Industrials: Set to shine?

Industrials had a positive, albeit lagging, year in 2023. But for 2024 and beyond, it may be a mistake for investors to underestimate this sector's potential.

Big-picture drivers like federal investments in infrastructure and corporate investments in onshoring have the potential to help fuel long-term growth. And any strengthening of the economy could provide a catalyst for economically sensitive segments of the sector.

Here are some key trends I'm seeing in the sector for 2024 and beyond, and where I've recently found opportunity.

A positive past year

Industrials were in the black over the past year, although the sector’s gains lagged the more sizeable returns of the S&P 500^®. While that might seem like a negative reflection on the sector, it's important to remember that the S&P’s rally was very narrow for most of 2023, with only a handful of mega-cap stocks driving the great majority of the market's gains. The major winners of the past year have been largely concentrated in the communication services and technology sectors—reflecting investors' enthusiasm for generative artificial intelligence.

That said, the sector's positive double-digit returns as of mid-December were strong in absolute terms.

Longer- and shorter-term drivers

However, I believe the current environment offers reasons for bullishness on industrials. After decades of underinvestment in the US industrial base, supply-chain difficulties during the pandemic and geopolitical tension have highlighted the advantages of greater US self-sufficiency. As a result, hundreds of billions of dollars in federal funding and other incentives are set to pour into infrastructure, onshoring/reshoring, combatting climate change, and the "electrification of everything," through legislation such as the 2022 Inflation Reduction Act and the 2021 Infrastructure Investment and Jobs Act. This massive investment could help drive long-term growth for the sector.

Over the more short- to medium-term timeframe, industrials could eventually come into favor with investors as the current economic cycle continues to evolve. Key indicators that I follow are signaling that we are late in the current economic cycle and possibly poised for improvement. For example, a key manufacturing index that I follow is the Institute for Supply Management (ISM^®) Purchasing Managers Index (PMI^®), which surveys purchasing managers at manufacturing firms. This index has already been in contraction territory for more than 12 months. In my opinion, the index may be near trough levels and is signaling that the industrial economy is currently quite weak. This could set industrials up for an eventual recovery.

Other indicators such as inventories, new orders, and loan growth tell a similar story, suggesting a manufacturing sector that is in the latter stages of an economic cycle, but could improve. History suggests this has often been an ideal time to take positions in industrials.

Potential opportunities in aerospace and infrastructure

You can think of industrials as divided into 2 main groups. The first consists of "long-cycle" industries—businesses that are less sensitive to short-term economic bumps because they face long lag times between when an order is placed and when the product is delivered. For example, commercial aerospace is a long-cycle industry. The other consists of "short-cycle" industries—businesses that are quite sensitive to the near-term health of the economy, like trucking and building products. Deciding on the mix of long- and short-cycle investments is a key factor in constructing a portfolio in this sector. Recently, I've found compelling opportunities in both groups.

Commercial aerospace has been one opportunity in the long-cycle bucket. Supply-chain tie-ups and production glitches have caused major delays in the production of commercial aircraft. Yet, there is still healthy demand from emerging markets such as India and China. And even in developed markets, we're seeing a pressing need to replace older, less-efficient planes, as post-pandemic air traffic continues to recover.

These trends could aid companies that manufacture aircrafts, jet engines, and underlying components that go into engines and aircrafts. Companies that have illustrated this theme include aircraft manufacturer Boeing (), as well as jet engine maker General Electric (), and Howmet Aerospace (), a parts supplier that makes many of the original parts used to manufacture aircrafts. Further, given the number of older planes still in service, companies supplying aftermarket parts and service could see long-term demand. Components-maker TransDigm Group () is a portfolio holding that has illustrated this thesis.

Another area of long-term potential opportunity may come from an anticipated ramp-up in spending on electric utilities. For example, California-based utility Pacific Gas & Electric announced a multiyear initiative in 2021 to underground 10,000 miles of power lines in California to help reduce the risk of major wildfires and address climate change. These types of investments could create opportunity for companies that provide infrastructure for electric utilities. Quanta Services (),² which provides design, installation, and maintenance services to utilities companies, is a recent portfolio holding that has exemplified this theme. Eaton (),³ is another electrical equipment manufacturer that serves the utilities market, but also provides electric powertrain technology to the electric vehicle market—and so can also be seen as a potential play on the EV transition.

Building products and trucking companies

Turning to short-cycle opportunities, the US housing shortage has been driving increased demand for residential building products. A recent portfolio holding that has illustrated this theme is The AZEK Company (),⁴ which manufactures a variety of housing exterior components, like siding and decking. Increased focus on sustainability and decarbonization could support companies that produce HVAC systems, as regulators and homeowners seek to reduce the carbon footprint of housing. Trane Technologies ()⁵ and Johnson Controls International ()⁶ are companies that have exemplified this thesis.

Lastly, I see potential opportunity for a segment called "less-than-truckload" freight transportation services—meaning freight that accommodates smaller shipment sizes, with multiple different shippers sharing space on a truck. The move to onshoring could increase the number of small shipments moving through the economy. And last summer, a major player in this market went bankrupt and exited the business, leaving more market share for the remaining players, which include less-than-truckload shippers Saia ()⁷ and XPO ().⁸

For 2024: An eye on risks and valuations

Of course, the big question for industrials—and all sectors—for the year ahead is whether we are headed for a recession or a soft landing. Unfortunately, the answer to that question remains murky. A recession would undoubtedly hurt the groups and stocks mentioned here, especially the short-cycle businesses. However, in my opinion short-cycle groups also offer the most potential opportunity at present due to their relatively inexpensive valuations.

The fact that demand in many industrial groups has been depressed for quite a while suggests support for the view that recovery could be on the near-term horizon, as in the soft-landing scenario. Taking all these factors into account, I have been favoring a number of longer-cycle stocks with specific catalysts and also healthy exposure to short-cycle stocks, which tend to outperform in the early stages of an economic recovery.