Investment themes—social and economic trends that provide “tail winds” for certain companies—can last for years and years. Washington is abuzz about “income inequality,” which I highlighted as an investment theme in the late 1980s, advising clients to avoid the “mediocre middle” of retailing in favor of chains serving lower income folks or the affluent. You need to get two things right: correctly identify the theme and find good companies that really will benefit from it. Themes, including the ones discussed here, are often rather obvious, but they tend to get overlooked by professional investors focused on:
- Short-term risks (“Will XYZ Corp. miss the quarter?”),
- The always inscrutable business cycle (“Is it time to buy ‘defensives’ because the economy is weakening?”),
- Financial characteristics (“Consumer staples should outperform because they have high dividend yields”).
Theme # 1: Purity Plays
Thanks to globalization and rising living standards around the world, there is more and more concern – on the part of consumers, regulators, and companies – about a broad range of contaminants that must be avoided:
- Diseases that can cross oceans on airliners – avian flu, swine flu, HIV
- Intestinal “bugs” that could ruin your whole Caribbean cruise
- Impure or fake pharmaceuticals
- Toxic substances in consumer goods (e.g., lead paint in toys)
- Toxic factory emissions such as lead and mercury and even CO2
- Bacteria such as salmonella and E. Coli in fish, meat, and vegetables
- Mislabeled food (horse meat in the hamburger, Yellowtail passing for mahi-mahi)
It is “mission critical” for governments and companies to avoid these contaminants. Bird flu in China cratered YUM’s stock price and caused a 20 percentage point swing in earnings. Therefore, respected and reliable companies that can help customers detect and eliminate contaminants enjoy strong demand and have ample pricing power; they include Ecolab, Clorox, and instrument makers such as Thermo Fisher and Agilent.
Theme # 2: A Cleaner, Greener, Safer Infrastructure
Much of the global energy and industrial infrastructure is being rebuilt to increase energy efficiency; reduce emissions of particulates, toxic substances, and CO2; and make the built environment (vehicles, houses, hospitals, airports) safer. This phenomenon has many interlocking elements, including:
- Around the world, tougher government regulation to reduce emissions by factories, power plants etc.
- Shift from coal to natural gas, especially in the U.S. This requires new pipelines, processing plants, petrochemical plants, LNG export facilities, etc.
- Renewable energy (solar and wind) and electric cars
- China’s pollution crisis will force it to rebuild its industrial infrastructure
- Cars and trucks will become smarter (stay in lane, avoid blind spots) and safer (more air bags, anti-lock brakes.)
- Smart thermostats and sensors that save energy and enhance security.
Ways to play this broad theme include: engineering and construction stocks such as Fluor; diversified industrial stocks such as GE, Siemens, and 3M; semiconductor and electronics stocks with exposure to the automotive and industrial markets; vehicles with lower emissions such as Cummins Engine, Honeywell, and Borg Warner; makers of thermostats such as Honeywell (which will have to compete with Google following GOOG’s acquisition of Nest).
Theme #3: Emerging Market Demand
Emerging markets may be slowing but they are still growing, and as they develop they need a lot of what sophisticated companies in developed nations produce, in such areas as:
- Agriculture—Monsanto, DuPont, Deere, Potash, etc.
- Aerospace—Boeing, Airbus, GE, United Technologies
- Commercial Real Estate—United Technologies, Honeywell, Siemens, etc.
- Tourism—bullish for aerospace, hotels, luxury retail
- Back-up power – Cummins Engine, CAT, GE
- Cars, trucks, and trains—GE, Siemens, auto and truck makers and their suppliers
Many diversified industrials sell into these markets, including GE, UTX, MMM, ETN, PH, ITW, DHR, EMR and many others. Short Wall Street research reports fail to convey how the three themes discussed above drive earnings. In the slide deck accompanying its latest earnings report, 3M gave us a flavor by highlighting three items:
- 3M’s liquid filtration business in China rose 70% in 2013
- 3M’s infection prevention business in India was named “Sterilization Services Company of the Year” by Frost & Sullivan.
- A 3M product was recognized by Uptime Institute with the “Green Enterprise Award” for improving the energy efficiency of data centers.
Three Themes Propel Superior EPS Growth by Industrial Companies
Obviously these three themes overlap and intersect, but they are all positive for companies involved in creating a cleaner, safer environment in emerging and developed economies. That is bullish for a broad range of industrial companies and their suppliers, including many tech firms. But perhaps this thematic talk sounds too ethereal and abstract. To measure its real world financial impact, I created two groups of stocks and compared their earnings growth, dividend yields, and valuations:
- 16 major industrial stocks: UTX, GE, ETN, BA, MMM, PH, ITW, PCP, FLR, UNP, BWA, CMI, CAT, DE, EMR, HON.
- 16 major consumer staple stocks, many with significant emerging market exposure: WMT, PEP, KO, PG, CPB, GIS, K, KMB, CLX, CL, KR, SWY, COST, AVP, MCD, CAG.
The industrial stocks grew much faster than the staples stocks, had somewhat lower dividend yields, and about the same PE ratio. Specifically:
- The Industrials’ median 8-year (2005-13) EPS growth rate was 10.8% versus just 7.3% for the consumer staples stocks.
- Industrials’ median PE was 18.2x versus 18.0x for the staples stocks.
- Industrials median dividend yield was 2.1%, lower than the staples’ 2.9%.
Bottom line: the industrial stocks look more attractive. Using the metric [PE / (EPS growth rate + dividend yield)], the industrials get a valuation score of 1.41 or [18.2/(10.8 + 2.1)], which is much cheaper than 1.76x for the staples stocks [18.0 / (7.3 + 2.9)].
Of course, these scores use historical growth rates and only have investment significance today if these growth rates continue. That’s where thematic analysis comes in. I think the three themes identified here will, in fact, continue to drive faster earnings growth for the industrial stocks than the staples stocks– particularly because such firms as PEP, KO, CPB and MCD will be hurt by a global push for healthier foods to fight obesity and diabetes.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
Full disclosure: I own quite a few of the stocks mentioned in this post but I am not specifying which ones to avoid appearance of an endorsement.
