Lowland: Industrial Strength



Is it right to continue with our significant weight in industrials given the late stage in the economic cycle?
On one hand the post-Brexit environment is quite reassuring. Markets have recovered to beyond pre-referendum peaks and data releases are, on the whole, upbeat. In the face of already extremely low interest rates, Theresa May could turn to fiscal policy to boost the economy, increasing infrastructure spend and driving industrial sector demand.
On the other hand this view may be too optimistic. Fiscal policy may disappoint in its scale and take time to filter through into underlying demand for goods and services (for companies such as contractors and housebuilders). There is also the risk of a broader global slowdown emanating from the US.
Either way, given the uncertainty, investing in the industrial sector is likely to be viewed as somewhat contrarian. For Lowland Investment Company the industrial sector is its biggest sector overweight, making up around one quarter of the Trust’s assets. Despite the uncertain backdrop we think there are some compelling reasons to invest in these businesses:
1)     The engineering involved is often highly specialised creating globally competitive products and services with excellent overseas demand. Many of the businesses have highly international end-market exposure. This is true even for smaller market cap companies that we hold such as Somero (described in more detail below). In the face of uncertainties in single markets, a diverse source of revenues from across the globe prudently reduces these risks.
2)     Even in competitive markets these businesses tend to retain strong operating margins, in the low to mid-teens. This means they are highly cash generative - helping to secure the dividend payment and enabling management to be reactive and explore new opportunities such as investing in new projects or merger & acquisition (M&A) activity.
3)     The financial crisis has left management teams approaching their balance sheets rather conservatively; many suffered from being overly leveraged going into the financial crisis and have learnt from this mistake. With stronger balance sheets the dividend payment is covered with greater security, offering confidence to investors.
Is this too much sector risk?
Putting aside the relative positive factors between these businesses, few similarities exist beyond these. The sheer breadth of business in which they engage is vast, operating in many countries across the globe and in many niche end-markets. As is evident in the companies outlined below, manufacturers specialising in road signs are poles apart from those in components for 787 jets. It means end market conditions vary wildly from sub-sector to sub-sector, company to company, so rather than the whole sector moving in one direction, companies will often differ depending on the micro-market influences affecting that one particular stock. It’s a fertile hunting ground for stock-pickers. Below are three examples from the portfolio.
Senior is a stalwart British engineering firm specialising in components for the auto, industrial and aerospace sectors. It has two main divisions: Aerospace, providing components for aircraft structures and gas turbine engines, and Flexonics, or flexible components such as fuel injection lines.
Roughly 40% of sales are in the large commercial aircraft segment with components designed into Airbus’ A350 and A320neo and Boeing’s 787 and 737MAX. With production of these jets being significantly ramped-up over the next few years, supplying these projects is a marriage of inextricable linking. The precision nature of the parts means Senior is very unlikely to be outcompeted or replaced, unless indeed the quality of engineering falls below par or delivery deadlines are missed. It means operating margins are strong and revenues are stable over the lifecycle of the projects, which also tend to be lengthy.
Hill & Smith
Hill & Smith manufacture products for the infrastructure and construction industries. Their most notable area of specialisation is in crash barriers and variable message signs for roads. They command a large part of this specialised area of the market.
Road spend in the UK is exposed to relatively long-term structural growth as the Government’s Road Investment Strategy already sets out significant spend to 2020, and this could be topped-up if Theresa May’s government allocates more to infrastructure. There is also further potential in the US where a ramp-up in road building is beginning.
As you can imagine, a lot of concrete is poured the world over amid the endless development of global infrastructure. The stacking of floors in buildings requires concrete to be very flat. In many places his tends to be done by hand, however Somero – founded in the 1980s by a technician in this area - provides laser-guided machine-assisted solutions that create precision casts at much quicker relative speeds.
Having performed poorly initially at IPO, Somero has been doing better in recent years as investor fears around market concentration and the associated cyclicality have waned with management’s success in diversifying revenues.
A volatile ride?
In difficult end markets it is increasingly important to be positioned in skilled and specialised companies with strong barriers to entry. We think industrials are a good example of this – the companies we hold tend to be designed into long life programmes, in many cases with structural growth in areas such as civil aerospace. We believe this should provide a path to more reliable earnings growth and cash flow generation; an attractive proposition for Lowland’s shareholders.
The above example is intended for illustrative purposes only and is not indicative of the historical or future performance of the strategy or the chances of success of any particular strategy. Henderson Global Investors, one of its affiliated advisors, or its employees, may have a position mentioned in the securities mentioned in the report. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.


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