SCOTT DAVIS: When I think about mega trends that influence industrials the most, it would be things like electrification. So, you think about electric vehicles, which in itself is amazingly exciting. But even further than that, it's just the electrification of the world.
You go from a world that is burning a lot of coal to solar and wind and other more environmentally friendly technologies. Each of those technologies benefit the industrial world and if nothing else, because you need to spend money around them.
My name is Scott Davis. I run a company called Melius Research, which is a boutique research investment house that was founded about 18 months ago, a bunch of ex-Morgan Stanley and Barclays senior folks. And we focus on industrials and data analytics.
What's the case for industrial stocks?
We focus on industrials research. And industrials, when you really think about is it is the oldest sector in the S&P 500. It is battle tested. It's been around for over 100 years. GE was the original industrial, if you want to call it, then it actually was thought of as really a tech company back when it was founded back in the late 1800s. We focus on industrials research, because it's central to almost every major economy in the world, particularly when you go into emerging markets where industrial economies tend to equate to extraordinarily large amounts of GDP say, two or three times that is as important as the US.
We follow a lot of macro data, we look at an awful lot of just reams of data, most of which is macro, some of it is micro, some of it is proprietary, really to glean- have a view at least about the economy overall. And then what sectors make the most sense to invest in any particular time. And, of course, as I said, our expertise is in fact, in industrials.
What's your view of the business cycle?
Generally, we're bullish on the industrial cycle and the cycle overall, the business cycle. What we see really playing out in the next several years is a return to investment in developed markets. So, when you really think about the last 20 years, every incremental dollar of capital has been spent, predominantly in emerging markets. We see that reversing. Now, more money coming back to and particularly the US, to a lesser extent, maybe Europe. But really, the US is the place that we're most bullish on. And then the countries around the US, like Canada and Mexico are certainly beneficiaries as well.
When we think about that incremental dollar of capital spent in the US, the best illustration I'll give you why this is important is that when US companies sell into a country like China, there's typically selling into a region with a ton of competition. You're competing against the Japanese, the Koreans, the Europeans, on average, you might capture maybe 15% market share. When you sell into the US market and on your home turf, your market share may be as high as 30% to 50%. So, every dollar of capital that comes back from being spent in an emerging market to a country like the US has really a multiplier effect on the companies that we follow.
And when I talk about companies we follow, it could be everything from 3M to Emerson, to Honeywell, even we cover aerospace. So, companies like Boeing, for example, which obviously has some challenges right now. But longer-term, big picture is fairly bullish overall.
So, that's the way we look at it that as far as what inning we are in the cycle- we think we're probably in the general business cycle, we're probably in the seventh inning. In the industrial business cycle, we think we're probably more like the fourth inning. So, I wouldn't call it early cycle, but probably more like mid-cycle. And we think we've got several really good years in front of us on the industrial side.
What's your take on Q1 earnings?
What we learned in 1Q is that the business cycle, the things that we just referenced as far as being bullish longer-term are actually playing out. Investment is being made in the US. And that investment could be as simple as supply chain, things like warehousing and stuff like that, to actual factories, to automation, to robotics. We're seeing that spend. What we are seeing on the other side of it is a real slowdown in emerging markets, in particular China, and particularly the Chinese consumer.
So, when you think about the Chinese consumer who has been just buying car after car for the last several years, auto sales have been through the roof. Auto sales, for example, right now, we're seeing is really, really weak. So, our investment case, as far as money coming back into the US is playing out in real time, we're seeing that for sure. We saw that in the results.
The companies that were more levered to the Chinese consumer were the companies that really struggled this quarter the most. So, like 3M is our most global company. And it's about 35% emerging markets and really struggled this quarter because those markets in particular are weaker. The companies that are more focused on the US and more focused on what we call later cycle things which are more project and capital spending type activities. Companies like Honeywell. Those are the companies that that gave us just fantastic results in the quarter. And we think that's going to continue, really for at least the next year, maybe up to three years.
What broad themes are you watching?
The other thing we get excited about industrials are mega trends. And when I think about mega trends that influence industrials the most, it would be things like electrification. So, you think about electric vehicles, which in itself is amazingly exciting. But even further than that, it's just the electrification of the world. You go from a world that is burning a lot of coal to solar and wind and other more environmentally friendly technologies. Each of those technologies benefit the industrial world, if nothing else, because you need to spend money around them.
You need to spend money to fix the electrical grid if you're going to put solar and wind on, you need to build new factories if you're going to build electric vehicles. Just look what Tesla has done out in California. And look at some of the electric vehicle launches that we're seeing even from like General Motors and Ford, they required new plant and equipment. They required new robots and I'll just call it new capital period. And that investment benefits us tremendously.
The other thing that excites us is infrastructure. And I don't think it's going to come as any surprise to anyone when you look across the US and just see how old our infrastructure is. And I don't care whether you're talking about our highways, or rail or airports, whatever. And we haven't built a new airport. And gosh, I think it's like 45 years or something the last new airport that was built in this country, bigger part at least was in Denver. All of that stuff needs a huge investment. And so, when out of Washington, I talk about a $2 trillion infrastructure plan. I think that eventually you'll see money being spent out of the federal government. We almost don't need it because the private sector itself will start to invest heavily in the infrastructure because it just has no choice. That is also just extraordinarily bullish long term for industrials.
The other thing we're excited about is global air travel. And when you think about the population in emerging markets of which so many people are getting on an airplane for the very first time, and you're rather than taking an eight-hour boat ride between different islands in Indonesia, for example, or the Philippines, jumping on an airplane for a 30-45 minute John is just so much more practical. And I think once you do that, you're unlikely to go back to the methods of transportation that you're engaged in before.
So, when we think about global air travel, that's an exciting theme as well, which will also require spending. It will require spending on new airplanes, and we've seen very strong orders for Boeing and Airbus, really the only two aircraft manufacturers in the world. And will need new airports. And when you talk about new airports, airports need a lot of electrical wiring and lighting and air conditioning and security systems and all kinds of stuff that our companies sell. So, that's another theme that I think we're really excited about.
Do you think about industrials domestically or globally?
When we think about industrial companies, we think globally. It's tough to have a conversation about Boeing without talking about Airbus. It's tough to have a conversation about Caterpillar without talking about Komatsu. It's tough to talk about Emerson without Yokogawa, which is a Japanese Process Automation player that competes against Emerson. It's a global industry. When you look at the US players and the European players, their footprints are pretty similar. And normally, what we see in in a global industrial, in the average global industrial, let's just say a Honeywell, for example, would be revenues of about 50% in the US, call it 25% in Europe and 25% in emerging markets, some mix roughly about that ballpark.
So, it's not good enough just for the US to be strong for our average industrial company to do well. The world needs to be relatively healthy. You can't be in a recession in the rest of the world and still be okay in the US for more than maybe a couple quarters, which I think we've seen some of that lately, where the rest of the world is slow, while the US is strong. We would expect the rest of the world to perk up and we've seen signs of that already. But it really is a global industry. Folks compete globally. It is largely consolidated because industrials- and talking about industrials goes back 100 years. You have major conglomerates, big successful great companies like Siemens in Germany, for example, or Schneider, Air France and competing against companies like GE in the US and Mitsubishi in Japan.
These companies have had literally 100 years to consolidate their competitors and their supply chains and things like that. And so, generally, industrials are much more consolidated than most other sectors out there just primarily because it's just been around a long, long, long time.
What's your view on robotics & automation?
One of the things that we're really excited about is technology moving down to the factory floor. And I think most people are comfortable or at least aware of what a robot is. But robotics technology has come a really long ways. And I'll just give you an example, a traditional robot was something that was put in a cell somewhere that had to be far away from people because it could whack you in the head or generally could be dangerous if it was moving and somebody didn't pay attention.
Now, they have things called cobots, which are basically robots that will stand right next to you on the factory floor and help you so maybe instead of bending over and having to pick up something and put a part together, let's just say on an auto plant, you could stand next to that robot and the robot could really do the heavy lifting and all the difficult stuff for you. And maybe the person just make sure that it's done right in positioning and such.
So, that change is massive, because when you look back 20 years ago, jobs went to places like China, purely because of labor costs. And when folks put factories into China, they did not automate them, or they automate them just a little bit. When you think about bringing jobs back to the US and factories back into the US, you need to do so in a reasonable cost basis. And how we think about it is if you can take 50% of the jobs out of a traditional factory, and put it in the US, you're pretty much at cost parity with that same factory in China. The only way to take those jobs out, though, are with robots and general automation.
And so, we think companies like Rockwell Automation, for example, which is one of the leaders in automation are really exciting for us, because these factors just have to change. They need to become more productive, more efficient, quality control needs to be higher, and they need to move closer to the supply chain, which means closer to the customer. And if that customer is in the US, then you're more likely to build that product in the US going forward versus building it somewhere else, and then shipping it all the way across the world.
So, I think those developments are exciting. It's still early days, but the technology is moving really rapidly from what we'd characterized as the consumer electronics boom that we've seen in the last 10 years or so to something similar we think is going to happen on the factory floor, particularly around connectivity and IoT, that could just completely change the way that companies make products going forward.
Will automation change the competitive landscape?
It's actually a great question around what are the competitive threats as automation proliferates? And what we've learned at least is, and gosh, I've toured hundreds of factories in my life. And what we've learned is that that domain knowledge is still critical. So, it's really hard people come to us and say, okay, we don't understand why Microsoft or Oracle hasn't come down to the factory floor more aggressively and taken market share from some of the traditional automation guys. And the reality is, is that each individual customer type has its own processes and their own nuances.
So, pharmaceutical, for example, has its own needs versus the auto industry versus consumer electronics, if you're making an iPhone, for example, is going to be way different than making a biologic like Humira. That domain knowledge becomes really critical. And that's the main barrier of entry from the tech industry coming in aggressively into the industrial world.
What needs to happen, though, and what we think will happen are more partnerships. So, for example, we do see situations where like Rockwell Automation has a tremendous partnership with Microsoft, because there's technologies they both can bring to the factory floor together that are more powerful than going separately.
What's your framework for evaluating equities?
When we think about picking stocks, we start thematically. What are we excited about? We talked earlier about being excited about capital spending, automation, electrification, some of these mega trends, then you bring it down to the individual stock level, it gets a little bit muddy or a little bit more difficult. We are super excited about Rockwell Automation, because it's a pure play automation company and the factory floor just exceptional company.
We're excited about Emerson. Emerson is about two thirds to three quarters automation now. It's almost a pure play. It has some other businesses but huge automation business.
Honeywell plays to these themes, not just automation, but also other capital spending themes and has a large aerospace business that we're bullish on. Those are three names that come to mind on the automation side.
When we think about electrification or TE Connectivity, maybe a company that not a lot of folks have talked about, it's not a household brand. But TE Connectivity is a company that makes all the connectors and little electrical widgets that go in and in an electric vehicle. And that's exciting to us as well.
So, there's several names to play- everything I think we're recommending stock wise plays into a capital spending theme in some way, shape or form. I want to think about my colleagues at Melius, some of the stocks that they're excited about- Carter Copeland, who does aerospace for us, loves Boeing. He loves buying Boeing in this pullback that we've had here, because he believes in the dynamics around global air travel and the demand for new airplanes over the next long term more than five years, 10 years as folks travel more.
My other colleague Rob Wertheimer is super excited about the technology advancements being made at companies like Trimble, for example. And the value that you get in buying a Caterpillar because when you think about infrastructure span, you really can't do that without moving dirt. And Caterpillar is the best dirt mover in the world.
So, those are a few stocks we're excited about. There's others smaller down the market cap that you can play that maybe provide some more upside things like Rexnord, a company probably not a lot of folks have heard about. ITT, which is another one that's relatively small, but exciting as well.
What stocks are you bearish on?
So, when we think about the stocks we don't like, it's really just the inversion of what we're recommending, which is if we love capital spending, that largely means we don't love stuff that's going to be shorter cycle, more flow goods, that the poster child or that would be a 3M. And 3M is struggling right now. It is a world class company. It's a fantastic company. But we just don't see the demand for their products right now. That'll change in a couple years as things cycle in and out. They're also more exposed to emerging markets than other companies that we cover. And again, we would we would prefer to have more US based exposure. And as much as you can get it, most of our companies are global, of course, but less global.
Generally, I think anything that is it is shorter cycle, more flow goods, we're going to be less bullish on. Not outright bearish, I would say in anything just because the industrial economy is still in its relative infancy compared to the consumer economy, and they were just now a couple years, I think we're seven quarters into an industrial up cycle. That's really not much at all, compared to the general business cycle, which is now a solid, eight, nine years in the making.
What's your view of the global macro picture?
When we think about the global macro picture, and first of all, just the elephant in the room is