By Alex Game, manager of the Unicorn UK Smaller Companies Fund
Industrials have been unloved by investors, seen as too dull at a time when growth stocks were in favour, or too cyclical at a time of economic weakness. While they may lack glamour, the UK is home to a rich pool of high quality, engineering-led industrial companies that merit closer attention.
By virtue of its early industrialisation, the UK has a lengthy pedigree in precision engineering. These companies are often off-the-radar, but are genuinely world-class, serving global markets in niche areas. They are often global leaders, with a long history of delivering reliable returns through a range of market conditions.
Today, these companies have a compelling short and long-term investment case. In the longer-term, they are benefiting from key structural growth trends, such as decarbonisation. For example, among its many business lines, Birmingham-based Castings manufactures specialist parts that protect the undersea power connections of offshore wind farms. This is a highly specialised activity, with parts needing to be uniquely robust while also rolling around with ocean movements. Ashtead Technology is also participating in the development of the global offshore energy sector.
Elsewhere, Goodwin specialises in making high-specification steel products. These are used in frigates and submarines, with the company benefiting from the recent surge in defence spending. Products from filtration equipment company Porvair are used in aeroplanes, laboratories, or water filtration – wherever there is a need to make something cleaner, better or more efficient. This is vital at a time when companies are trying to preserve resources.
In the shorter term, these companies are benefiting from demand built up during the restrictions of the Covid pandemic. Industrial companies were impacted by production slowdowns, which reduced demand for the parts they create. As supply chain issues have resolved, that demand has come back, giving these companies unprecedented visibility on their order pipeline.
Castings, for example, has two major customers in Volvo and Skania. In a normal cycle, visibility on orders will be short because the two manufacturing giants keep their suppliers on a tight schedule. Today, these companies are scrambling to meet demand for trucks and other vehicles that weren’t manufactured during the pandemic. For Castings, this means its order pipeline is several months long, rather than a few weeks, which allows them to invest in new capacity and grow their business. This is generating a strong underlying recovery from those depressed volumes.
These are global businesses, whose customers might include the US Department of Defence, global governments or police forces. They have traded through world wars, pandemics, multiple governments and have relatively little sensitivity to the UK economy. Yet the market still under-rates these specialist companies. It is inclined to see them as highly cyclical and subject to the normal industrial cycle. As a result, these companies are trading at a 20% discount to their 10-year average.
The economic outlook has improved but is still uncertain. Nevertheless, these companies can take comfort in a strong order book and their exposure to structural growth themes. The long-term outlook is, in our view, extremely strong.
Equally, their cyclicality has been exaggerated. The market is looking at industrials as if they are facing a textbook recession. In this environment, one area would see a fall in activity, rein in spending and bring about contagion to other industrial areas. This isn’t happening. If anything, the reverse is happening. These companies have a far brighter future ahead than their current share prices suggest.
There is also a shift in attitude from many of their customers. Increasingly, manufacturing companies are taking a ‘just in case’ view rather than a ‘just in time’ view. Inventory levels are higher, and we believe they are likely to stay higher. This is also changing the outlook for this type of business.
What could be a catalyst for these companies to be reappraised? Certainly, we are seeing more M&A activity across the portfolio and these companies have the characteristics that make them attractive to buyers: they have specialist products in areas with a growing end market, they are cash generative, conservatively valued, and sterling is low relative to its history.
However, M&A is only ever a backstop – it can take great companies off the market. We would rather they were reappraised by investors. Our view is that in the current environment, where the cost of capital is greater and interest rates could stay higher for longer, investors should place greater value on those businesses that are generating cash now and have a clear pipeline of growth. The UK’s industrial companies fit the bill.