Using Secular Tailwinds to Navigate a Choppy Market

The final few weeks of the first quarter were characterized by significant market volatility, with some of the largest regional banks vaporizing almost overnight, creating concerns about broader contagion across the banking sector. Thankfully our portfolios were largely insulated from the volatility, as we cut nearly all our bank exposure last year and quickly acted to sell shares of our one remaining bank stock before the worst of the selloff took hold.

In many ways the current banking crisis is a cautionary tale about failing to manage risk. In this piece we focus on companies and sectors we favor because of their long-term growth attributes. As you know, we run concentrated, high conviction equity portfolios composed of attractively priced companies generating significant cash flow and exhibiting reliable growth.

One of the key elements of our due diligence process is determining the underlying drivers of a company’s growth. Specifically, we try to assess whether the growth is driven by temporary cyclical forces or more durable secular trends. Cyclical businesses tend to do well when the economy is strong and suffer during downturns. Oil exploration and production is a classic example of a cyclical industry: oil is a global commodity that rises in price as demand grows but can collapse during periods of weakness. Secular growth trends, on the other hand, are less sensitive to the economic environment, as these trends are driven by structural (and often irreversible) changes in the economy.

Our equities are currently focused on a few key secular growth trends that present highly attractive opportunities and appear to have long runways for continued expansion:

1. Cloud computing
2. Onshoring
3. Growth in aerospace
4. Aging population

Cloud Computing

Cloud computing represents the delivery of computing services — servers, storage, databases, networking, and software — over the internet. The benefits of shifting to the cloud are numerous, from improved IT security to more efficient use of computing to reduced IT personnel costs. Companies report savings of as much as 30% on their IT budgets by shifting to the cloud.

Importantly, the penetration of cloud computing remains relatively low by virtually any measure. Estimates vary from less than 10% penetration to perhaps 30-40% penetration. Regardless, the cloud market remains wide open and should see years — perhaps decades — of growth ahead.

There is a wide array of companies serving the cloud computing market, and we have invested in several that should benefit. Two of the largest providers of cloud infrastructure and services are Microsoft and Alphabet (Google), both of which we own. Given scale advantages, high switching costs, and significant network effects, displacing the existing players is exceedingly difficult. Thus, the dominant players should see a long runway of rapid growth at high profit margins, despite bouts of cyclical slowdown like the sector is experiencing today.

Software players will also see benefits, as they transition from physical delivery of software to a cloud-delivered model known as software as a service (SaaS). New software offerings all use a SaaS model, but Oracle is still in the early stages of transitioning its legacy database business to SaaS. The shift to a cloud-based model should ultimately deliver higher margins to Oracle while increasing customer retention and streamlining upgrades and improvements. We invested in Oracle under the hypothesis that profitability and growth would improve because of this transition.

Accenture, another company we own, is the largest IT consulting firm globally and boasts unique advantages because of its scale and culture. The company plays a key role in helping clients shift their infrastructures to the cloud to reduce costs, improve security, and modernize their IT systems.

Another company we have invested in, Advanced Micro Devices, helps produce many of the semiconductors that operate cloud servers more efficiently. The company’s chips are rapidly taking share in the market for graphics processing units used in data centers.

Onshoring

We have written extensively about the trend of onshoring, arguing that manufacturing is likely to return to the U.S., as the Covid crisis exposed the risks of operating global supply chains, an aging population in China has reduced cheap labor availability, and a broad retreat from global trade deals has made foreign manufacturing more costly.

Recent data helps confirm our thesis. For example, for the first time since the 1970s, U.S. manufacturing employment is above prior peak levels and appears poised to grow further. Likewise, spending on construction of U.S. manufacturing facilities has also inflected higher. In addition, nearly $200 billion of domestic semiconductor manufacturing spend has been announced since 2020. Recent laws like the CHIPS Act and Inflation Reduction Act create strong economic incentives for onshoring.

The rise in onshoring should increase demand and activity across the U.S. industrial base while also accelerating the need for automation to save on labor expense. We have invested in an array of companies that should directly benefit from these trends.

Union Pacific and Old Dominion Freight Line are high-return, competitively advantaged transportation companies that directly serve the manufacturing base of the country and should see higher volumes as domestic manufacturing accelerates. Air Products & Chemicals is a dominant utility-like industrial gas company that serves the U.S. manufacturing sector. Ametek sells highly differentiated and mission-critical products for automation and semiconductor testing and measurement. And EastGroup Properties is an owner and developer of industrial distribution centers in supply-constrained sunbelt markets that have exhibited extraordinary pricing power as demand has shifted to the U.S.

Growth in Aerospace

One of the sectors that was most harmed by the Covid crisis was the travel industry. Hotels saw fewer guests, and flights in North America fell around 80%. As a result, revenue, earnings, and cash flow declined significantly, causing severe financial pressure for the aerospace industry. In the case of the airlines, they reacted by reducing flights and cancelling new orders. They also delayed taking delivery of new planes, limited orders of replacement parts, and parked planes instead of performing routine maintenance.

Historically, the aerospace industry, which provides equipment and services to airlines, has grown on average around 5% annually as demand for travel around the world increased. The pandemic reversed this trend. Post-Covid, however, global travel has begun to normalize, and airlines find themselves without enough young, fuel-efficient, environmentally friendly aircraft. Moreover, many of the planes that the airlines own need repairs and maintenance to get them back into flying condition. So, what was already a 5% growth industry is now being turbocharged by a multi-year snapback. This has created a situation whereby order books for aerospace companies such as Airbus, which we own, extend out many years as airlines try to replace their fleets. And demand for high margin components is benefiting other players in the industry, including engine and parts manufacturer Safran, another company we own. Ametek also benefits as a key supplier of niche, mission-critical parts to the aerospace industry, which represents nearly 20% of the company’s revenue. We believe that it will take at least 5-10 years for the aerospace industry to catch up with current demand. This will lead to outsized growth in revenue, profitability, and free cash flow generation over this period.

Aging Population

For many years, we have invested in a variety of health care companies that benefit from the aging of the baby boomer population. The U.S. population 65 years and older grew by a full one-third from 2010 to 2020, far faster than the rest of the U.S. population.

The health care sector benefits directly from this demographic trend, as the aging population has driven a substantial increase in the utilization of health care services. There are of course many different sectors within health care that are positively impacted, from OTC drug makers to providers of retirement homes and nursing facilities. However, we have focused our investments on a handful of companies we view as competitively advantaged and that should continue to see rising demand.

Becton Dickenson and Teleflex — both of which we own — are two highly innovative designers and manufacturers of medical devices and medical supplies. The companies benefit from increases in health care utilization and procedures, which are the direct byproduct of an aging population. These companies’ devices serve key needs for older patients by helping address a broad range of afflictions, from cardiovascular disease to prostate cancer to strokes, among many others. The devices often lead to better outcomes with less intervention at lower costs. Importantly, the companies’ devices tend to be highly regulated, have patent protection, and are embedded among the physician population, providing significant insulation against competition.

Final Thoughts

As always, we seek to invest in businesses we view as competitively advantaged and that offer attractive returns with limited downside. An important adjunct of this approach is to buy companies that benefit from strong secular tailwinds, because players in these industries tend to grow even when the broader economy is weak. The trick is to not overpay for such businesses.

To the extent we can identify underappreciated businesses operating in attractive growth industries at good prices, we believe we can better generate attractive risk-adjusted returns for our clients.

John Osterweis

Founder, Chairman & Co-Chief Investment Officer – Core Equity

Gregory Hermanski

Co-Chief Investment Officer – Core Equity

Nael Fakhry

Co-Chief Investment Officer – Core Equity