Pockets of Opportunity in Industrials

Updated version of original article from May 2023

At Prospector we evaluate all of our investments from the perspective of downside risk mitigation above all else. Across all industries, we target companies with strong, low-leverage balance sheets, dependable free cash flow generation, owner-oriented management teams, and M&A potential. The industrials sector happens to be an area of the market that lends itself well to our style of investing. Our exposure to the industrials group is not a function of where we think we may be in an economic cycle, but rather a constant feature of our portfolios that reflects our bottom-up, value-oriented approach to investing.

Considered by many to be the backbone of the US economy, industrials include a vast array of products, services, and technologies supporting just about every physical need one can imagine. As a sector, industrials is perhaps the most heterogeneous of them all, comprised of everything from aerospace & defense, building products, electrical equipment & machinery, construction & engineering services, and environmental services, to name a few. Like Financials, which we’ve discussed in recent blogs, the industrials sector is not the monolithic entity many make it out to be. The group should instead be considered a rich tapestry of sub sectors, each driven by its own unique dynamics and cycles.

With a growing consensus that economies are slowing across the developed world, industrials have faced pockets of selling pressure in recent months. In some situations, the proverbial baby has been thrown out with the bathwater, and many stocks with either meaningful earnings growth potential or profits that aren’t highly correlated to GDP growth have sold off. In other cases, there are quality companies operating in sub-industries with obvious secular headwinds that have been beaten down. We seek to take advantage of valuation anomalies in both situations.

On certain occasions, we find opportunities in sectors with relatively less earnings variability, such as Defense, or in companies with meaningful aftermarket or service-based economics. Conversely, we also look to capitalize on opportunities to add exposure to more cyclical names near the bottom of the cycle when valuations have excessively discounted intermediate-term headwinds. Our favorite ideas, however, take place when we identify stocks with secular tailwinds, attractive fundamentals, and reasonable valuations.

For example, we anticipate a significant secular tailwind for select industrials stocks as a result of four laws passed in 2021-22. Together, these laws add up to $1.1 trillion in loans, grants and tax credits: The Bipartisan Infrastructure Law (BIL), the Inflation Reduction Act (IRA), the Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act, and the American Rescue Plan (ARP).

More Government Infrastructure Spending Ahead Chart

Source: Politico

Our objective at Prospector is to capitalize on mispriced assets using our rigorous approach to fundamental analysis. Regardless of the macroeconomic environment, we have consistent exposure in our portfolios to a diverse set of high-quality industrials. As described above, this does not imply that every stock we own has a strong secular tailwind at its back. In our experience, some of the most compelling investments can often be found in sub sectors that are, for good reason, temporarily out of favor.

As always, there’s never a shortage of investment opportunities, there’s only a shortage of hours in the day.


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