April 2021 (click here to download)
What to do about raw material inflation? Aside from owning commodities, a group that performs well during periods of rising input costs early in an economic expansion is multi-industry and machinery stocks. Towards the end of the downturn, these stocks’ multiples will begin to expand, once there is visibility into an earnings recovery. When the recovery commences, earnings power for these companies can be very strong. Owning stocks facing rising input costs may seem counterintuitive, but it turns out the underlying driver of inflation, which in this sense is economic growth, more than offsets these variable costs.
Once an economic recovery ensues, inventory gets worked down and industrial production begins to ramp up in order to meet new demand. Inflationary pressures emerge as demand quickly outstrips supply. Multi-industry and machinery stocks benefit from this early-cycle dynamic; and despite facing rising input costs in the form of steel, energy or aluminium, fixed cost leverage from volume growth – in addition to price – increases drive strong earnings growth. Therefore, multi-industry and machinery stocks perform well coming out of downturns and into the early phases of an economic recovery as investors gain confidence in the recovery. The group’s organic growth is highly correlated with industrial production (Exhibit 1).
Cyclical earnings growth is a function of both revenue growth and margin expansion. The latter is the more interesting driver. As input costs increase, they often get passed on to customers. One example that demonstrates this well is margin performance during periods of steel inflation. Exhibit 2 shows operating margin performance during episodes of steel inflation.
There are many more relevant nuances involved than outlined in this note, such as hedges that attempt to preserve cash flow, market share shifts and regulations. Every relationship has outliers, and each cycle is unique but, generally, multi-industry and machinery companies can produce strong earnings growth above consensus estimates for many quarters coming out of a recession despite higher raw material costs.
Source: Ryan Lowery of Driehaus Capital Management LLC.
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