Industrials have been facing and continue to face headwinds, but companies can shine if they follow the right playbook. Over the past few years, industrial companies’ investors and leaders have coped with a global pandemic, supply chain disruptions, soaring inflation, high interest rates, and more. Nevertheless, across the micro-verticals of the industrial sector, some companies are thriving. Digging into the practices of these companies shows where attractive opportunities lie. Lessons from the top quartile of value generators suggest ideas for a successful future.

Industrials in Interesting Times‍

Industrial companies have been navigating unusual and often unexpected circumstances. A surge in inflation in 2022, combined with the Fed’s aggressive increases in interest rates, created what we call the 2I shock—a double shock from inflation plus interest rates. And geopolitical tensions, including the conflict between Russia and Ukraine, disrupted supply chains further after the pandemic, as well as impacted key metrics including crude oil prices.

For investors and managers, it is important to put such challenges in context. Inflation has often exceeded the Fed’s current 2% target rate, including spikes of 11.1% and 13.5% in the 1970s. During such times, the Fed has commonly raised interest rates. Similarly, geopolitical tensions with economic impact occur all too often and are reflected in metrics such as oil prices. The uncertainty and change are a recurring normalcy.‍

While headwinds from interest rates and oil prices are normal, the winds of change have dramatically altered the macroeconomic context for industrial companies. During the past 10 years, the US money supply more than doubled, and low interest rates kept the cost of capital near zero, making speculative buys more attractive to investors. In this context, relatively risky ventures in the tech sector attracted substantial capital, and the market cap of the eight largest companies, most of them tech giants, soared. But when interest rates rose to 5% or more, multiple low-risk options began delivering returns near those of higher-risk investments, so investors shifted away from the riskiest bets.

Low Risk and High Returns

Industrials make a strong case for investment in the coming decade, offering a combination of relatively low risk with an opportunity for high returns. Conditions that lower risk include across-the-board operational performance, strong liquidity and balance sheet management, and an attractive industry structure. Over the past five years, the US industrial sector delivered revenue growth of 6%, which is 400 basis points more than the US GDP in that period and expanded its EBITDA margin by 40 basis points more than the overall US market achieved. Evidence of robust liquidity and balance sheet management includes free cash flow (FCF) margin expansion of 70 basis points over the past five years, as well as cash on average exceeding 40% of short-term liabilities. And the industry structure features broad scope and relatively low technology risk.

Companies can find opportunity for higher returns because the sector includes outperforming companies whose example can suggest a playbook for success. We find companies of all sizes and in all micro-verticals achieving growth in shareholder value at rates exceeding the industry average. This performance is correlated with management actions (what companies do). Company attributes such as size and micro-verticals did not determine success; rather, ability and speed to transform did. Other factors contributing to higher returns include tailwinds from secular trends in the industry and relatively low valuations (enterprise value to sales averaging 1.8 for industrials, versus 2.3 for the market overall), which tend to attract investors.

A Playbook for Industrial Companies

Our analysis included a deep dive into the financial performance of industrial companies with individual market capitalization greater than $100,000, revenues exceeding $50 million in 2022, and complete financial information available for the last 10 years. The industrial companies in the top quartile for total shareholder returns vastly outperformed the sector overall, with total shareholder returns of 18.4%, versus 6.7% for all industrials.

How did they do it? The example of the high-performing companies suggests a four-part playbook for industrials:

1. Active portfolio management: Portfolio management sets the direction for the company and ensures that its assets are working toward a clear and compelling objective. M&A that matters will be directed to strategy, including divestments of noncore assets.
2. Resilience and transformation culture: A resilience and transformation culture is a way of operating that focuses on how a company can transform itself into a desired state in a way that enables its people to adjust to unanticipated changes. A practical approach to implementing a resilience and transformation culture is to set financial goals along with a plan for offsetting the impact of unpredicted events.
3. Holistic approach to innovation:  A holistic view of innovation involves a three-part focus on product, operations, and business model. Examples of promising areas for innovation in industrials include smart technology, product sustainability, Industry 4.0, and end-to-end integration.
4. Strong investor engagement: For companies’ efforts to show up in higher valuations, leaders need to manage investor expectations. Well-informed investors are aware of the challenges of running a diversified company, so investor engagement includes developing a business model that balances conflicting needs and interests, as well as communicating in a compelling way.

The industrial sector is poised to offer relatively high returns and low risk, but for any given company to deliver on that potential, it will have to transform its operations and build its resilience. These are not simple processes to lead, especially at smaller companies with more limited pools of talent. To reach their potential, such companies may seek a business model that includes partnering with experts in the industry who can fill capability gaps.

Do check out our podcast episodes with William Johnson , Former CEO, Welbilt Inc. (https://www.ayna.ai/podcast/bill-johnson-driving-and-sustaining-transformations) and Andy Mattes , Former CEO, Coherent (https://www.ayna.ai/podcast/a-ceos-blueprint-for-leading-and-transforming-industrial-powerhouses) where they share stories of leading the transformative growth of their respective companies.