As business leaders and investors consider recent events—a pandemic, international conflicts, soaring inflation, and technological disruptions, to name a few—a few questions come to mind:
The answers to these questions point to significant opportunities for company leaders and investors in the Industrial sector.
The last few years have been marked by challenges. A surge in inflation in 2022, combined with the Fed’s aggressive increases in interest rates created what we call the 2I shock—that is, the double shock from inflation plus interest rates. Geopolitical tensions, including the conflict between Russia and Ukraine, have resulted in economic stresses such as higher oil prices and more widespread food insecurity. And in the 2I environment, many commentators and media outlets have suggested that the US markets are losing their preeminence.
However, we find much of the talk to be exaggerating the extent to which these stresses are abnormal. Inflation has often exceeded the Fed’s current 2% target rate, including spikes of 11.1% and 13.5% in the 1970s (Exhibit 1). During such times, the Fed has commonly raised interest rates. And, of course, geopolitical tensions with economic impact occur all too often and are reflected in metrics such as oil prices. Meanwhile, there are significant signs of robustness in the US stock market, including its sheer size (Exhibit 2), the performance of listed companies, and the rising investor confidence as evident by increasing valuation multiples.
So yes, these are interesting times, but the past was interesting in its own way. We have always been living in times we can call interesting.
The factors that make our times interesting have shifted in ways that may change investors’ decisions in the years ahead. Particularly relevant are shifts related to interest rates.
During the past 10 years, macroeconomic fundamentals included the money supply more than doubling while low interest rates kept the cost of capital near zero. This contributed to a bull market for stocks, in which speculative buys were more attractive. With rates low across the board, the premium on risk assets equaled the premium on risk-free assets—resulting in the market imposing no penalty for risk. In this context, relatively risky ventures in the Tech sector could attract substantial capital for expansion. The market cap of the eight largest companies, most of them Tech giants, soared (Exhibit 3).
Now interest rates have risen to 5% or more, and the yield curve is inverted. Inflation has slowed but remains above the Fed’s 2% target. This creates a fundamental shift for investors: the existence of multiple low-risk options delivering returns similar to higher risk investments means the market now gives no reward for taking risk. In this situation, investors are shifting away from the riskiest bets, and the last decade’s market winners underperformed in 2022 (Exhibit 4).
These changes seem likely to favor Industrial companies with market caps below $5 billion; we call this group the Industrial Sub–$5 Billion Cohort (S5C). As a group, these companies outperformed their sub–$5 billion peers in the US market in terms of growth in revenues and increase in profitability from 2012 to 2022 (Exhibit 5). Further, the sheer number of companies in the Industrial S5C category provides many interesting opportunities for investors.
The attractiveness of the Industrial S5C results from a combination of relatively low-risk and high-returns. Low risk for the category reflects its operational performance, strong balance sheets, and attractive industry structure. Higher returns are possible because of the opportunity to learn from “Trailblazers,” the companies that successfully expanded investor returns over the last decade (Exhibit 6). Other factors contributing to higher returns are relatively lower valuations at present and tailwinds from secular trends such as technological disruptions and government spending on infrastructure.
With the sun shining on the Industrial S5C, management and investors alike have a chance to get busy making hay—that is, reaping a harvest of growth from strategic investments. To take advantage of this value creation opportunity, executives of S5C companies should engage in active portfolio management, balance sheet and liquidity management, pursuit of stellar operating performance, and balancing investors’ expectations with growth needs of the company.
For investors, “making hay” in the years ahead would include a careful look at the Industrial S5C to find companies that may be undervalued and/or ready to capture value from riding today’s tailwinds. In general, these are most often companies with a focused portfolio (Exhibit 7). And just as the Trailblazer companies provide examples for management, they can show what an engaged investor would want to seek and promote.
Implementing these ideas calls for balancing growth objectives with investors’ eagerness to generate short-term profits. One business model that can achieve this balance is a spin-out/spin-in partnership (Exhibit 8). In this model, a company continues to operate its core business and spins out the growth business(es) with a partnership arrangement in which the parent company owns a minority stake and thus focuses more on its core business on a day-to-day basis. The partner with majority stake runs the new entity, supported by guidance from a capability partner.
For executives and investors alike, the times we operate in are certainly interesting. For well-managed Industrial companies with market caps under $5 billion, the times are interesting in a good way, with plenty of upside potential. Understanding the right levers to pull will help company leaders and investors make the most of the present opportunities.