Investing in megatrends through mission-critical ‘ingredients suppliers’
Suney Hindocha, analyst on the Global Sustainable Equity Team led by Hamish Chamberlayne, discusses some of the mission-critical, and often overlooked, businesses that are essential to the megatrends which are shaping the future.
7 minute read
Key takeaways:
- Megatrends serve as powerful ‘forcing functions’ for secular investment trends that cut across all industries and sectors.
- Beyond the well-known companies that feed into today’s megatrends are many other essential but overlooked businesses, which often present a good degree of pricing power and a predictable demand profile rooted in customer stickiness.
- We believe that these types of businesses have the potential to act as ‘natural compounders’ over time, offering a more predictable growth profile, often at a compelling valuation.
A megatrend can be characterised as a trend that has an effect on a global scale. These megatrends may be environmental or social in nature and, given their worldwide reach, serve as powerful ‘forcing functions’ for secular investment trends that cut across industries and sectors. Within the Global Sustainable Equity Team, we employ investment themes, as defined in our process, to seek businesses that are potential beneficiaries of these large-scale and inexorable currents. As a result of the forcing function of the megatrends, they can serve to have a ‘natural compounding’ effect for the businesses embedded in their steady motion.
We have identified a number of current megatrends that span industries and themes. One such megatrend is ‘the Electrification of Everything’, an area in which we have endeavoured to identify rewarding investment ideas on behalf of our clients.
The ‘Electrification of Everything’
The world’s infrastructure is becoming electrified, driven by technology and the need for more sustainable solutions. There will be $3.5 trillion1 in investments over the next five years targeted at new infrastructure to deliver 5G technology for an increasingly connected world. Industrial automation is also taking hold at a rapid clip, with $330 billion2 in investments by 2025 geared towards the utilisation of smart tech and big data in manufacturing. Smart buildings will require new solutions that are electrified and improve energy efficiency. Yet a further instantiation is the $2.1 trillion3 in rail investments, given the fact that rail is an alternative sustainable form of transportation requiring significant investments to modernise rail infrastructure. The transition to clean energy and decarbonisation is also driving electrification, with Europe, China, and the US planning to invest around $2 trillion each in this regard.
The broad trend of electrification is in turn driving more power and data usage. This megatrend has popularly been referred to as the ‘Electrification of Everything’, spanning the modernisation of the grid, the adoption of more renewable energy, the expansion of broadband with 5G, and the shift to electric vehicles, among other ongoing transitions. Electricity demand is growing at breakneck speed – a dynamic that has become ubiquitous across the globe.
The World Nuclear Association predicted in 2020 that data centre growth, along with the electrification of transportation and heating systems, would lead to growth in demand for electricity being about two times faster than growth in overall energy demand. Consequently, the global electrical equipment market is expected to have a compound annual growth rate of around 8% from 2022 to 2027.4
Playing megatrends with ‘ingredients suppliers’
The great investors of the current epoch, most notably the likes of Charlie Munger of Berkshire Hathaway, have routinely applied a ‘mental models’ framework to investing – identifying categories of business models with common characteristics that could potentially outperform the market over the long haul.
Seeking out businesses that supply mission-critical products can broadly be categorised under the mental model of ‘ingredients suppliers’; these companies often produce key components for a larger process or end-product, which are commonly out-of-sight of the end consumer, yet their function is pivotal to the overall operation of the final good or process that they serve.
Typically, these ingredients constitute a small proportion of the overall cost of the final product which they feed into, but as with ingredients used in cooking your favourite meal, even marginal variations or imbalances can spoil the dish! Owing to the high cost of failure coupled with their negligible cost contribution, such products are conferred a greater degree of pricing power, alongside a predictable demand profile rooted in customer stickiness, leading to attractive returns and a narrower range of potential outcomes for investors.
We believe that exposure to megatrends through essential ‘ingredients suppliers’ provides an effective means of generating favourable investment outcomes for investors, often with a relatively lower risk profile compared to the businesses which produce the ultimate end-products. Moreover, many of the end-products exposed to megatrends may be present in cyclical underlying industry structures; therefore, being one-layer-removed, through investments in suppliers to these product areas, could aid in mitigating volatility and dampening the cyclicality, as the ‘ingredients’ tend to be longer-cycle by their very nature.
It can also be difficult to invest in the end-products due to competition, poor industry structure, government regulation, and capital intensity, which are dynamics that the suppliers are often less exposed to. We want to invest in companies with attractive economics and stable returns, and these are frequently found in the companies providing the critical enabling technologies, parts, and ingredients for the end-products.
Identifying mission-critical ‘ingredients suppliers’
We are advocates of seeking out high-quality, durable business models with the scope to compound capital over the long term. nVent Electric is a global leader in protecting and connecting electronics, and is a prime example of an ‘ingredient supplier’ which plays on the electrification megatrend, while also serving to promote safety and drive efficiency.
The company’s core value proposition as it pertains to electrification lies in its ability to protect and ensure the efficiency of electronic systems. As electrification persists, the increasing installed base of electrical equipment will require protection and connection. As is the case for many ‘ingredients suppliers’, nVent offers mission-critical electrical solutions where the product represents a small portion of the total materials cost. For nVent, this includes the supply of technical enclosures, fasteners, control systems, and other critical components. These products serve to protect its customers from the high cost of failure, with downtime potentially aggregating up to $1 million per hour(!) for some end-users.
As industries and applications become electrified and digitalised, an increasing number of data centres and connected products will be required. In addition to data centres, nVent’s products are also used in automation, onshoring, sustainable technologies and the internet of things.
Aside from nVent, there are many other ‘ingredients suppliers’ which serve a multitude of end markets, and which are exposed to different themes. To name a few, Knorr-Bremse is a market leader in braking solutions for the rail industry with over 50% market share, and looks well positioned to benefit from the modernisation of rail infrastructure given it supplies components that are vital for rail safety and sustainable vehicles. Meanwhile, Advanced Drainage Systems, which supplies critical piping, water management and drainage products, has a dominant share of the growing thermoplastic pipe market in the US. Here, we believe the company is a key enabler in the pipe industry’s significant material conversion shift from high-emitting traditional materials, such as concrete, towards plastic. Another example is ASML, which produces highly advanced machines for the production of semiconductor chips through lithography, used in everyday consumer technology products such as smartphones.
The importance of process and patience
As a team, we place emphasis on investment opportunities that offer a clear path towards a more sustainable world and that are exposed to megatrends and secular dynamics that are shifting the world around us. We believe these types of businesses can often display healthy and predictable growth with more straight forward risk profiles. Given that ‘ingredient suppliers’ are often overlooked, they can sometimes be mispriced by the market, leading to compelling valuations which can provide a margin of safety for investors. Companies such as these have the potential to act as ‘natural compounders’.
Indeed, compounding is often referred to as the “eighth wonder of the world”. The ‘natural compounding’ effect of megatrends tends to play out over a number of market cycles, so we are firm believers in the value of patience in the investment process to achieve this, which can be an imperative source of investment edge. As Charlie Munger once famously said, “the big money is not in the buying or selling, but in the waiting.”
Footnotes
1 Oxford Economics Report 2019
2 Fortune Business Insights 2020
3 International Union of railways, Analysis of Regional Differences in Global Rail Projects by Cost, Length and Project stage, 2o17
4 The Business Research Company
Cyclical stocks are companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. The prices of equities and bonds issued by cyclical companies tend to be strongly affected by ups and downs in the overall economy, when compared to non-cyclical companies.
Volatility measures risk using the dispersion of returns for a given investment.
Alpha compares risk-adjusted performance relative to an index. Positive alpha means outperformance on a risk-adjusted basis.
7 minute read
Key takeaways:
- Megatrends serve as powerful ‘forcing functions’ for secular investment trends that cut across all industries and sectors.
- Beyond the well-known companies that feed into today’s megatrends are many other essential but overlooked businesses, which often present a good degree of pricing power and a predictable demand profile rooted in customer stickiness.
- We believe that these types of businesses have the potential to act as ‘natural compounders’ over time, offering a more predictable growth profile, often at a compelling valuation.
