Research in Action: Secular trends outweigh the cyclical in industrials

Carolyn Bigda: Welcome to this special series of Research in Action, where we provide a quick take on the outlook for the major economic sectors and the investment implications for 2024. We’re your hosts, Carolyn Bigda…

Matt Peron: …I’m Matt Peron, Director of Research.

Bigda: And in this episode, we’re joined by Associate Director of Research, Chris Benway, who’s also the lead analyst on the Industrials & Materials Team here. And he’s here to talk about what’s next for freight transportation, electric vehicles, industrial agriculture, and more in 2024. Chris, thanks so much for joining us.

Chris Benway: Thank you for having me.

Bigda: If we start broadly, industrial demand slowed considerably in 2023 on account of higher interest rates, uncertainty about economic growth, and some supply-demand normalization that followed the pandemic. Are you expecting that slowdown to persist in 2024?

Benway: Sure. Maybe a little background: In 2023, it was a unique cycle because even though the Purchasing Managers’ Index (PMI), which is a gauge on manufacturing activity, was slowing and in contractionary territory, we actually saw revenue growth in this sector for a couple of reasons. One was there was a significant backlog that built up over the past few years because of the supply chain challenges post-COVID. And then we also saw significant pricing as companies tried to offset the raw material and transportation costs. So even though end markets were slowing a bit, we still saw growth in ‘23.

Now, going into ‘24, we do expect some cyclicality as order growth is slowing across the space. But the unique aspect is that we do have some secular drivers that are really important, such as the Inflation Reduction Act, the Infrastructure Act [The Infrastructure Investment and Jobs Act], onshoring, and reshoring. We’re seeing a lot of investment with chips and EVs [electric vehicles]. So we do expect to see a cycle, but I think it will be a little bit more muted than we’ve seen historically.

Bigda: And just remind us quickly, did investors pay attention in 2023 to the revenue aspect of industrials, or were they just more concentrated on PMI? And how did that impact the stocks?

Benway: That’s a great point. The stocks were relatively resilient, and I think it’s both a combination of the revenue growth but then also they saw a significant margin expansion over 2023. Because we started to see raw material costs decline, transportation costs, supply chain costs decline, while pricing was continuing to flow through. I would say, as a whole, the sector was a little bit more resilient than historically.

Peron: Staying on the theme of growth or lack thereof, in the trucking and rail sectors, volumes were down?

Benway: Yes.

Peron: And how are you thinking about that now both from a growth outlook, and how’s the valuation setup?

Benway: We actually see the transportation sector as pretty attractive going into 2024. A couple of things to mention – the volumes have started to rebound both on the intermodal and on the commodity side. We’re starting to see growth. And then we’re also starting to see trucking rates, truckload rates, ocean carrier rates from Asia-Pacific to U.S. have bottomed and are starting to improve. It seems like we’re seeing some bottoming in the sector.

In addition, there was a large destocking as consumers switched to travel and leisure activities versus goods, and we have worked our way through that. And we’ve hit the bottom of the destocking, as well. It’s always tough to call the transportation cycle, but historically, when we’re at lows like this, it’s been a good time to invest.

Bigda: And how do those trends in transportation reconcile with the concerns we’re hearing about a potential economic slowing in 2024? Is it running contrary to those outlooks?

Benway: Sure, I would say a lot of the industrial companies and the railroads themselves would say that they’ve already seen a decent amount of the slowdown in commodities, and you could see in the rail volumes that their rail volumes are down 5%+ in a lot of these large commodity end markets. It is tough to call, but I think the consumer potentially switching back to a more normalized good. We’re seeing goods spending starting to normalize back to the trend line. And we’ve already seen some pockets of slowing. It’ll probably be a little choppy, but again, it seems like we’re more at the bottom versus the top.

Bigda: Another area where we’ve seen a lot of growth is airline travel. That’s been rebounding, basically, since the pandemic. What has that meant, then, for the companies that supply the aircraft, the aerospace industry?

Benway: This is another end market where we’re very positive on. And I think the unique aspect is that even though the aerospace market is typically cyclical, we see a long secular cycle within the cyclical. And historically, that’s been a good time to invest.

A lot of the airlines United, Southwest, have large capex outlays of $7-plus billion spending on new aircraft, replacement aircraft, wide-body aircraft, as they continue to expand. And so, the suppliers are really well positioned to benefit from this consistent growth. For investors, it’s hard to accurately appreciate the duration of that growth in a cyclical industry.

Bigda: During the pandemic, did orders slow down and then, as a result, they’re now catching up and that could provide a tailwind, potentially?

Benway: That’s exactly right. Essentially, it cut off in COVID and it was zero. And so it was a supply chain and a production nightmare, and now we’re still working through that. And then we also had the [Boeing 737] MAX issue and so that also made production very challenging. And we’re now working through all of those, and now we’re seeing the secular growth kick in, as well, over the next few years.

Bigda: And just speaking to the duration, do investors accurately appreciate that potential growth as reflected in the stock prices, or do you think there’s still some room for potential upside there?

Benway: I would say that I still see potential for upside. A lot of times, investors appreciate the next year or next couple years. But this seems like it will go, persist beyond that. And so I think, based on the current valuations, there’s still opportunity.

Peron: Let’s zoom out then and talk about the long-term themes that you like. You’ve mentioned a few already, but I think some of the ones we’ve talked about are precision agriculture, electric vehicles, and renewables in general, factory automation. What are the things that you’re looking to focus on in the next couple of years?

Benway: Maybe we can start with electric vehicles. That’s been a big theme recently. And interestingly, we’ve seen electric vehicle adoption slow over the past year. Maybe stepping back, from 2020 to 2023, EV adoption globally went from 4% to almost 16%, so increased fourfold. But in 2023, in the U.S., in Europe, we’ve seen those adoption rates plateau a little bit. China, on the other hand, continues to go linear, up and to the right. The trend remains in China.

I would say in Europe and the U.S., it has been more cyclical- and interest rate-impacted. I don’t think that changes the long-term view of EV adoption for a couple of reasons. One is that, especially for those manufacturers that started from the ground up, it’s just a better product. And then, two, another very important thing is that the greenhouse gas emissions and the CAFE [Corporate Average Fuel Economy] standards and the EPA [Environmental Protection Agency] standards, those are not getting rolled back.

I feel like the horse is out of the barn. Yes, there’ll be a little cyclicality, but it’s more of a small cycle in, again, a long-term secular growth area. And so we continue to see EV adoption moving up over time.

Bigda: How are the automakers positioned at this stage in this cycle of EV adoption? And how are the stocks positioned, importantly?

Benway: On the automaker standpoint, you really have a bifurcation between the legacy, original electronic manufacturers, or OEMs, and then the new EV companies, such as Tesla and Rivian. And my view is that the legacy OEMs are in a really challenging position because they don’t have the ability to build an EV from the ground up. And that’s crucial because these cars are now very tech-enabled, and so you need the ability to wirelessly communicate updates to the vehicle. And the legacy OEMs just do not have that tech infrastructure. And from just a product standpoint, they’re behind the eight ball and trying to catch up.

And then on the other side, from a capital standpoint, the capital outlays to produce EVs versus the traditional infrastructure is just significant and it is money-losing. And because of that, I think it’s hard to get an accurate valuation and get comfortable with the investment case.

Bigda: And for the companies that started out as EV makers, some of them still haven’t turned a profit yet, is that correct? And what’s the outlook then for those companies?

Benway: Yes, that is correct. That’s why we really are focusing on those that have a great brand, a great product, that have a lot of positive feedback, that have larger backlogs, that are showing progression, and showing that they can manufacture these vehicles successfully. And to your point, that is just a handful. We’ve seen some shakeout within the upstart EV space. We think we’ll continue to see that, and ultimately, it‘ll probably just be one or two of that, that make it. And we’ve seen this, if we look back 100 years, we’ve seen this dynamic with the auto space. It’s just a really tough industry.

Bigda: And then what about something like precision agriculture?

Benway: We continue to be positive on precision agriculture. Again, in industrials, you have to be cognizant of the cycle. But I think the key takeaway is that precision agriculture saves farmers significant money, on labor, on equipment spend, on input cost. You use less fertilizer. You use less chemicals. And I think that is the key underlying theme – is that, yes, maybe farmer income is slowing a little bit as commodity prices have come down, and so, there will be some slowing. But long term, farmers are going to spend money because they save so much. And we continue to be very positive on companies that are participating in the precision ag space.

Peron: We’ve been talking about autonomous vehicles for years, but it’s actually happening in that sector.

Benway: That’s exactly right. I was actually out on a farm for a company and with just the swipe of their phone, the tractor started and started going down the road. And it makes sense that it would start in agriculture because there’s a lot less danger on the farm versus going down the road.

Bigda: I imagine there’s a pretty big outlay in order for these farmers to get these tools to do precision agriculture. But in the end, it does provide a cost benefit?

Benway: It does, it definitely does. And that’s a great point that companies are trying to figure out a way to reduce that cost burden upfront. And they’re working with different revenue models, subscription services, retrofit models to where you don’t have to buy a new piece of equipment. You can buy an add-on to your existing sprayer or planter and still get the same benefits. And they’re working on being able to enhance adoption without the huge capital outlays.

Bigda: Maybe just to end the conversation, what are the biggest risks to the industrial sector that you are keeping an eye on in 2024?

Benway: One of the key risks is just labor inflation across the space. Historically, labor costs have been relatively low, and we’ve seen incremental margins be healthy across the industry. And so, now it seems like labor inflation is going to be a little more sticky, and we have to adjust our margin profile going forward.

I would say, definitely, from a cycle standpoint, a hard landing could occur. As we were talking about with the transportation space, it does seem like things have bottomed. But if consumers really start to slow with higher interest rates, we could see a double-dip and things could go back down and that would be negative across the sector.

Another more macro geopolitical risk is, as we saw with Russia, Ukraine, the impact on commodity prices and the impact on disruption across the space…in countries like the U.S. and China and relations there, it’s crucial that that dynamic remains stable and we continue to have good relations or that would ripple across the industrial industry.

Bigda: Sounds like there’ll be a lot to follow in the industrial space in 2024.

Benway: That’s true.

Bigda: Thank you so much, Chris, for joining us. We really appreciate it.

Benway: Thank you for having me.