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Industrials postcard from Tokyo

Challenges from Trump and trade

Global industrial companies have had a difficult time of late. While share prices have rebounded from a difficult fourth quarter in 2018, trade tensions and slower global growth continue to make investors nervous.

While industrial companies are sensitive to changes in the global economy, the sector is a very diverse one. Industrial companies serve a lot of different end markets, with their customers ranging from large mining companies to power generating utilities. Given the diversity of these end markets, there will always be some areas doing better than others. That makes it important to understand the health of an industrial company’s end markets as well as the overall health of the global economy.

One of the ways we achieve this is by talking regularly to company management teams. I took advantage of a recent visit to Japan to meet with several companies and discuss the trends they were seeing globally across different end markets. I was particularly interested in three areas we follow closely, the semiconductor equipment industry, mining capital equipment and warehouse automation. While we don’t invest directly in the Japanese companies I met with, primary research like this helps enormously with our company recommendations as many of these Japanese companies are global leaders in their sectors.

Semiconductors: trade risks still present

The semiconductor equipment end market has become increasingly important for industrial companies in recent years. Global semiconductor sales have more than doubled over the past decade, with semiconductors used in everything requiring computing power, or that use radio waves.

However, the semiconductor industry is highly cyclical, with fast bursts of growth followed by more moderate phases of expansion. The Japanese company I met with were slightly downbeat on the sector, saying that they expected to see continued weakness over the next six months as smartphone sales mature. This recent correction has been caused by a combination of the following factors:

  1. Lower than expected spending on manufacturing the new iPhone (see here for more on the fall of the iPhone)
  2. Companies finding a more efficient way to produce wafers – effectively the canvas for semiconductor chips
  3. Trade uncertainty, with the US-China trade dispute causing some companies to postpone new factories and equipment orders

Given Donald Trump’s recent announcement to delay tariffs with China, we may see some stronger demand for semiconductor equipment in the coming months, particularly with the rollout of 5G mobile networks in the US and Asia from the second half of this year. However, the short-term trading risk amongst industrial companies dependent on semiconductor equipment manufacturers is likely to remain elevated.

We await stabilisation in many of the leading indicators for a spending recovery in semiconductor equipment before we become more constructive on the companies concerned – possibly in the second half of this year.

Extended signs of life in mining equipment demand

My second area of interest was mining equipment. One of the key statistics to look at is the replacement level – or how much of their existing equipment mining companies are replacing. This  has been relatively low in recent years, with the mining industry spending less and less on new equipment as it focused on reducing leverage and delivering higher shareholder returns.

There are different estimates for replacement levels, but the view I took away was that replacement demand was still below mid-cycle levels, especially in the area of underground mining. The mid-cycle is  used as an average level for what demand should be, with the end cycle seeing higher demand as companies invest in new mines or extensions, and the early cycle seeing companies holding onto equipment as they try to save cash.

We believe there are three reasons to be positive on demand for mining equipment going forward:

  1. Spending on new mining equipment is recovering after falling between 2012-2016, with demand expected to remain elevated as ore grades decline and underground mining becomes more popular
  2. Mining companies have done a good job of repairing their balance sheets, leaving them with more money to spend if they find the right opportunities
  3. Commodity prices are generally supportive, particularly copper, where long-term drivers like electric vehicles and further electrification should support demand in the coming years

There are still reasons for caution given the dependence of the sector to Chinese infrastructure demand, but companies that will benefit from the shift to underground mining are well positioned to benefit.

Warehouse automation: strong structural growth

Perhaps my most encouraging meeting was with one of Japan’s leading warehouse automation companies. This makes sense – warehouses tend to take a long time to get planning approval for and build, so they’re unlikely to be as affected as other industrials sector by short-term changes in sentiment.

The wider case for investing in warehouse automation remains robust. The growth of online shopping is leading to much higher demand for logistics related property, with Indonesia’s ecommerce market expected to be 27 times larger in 2025 than it was in 2015. While that might be an outlier (Singapore’s market is ‘only’ expected to be five times larger), there is clearly a favourable trend for more warehouses to be built, and more automation to be put into them.

Conclusion

My trip to Japan was instructive in getting a second perspective on the trends that we are seeing in US and European markets. While I expect the short-term performance for industrial companies to be closely tied into Trump’s trade rhetoric, I came away from my meetings in Japan feeling relatively positive on some end markets; for those willing to look, there are indeed opportunities in the industrials sector.

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