquisitions (M&A) to positively transform the profile of the business. These changes include shifting product offerings from commoditized to value-added, aligning to higher organically growing verticals, and improving the returns on capital. While the market may await a longer track record for the underlying sustainable profile of these businesses, which may have been masked by the economic and supply-chain disruption over the last year, we believe that such portfolio transitions may not be fully reflected in valuations. We believe this environment provides compelling risk/reward opportunities.
Furthermore, in addition to capital allocation decisions to shape business portfolios, there is a strong opportunity for shareholder value through M&A which we believe is not reflected in share prices. Strong executors of acquisitions in fragmented global markets provide opportunities to scale and operate smaller brands more efficiently. These opportunities become even more compelling in pressured markets as pricing becomes even more favorable for those best-in-class operators with the balance-sheet capacity to capitalize on these opportunities.
Conclusion
Industrials is a sector where we are seeing positive change in medium-to-longer term fundamentals yet differing outlooks provide for attractive relative valuations. Cyclicals with attractive structural tailwinds, businesses that can offer stability during economic uncertainty, and emerging best-in-class industrial capital allocators are areas where we find the most opportunity. As always, when the markets are volatile, we remain steadfast in our pursuit to identify and invest in attractive relative-value opportunities.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that strategy holdings and positioning are subject to change without notice. For additional Important Information, click on the link below.
Important information
For Institutional Clients Only. Issued by Newton Investment Management North America LLC ("NIMNA" or the "Firm"). NIMNA is a registered investment adviser with the US Securities and Exchange Commission ("SEC") and subsidiary of The Bank of New York Mellon Corporation ("BNY Mellon"). The Firm was established in 2021, comprised of equity and multi-asset teams from an affiliate, Mellon Investments Corporation. The Firm is part of the group of affiliated companies that individually or collectively provide investment advisory services under the brand "Newton" or "Newton Investment Management". Newton currently includes NIMNA and Newton Investment Management Ltd ("NIM") and Newton Investment Management Japan Limited ("NIMJ").
Material in this publication is for general information only. The opinions expressed in this document are those of Newton and should not be construed as investment advice or recommendations for any purchase or sale of any specific security or commodity. Certain information contained herein is based on outside sources believed to be reliable, but its accuracy is not guaranteed.
Statements are current as of the date of the material only. Any forward-looking statements speak only as of the date they are made, and are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment and past performance is no indication of future performance.
Information about the indices shown here is provided to allow for comparison of the performance of the strategy to that of certain well-known and widely recognized indices. There is no representation that such index is an appropriate benchmark for such comparison.
This material (or any portion thereof) may not be copied or distributed without Newton’s prior written approval.
Comments