Multi-Industry Update and Outlook

Industrial Yellow Brick Road Requires Digital Transformation to Thrive in Flat Industrial Economy

Monday, October 24, 2016

Multi-industry analyst Nick Heymann believes that we are on the cusp of a large change in how investors view the diversified industrial sector. After years of steadily diminishing end-market growth, multi-industry investors had come to view potential increased spending on public infrastructure in developed markets or eventual recoveries in energy markets as potentially better long-term places to invest.

By now, everything related to the oil patch was supposed to be pretty washed out, so stocks with energy market exposure presumably adequately reflected the requisite adjustments for the downturn in the energy sector. Meanwhile, the need for developed economies to shift to more-proactively expand public infrastructure funding led investors to believe this could result in better performance for some diversified industrials. Furthermore, growing doubts about the tangible benefits from data analytics resulted in diminished early adopters of new digital tools to create value in the cognitive technology economy. Instead, the merits of digital value creation strategies were widely perceived as too early or conceptual to fundamentally impact industrial companies near term.

We believe the current conceptual large-cap industrial investor framework could be turned upside down. The key catalysts for this change in perception would be a rising number of companies that have failed to achieve guidance for organic sales and earnings growth, particularly so close to the end of the current calendar year. Heymann doesn’t believe every large-cap diversified industrial will be forced to adjust guidance. “However, the increasing number that do is likely to force industrial investors to rethink their core investment strategies for large-cap multi-industry stocks,” he stated. This will have an impact on aspirational concepts such as public infrastructure exposure, and while unlikely to be totally dismissed, he believes the idea of investing for an energy recovery could be significantly scaled back.

“So how will the investment landscape for industrial investors evolve?” Heymann asked. “First, we believe the most important financial metric will be organic revenue growth.” In the current environment, the historical preeminence of ROIC has been superseded in the low-growth environment of the past several years by adjusted EPS. With the shift to inorganic growth to supplement dwindling organic revenue growth as the principal means of sustainably generating positive ROIC, any sustained further diminishment of today’s anemic organic revenue growth would force companies to develop a plan to participate in commercializing the Industrial Internet. He believes that the longer companies put off doing so will put their ability to competitively generate customer and shareholder value at risk. Structurally changing how companies create value is never easy. Today’s global economy and the recent trends in corporate capital allocation will make this change increasingly mandatory.

A possible source of improving global industrial productivity could be the Industrial Internet. If data analytics, deep learning, and digital optimization strategies using the Industrial Internet are able to more optimally utilize the estimated $20 trillion-$25 trillion of industrial fixed assets around the world, this could transform global productivity and growth without the traditional drivers of higher global trade or rising global GDP.

Heymann’s new framework for how diversified industrial companies are evaluated on their digital transformation starts with the premise that the companies earliest to incorporate digitization and stand-alone software are likely to be the most successful—but only if the entire company is committed, led from the top, and implemented throughout all levels of the organization. He believes “the most-successful early adopters will have to invest if they want to create predictive data analytics—the required skills sets are not readily sourced internally, particularly during an era of individual professional specialization.” Since these entail large investments for intellectual capital, Heymann believes this will skew the universe of digitally enabled diversified industrials to larger companies with strong cash flows and robust balance sheets, as well as a risk tolerance to willing go all-in digitally. Early leadership in digitization will likely generate cumulative benefits.

Heymann stated “today, industrial investors are at a crossroad: their historical metrics to assess and determine prospective fundamental performance has become increasingly less effective as a future predictor of stock performance.” The global economy seems to be caught in a vise of highly volatile subpar growth, diminishing the opportunity for companies’ fundamental performance to reaccelerate. This has encouraged industrial investors to shift focus to thematic investing around concepts such as higher public infrastructure spending or the future recovery of oil-and-gas capital spending. According to Heymann, the nature of the increased variability of the global macroeconomic environment and the shift to near-term niche investment strategies and thematic investing has challenged even the most nimble investors to generate sustainable above-average returns regardless of asset class and time horizons.

For a copy of this research report or for more information on the multi-industry companies covered by Nick Heymann, please contact your William Blair representative.

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