In June 2022, when inflation peaked at 9% and the Federal Reserve began a series of interest rate hikes, media reports began hinting that investors might soon seek alternatives to the US stock markets. However, the US stock market is a financial behemoth boasting $43 trillion in market cap and investor confidence based on 10 years of growth in multiples (enterprise value to sales). In this vast sea of opportunities, where might an investor find the best prospects for growth?
We propose that the answer lies in the industrial sector. The past decade saw the emergence of eight companies that drove 40% of the US market and multiples boom for the tech sector, but the allure of big bets grew riskier for investors in 2022, amid a high-interest-rate environment that offered multiple low-risk, high-return alternatives (T-bills, government securities, certificates of deposit, AAA corporate bonds). Given the persistent inflation rates exceeding 2%, we expect that interest rates will remain above 5% in 2024 and beyond.
The spotlight now shifts to sub–$5 billion market capitalization industrial companies. This group encompasses numerous firms with robust financial fundamentals and presently low-to-modest valuations. Investors would be wise to delve deeper into this category, seeking opportunities that present a blend of low risk and high potential rewards.
Over the years, the US stock market has endured a variety of shocks, but the most recent one delivered a one-two punch. First came a dramatic surge in inflation, and it was followed by an aggressive response by the Fed. In June 2022, US inflation peaked at 9%, its highest rate in 40 years, then ended the year at 6.5%. The Fed then hiked interest rates by a record-breaking five percentage points within a year (Exhibit 1). We call this combined impact of high inflation and rapidly rising interest rates the 2I shock.
The 2I shock led the Fed to cut the money supply beginning in October 2022—the first time in more than 50 years. The S&P 500 entered bear territory in October of that year, with its value down by 19% by end of 2022 versus the year before. In addition, US GDP contracted in the first two quarters of 2022. It bounced back in the second half of the year, but real GDP growth of only 1.3% in the first quarter of 2023 was taken as a possible sign of an impending slowdown. Consumer spending remains sluggish in 2023. The indications of a growth deceleration that initiated in the third quarter of 2022 are anticipated to culminate this year, with GDP growth forecast at a mere 0.2%.
Not surprisingly, the 2I shock generated headlines inside the United States and globally. Some of the most dramatic messages hinted that investors might be motivated to move their focus to other geographic markets. Headlines in such widely read sources as Bloomberg, the Wall Street Journal, and Wealth Professional referred to investors “seeking shelter in emerging markets,” “hunting for gains in foreign stocks, ”and “seeking bargains” in international stocks.
We consider such messages to be exaggerating the potential of the alternative markets and understating the role of US markets. The US stock market thrives, boasting a colossal $43 trillion in market cap—roughly eight times larger than the next-largest developed market(Japan) and more than six times larger than China’s market. Furthermore, the US market has the largest share of publicly traded stocks available to public investors—an 81% average float (Exhibit 2). Indeed, US listed firms generate total revenues more than twice those of China and have the highest operational efficiency at companies with sizable revenues. Further, the multiples of US firms have been resilient, matching leading economies’ metrics and have made significant gains. Together, these measures show sustained investor confidence.
Within the US stock market, the experience differs according to company size. Based on companies’ market cap, we segmented the US equities market into three broad groups (Exhibit 3). We found that the US markets’ outstanding performance was primarily a result of the substantial contributions of the Almost-Trillion Cohort (ATC)—eight companies with market caps exceeding $500 billion. With the cost of capital around zero, the ATC were able to attract investor funds so they could make bold moves to accelerate growth and improve profitability.
What followed was a virtuous cycle favoring these eight ATC companies. Investors valued their revenue growth and rewarded them with high multiples, attracting more investors and notable gains. Their combined enterprise-value-to-sales multiple, which started at a market-leading 2.4, rose 2.5 times to reach 6.0. In contrast, for the market as a whole, EV/sales rose 1.5 times, from 1.8 to 2.7. The pattern was especially notable in the tech sector.
The climate that favored the ATC changed in 2022 as the Fed began raising interest rates. We have now entered a period of yield curve inversion, and short-term T-bills—those with maturities less than two years—are yielding 5% or more. With risk-free assets yielding premiums like those for risky assets, the risky bets placed by the investors in the large companies and tech sector suffered a downfall. Over the ten years ending in 2022, the eight ATC companies achieved remarkable growth in total shareholder returns (TSR): 21.2%, which surpassed the S&P 500’s 14.0%. However, TSR growth for 2021–22 was −25.5%, worse than for the S&P 500, which averaged−12.3% (Exhibit 4). As a result, the eight companies lost substantial enterprise value, and their multiples shrank; the tech sector followed a similar pattern.
In 2023, inflation (excluding energy) continues to be above the Fed’s 2% target, so the market expects that the Fed will continue to raise or at least maintain interest rates at 5% or higher. If this expectation becomes reality, investors will have no reward for taking risks in the next decade, so they are likely to seek lower-risk vehicles.
The conditions that pressured the largest companies in 2022 do not necessarily mean the most resilient companies lie outside the US markets. Investors have many promising companies to choose from among the small to midsize market cap companies in the US market. The largest number of publicly traded companies valued at $1 million or more are within the industrials sector (see Table 1). Among the 729 companies valued at $5 billion to $500 billion, more than one-third are industrials, and in the sub–$5 billion category, close to one-fourth of the 1,248 companies are industrials.
Overall, the sub–$5 billion market capitalization industrial companies make a strong case for being a viable alternative for investors in the coming decade, based on how these companies combine their low-risk profile with potential for higher returns.
We see three markers of low risk at sub–$5billion industrial companies:
Three factors together lay a foundation for higher returns for the sector:
With a low-risk and higher-returns profile, sub–$5 billion industrials have arrived at their time to shine. The Trailblazers, with their formidable valuations trajectory, have already demonstrated that they are a viable alternative investment for investors in the 2I environment. Other companies in the sector can follow suit by adopting the playbook of Trailblazers: focus on active portfolio management, balance sheet and liquidity management, and operating performance and play the game with investors. On the investor side, those who get to know the players in this sector have a chance to participate in its areas of low risk and high potential returns.