Reflecting on my research trip to the U.S. meeting with over 50 companies in four cities across various sectors including the industrial and technology industries, the overarching theme was that the U.S. economy remains vibrant and the current outlook is for this to continue with commentary from most companies being constructive.
The U.S. economy and what companies are saying:
The U.S. economic statistics are undeniably positive, which is good for sales growth, but also poses some cost headwinds for companies. The unemployment rate is down to 4.3%, the lowest since 2000 and initial jobless claims at very low levels. So, not surprisingly, this is leading to labour shortages in many industries, so finding skilled workers and dealing with wage inflation has now become a meaningful topic among U.S. companies. Additionally, many commodity prices and other manufacturing inputs have moved upward and this has contributed further to increasing costs for companies and also to the increase in CPI which has been around 2% for the last 12 months.
Other key positive indicators include the strong recovery in industrial production and the high levels of confidence shown in the ISM manufacturing and non-manufacturing indices and at the consumer level with the consumer confidence indicator quickly approaching the all-time highs reached in 2000.
These strong indicators have vindicated the Federal Reserve's decision to increase the target fund rate to 1.25%, up 100 bps over the last 2 years and there are expectations for another three rate rises over the next 12 months.
The economic outlook remains solid and there is the additional catalyst of a reduction to corporate tax rates which seems to be getting more momentum having passed through the House and is now up for debate in the Senate. The majority of companies are expecting this momentum to continue.
How is the market pricing this in?
Investors in the U.S. equities market have definitely bought this macro strength and corporate optimism and money has continued to flow into equities and push up valuations.
Over the last 6 months, we have trimmed and sold out of stocks where we feel expectations are becoming stretched and those that have met our price targets. For the last few years we have had an overweight to the U.S., but we have been taking a more contrary stance and have become less enthusiastic on U.S. equities and now have an underweight position - the bulk of that money has been reallocated to Europe where we have found quality companies at more attractive valuations.
What are some industry and stock specific take-aways?
Outside the broader economy, there were more industry and company specific takeaways from the trip.
- Corporate spending on technology continues to increase and this investment is no longer just a budget allocation decided by the CIO/CTO, but it is being driven from the top down by CEO’s. This investment has accelerated as we move to an online, internet driven economy with detailed analytics playing an increasingly important component in gaining and maintaining a competitive advantage.
- Data centre spend is quickly becoming the epicentre of the technology landscape which is benefiting the equipment providers as more corporate and consumer data is stored in the cloud. Cloud spend is expected to double by 2021, a CAGR of 20%.
- Security is a bigger focus as we continue to move to a connected world where customers and employees are demanding access to everything from anywhere! As we have witnessed, a data breach can be catastrophic to a company's brand so consulting, software and hardware to detect, protect and recover from these threats is an industry that we expect to grow quickly
- This secular shift is being supported by innovation in semiconductor and chip technologies, however we feel that after strong performance, valuations don’t reflect the cyclical risk that still prevails in that industry. We believe the strong franchises are the companies that have the direct relationship with the corporate customer, and less so, the industry suppliers further down the value chain
- What to do? As a sector, the structural drivers support our overweight positioning, however, we are cognizant of the positive effect that momentum trades plus the flows from passive strategies have had on the sector's performance. Therefore after such good performance from the sector, we have been diligently trimming names that have rallied significantly and where valuations have been increasing to potentially unsustainable levels. Our portfolio of technology stocks is well diversified across the market cap spectrum and is well placed to benefit from various positive thematics.
- Skilled labour is in short supply and pushing up prices, one area that was highlighted was the shortage of truck drivers. This could put pressure on supply of capacity, hurt margins due to increased wages at the same time fuel prices have been increasing, but it could also be a positive for rail stocks like Canadian National as capacity at the margin shifts from road to rail.
- The auto industry seems to be going through a renaissance, the cycle has lasted longer and been stronger than many have expected. Although profitability has improved over the last few years, we are still skeptical on the sustainability of this and think the sector looks fully valued, so we are staying on the sidelines.
- Aerospace and defense are two industries that have been working well, the stars have aligned. Airline profitability is solid and spending on fleet renewal and growth plus the availability of many new generation models from both Boeing and Airbus have resulted in strong backlogs, increased earnings visibility and improving cash flows. Additionally, defense spend has been increasing globally and many companies are talking about further upside as NATO countries move towards the target of spending 2% of GDP on defense.
- What to do? Our overall exposure to industrials has remained steady, although we continue to reduce exposure to companies that have clearly benefited from the cycle and those that have excessive valuations and replacing with companies that have strong earnings visibility and that have demonstrated stable earnings through a full cycle.
- Cyclical pause or structural shift? Ad agencies are adapting to customers scrutinising their media spend which has been amplified by activist investors keen on squeezing costs. There is less budget going to the creative side and more spend shifting to actually buying advertising space/time.
- Less spend on traditional media and more spend going to digital creation (websites, social media etc.) and digital advertising (Google, Facebook etc.). This has also resulted in the ability to have more targeted advertising, but has also increased the difficulty to measure ROI. Together, this has meant the need for data analytics has increased as customers want an end-to-end understanding of their spend and their customers. The major beneficiaries of this have been the traditional consultancy firms such as Accenture.
- The online oligopoly. The advertising industry and its customers want a scalable third platform, Google and Facebook can’t continue to take the lion’s share of digital advertising revenue. Snapchat has failed to do this, Twitter continues to try….is Verizon’s Yahoo!/AOL a potential candidate?
- What to do? We have recently added to our exposure in the advertising agencies as they look oversold and at these valuations the companies may even be attractive acquisition candidates. We continue to hold positions in some of the industry disruptors, but have trimmed back those positions as valuations have increased.