Assistant Portfolio Manager David Chung discusses the ongoing recovery in the manufacturing sector and how technological innovation is helping drive longer-term growth in certain industries.

Key Takeaways

• Though typically more severely impacted during recessions, manufacturing has thus far recovered faster than the services sector.
• Recent data show positive results and an encouraging outlook for select industrials as the recovery broadens.
• While technology stocks have been clear beneficiaries of the digitization of the global economy, we also see technological innovation driving growth in less obvious, more traditional segments of the market, like industrials.

While the economy overall has been hit severely by the COVID-19 pandemic, in contrast with previous recessions, manufacturing has rebounded faster than the much larger services sector. Demand for services is typically more resilient in economic downturns, but lingering social restrictions and the resultant changes in consumer behavior have destroyed demand in many service-related industries.

In contrast, manufacturers have been deemed essential businesses, with factories predominantly remaining open during the pandemic and some even benefiting from behavioral changes and catch-up spending from delayed demand for physical goods. For example, as consumers cancel vacations and work from home, many have purchased new power tools to complete DIY home projects or bought paint to brighten up a room. And while December may see consumers finally purchasing the cars or dishwashers they had originally planned to purchase in May, the haircuts skipped in April represent demand that has been permanently lost.

Bright Spots Emerge Amid the Recovery

Recent data suggest that the economy and, in particular, manufacturing continue to rebound from a historical second quarter contraction much quicker than many would have predicted. The Institute for Supply Management (ISM) manufacturing purchasing managers index (PMI) level for November continued to register squarely in expansion territory, as it has done so for six consecutive months. There are very few signs that inventory restocking is driving the recovery, so assuming the pandemic doesn’t worsen materially, we believe short-cycle orders and industrial production can continue to improve from current levels, contributing to further growth.

Overall, we see stabilization across industrials sectors and a steady gradual recovery that has been better than expected as compared to company guidance and commentary in second quarter earnings calls, when results were at their weakest. Auto manufacturing and residential construction have been the clear bright spots as consumer spending remains relatively strong, bolstered in part by a rapid stock market recovery and a robust housing market. We expect select industrials firms to report results above management guidance or consensus estimates for 2020 and believe that current valuations for some stocks are still reasonable, allowing room for further price appreciation in the coming year.

Technological Innovation Helping Drive Longer-Term Growth

While we continue to see signs of a cyclical manufacturing recovery in the near term, we also see potential for longer-term secular growth as more traditional industries leverage technology in innovative ways.

For example, farm machinery can now be equipped with sensors and systems that collect and analyze data to more effectively prepare fields based on soil conditions, optimize seed placement and spacing, apply fertilizer more efficiently, and improve harvests. Tech advances like these that bring value to farmers may lead to an upgrade cycle in the industry, driving volume growth, strong pricing and product mix for manufacturers, and enhancing profits.

Investments in warehouse automation technology could also help amplify the benefits of rapid e-commerce growth. As online shopping has boomed, customers have demanded faster order fulfillment. At the same time, online retailers face qualified labor shortages and increasing labor costs in their distribution centers. Fully automated systems for scanning and sorting packages in warehouses could enable retailers to address these issues and operate with greater efficiency and safety. A “dark warehouse,” with order-picking robots that can grasp objects with dexterity comparable to the human hand and autonomous machines that load and unload trucks, is in the not-too-distant future.

In public safety and security, new technology is expanding the pool of available tools from traditional radios to exciting areas such as cloud-based software, facial recognition, machine learning and analytics. Consolidating voice, video and data onto a single cloud-based platform – rather than relying solely on 911 voice calls – allows public safety agencies to more effectively respond to and resolve incidents. Facial recognition technology and analytics can help agencies investigate and detect crime by effectively sorting through an ever-growing volume of video data. As government budgets are stretched and resources get dedicated to other needs, such as COVID-19 stimulus, we believe public safety departments will need to increasingly deploy technology to automate and enable more efficient operations, providing opportunity for durable growth.

Uncovering Growth Potential

Thus, while a select group of well-known technology stocks have been obvious beneficiaries of this year’s digitization of the global economy, we see technological innovation also driving growth in less conspicuous, more traditional segments of the market. Companies that are able to adopt and leverage technological advances may offer investors opportunities for long-term growth.

To that end, while we have begun to see signs of improving business and manufacturing activity, we believe it remains important to focus on bottom-up fundamentals to identify companies with strong balance sheets and sustainable competitive advantages that are positioned to benefit from long-term secular themes.