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Where We Are Finding Growth: Industrial Process Innovation

A relatively slower capital expenditure cycle is often cited as one factor behind the past decade’s tepid expansion in many developed markets. However, we believe this top-down point of view obscures a healthy, albeit different, sort of capex cycle—one that is more technology-driven and focused on efficiency and margin improvements.

Rather than making large expenditures on traditional fixed equipment to drive volume, firms globally have seemingly focused on reducing labor costs while increasing throughput and innovating faster via software-driven automation. The goal: bigger and more lasting competitive advantages. In our view, this trend of increased industrial process innovation is durable and has the potential to drive significant profit acceleration for firms that can execute well.

Automation has long been commonplace on manufacturing factory floors, in logistics, packaging and so on. However, a differentiating factor we see now is the rise of “smart” automation and instrumentation—software overlaying traditional automation equipment, allowing machine tools and programmable industrial robots to perform increasingly intricate tasks with minimal human intervention.

For example, next-generation machine-vision systems allow robots and scanners to “see” and improve quality control at every step of the manufacturing process, rather than just examining the final product—reducing waste-related costs. Automated warehouses integrated with supply chain management software can speed fulfillment and delivery times—increasing the availability of same-day delivery. The autonomous car is quickly becoming more of a possibility than science fiction thanks to more sophisticated instrumentation. And smart, programmable robots are even being used in biotechnology research—in some cases performing as many lab tests in one week as it would take human lab technicians to complete in 12 years.

Driving the Need for Industrial Process Innovation

Underpinning the drive for increased industrial process innovation—and therefore profit-acceleration potential in this area—are several factors we believe should continue for some time.

Wage Inflation in Emerging Markets

Outsourcing, often to emerging markets, has traditionally been one-way firms have lowered labor costs. Though economic growth rates may be moderating in some emerging markets growth, a meaningful period of vibrant economic growth in the early and mid-2000s resulted in meaningful wage inflation. China wages more than doubled between 2000 and 2015, while developed-world wages grew much more slowly—or, in the US’s case, modestly fell. In many parts of the developing world, these inflationary pressures have remained relatively intact despite more modest top-line economic growth expectations.

Adding to the impact of wage inflation, aging populations and falling fertility rates in Asia are limiting labor supply and putting additional upward pressure on wages. As wages go higher, the payback period for automation equipment gets compressed, increasing incentives to invest in equipment rather than labor.

Cost Containment and Operational Flexibility

Labor is one key cost firms aim to control by innovating on industrial processes. However, automation gives firms increased flexibility to manage a range of costs since operations need not necessarily be close to a large, manufacturing-based labor pool. Other factors—including local taxes and regulations, existing infrastructure and the political environment— may be as important in deciding where to build manufacturing facilities, increasing demand for automation equipment globally.

Shipping costs are another key factor to consider. Manufacturers often source components from multiple locations, then send finished products to customers across the globe. North American firms might find putting a next generation automation facility closer to its customer base means shorter shipping distances in addition to increased efficiency and lower labor costs—giving it an opportunity to compete with the emerging-Asia manufacturing cost base.

These factors are behind the recent trend of US manufacturing “near-shoring” to Mexico. For example, as of 2018, Mexico has overtaken Canada and Japan as the number-one source of car imports in the US. Global automakers have been building state-of-the-art manufacturing centers in Mexico, attracted in part by wages cheaper than in the US and Canada. However, also providing a big draw are the proximity to America’s massive car market, low cross border transaction costs and an educated work force that can manage a complex, automated operation. (Over 110,000 engineering students graduate from Mexican universities each year.) Further, the Mexican government has been welcoming to development of high-tech automation centers.

Increased Demand for Precision and Quality

Globally, consumers are demanding improved quality and safety profiles in the goods they buy. This is true in the developed world, and increasingly so in emerging markets as growing wealth correlates with demand for higher quality. From cars to power tools to children’s toys to baby formula and other packaged foodstuffs—product failure and/or tampering can cause an immediate and lasting, even terminal, backlash for a firm.

Even when not terminal, recalls, lawsuits and brand damage can be costly. Firms wanting to avoid costs related to product failures or even imperfections can invest in industrial innovation, including robots to improve precision and minimize defects, vision systems to manage quality control, and automated packaging and fulfillment systems to mitigate contamination and/or tampering.

Consumers are demanding higher quality, but many governments are making it a legal requirement as well via more rigorous safety regulations and product specifications—a trend we would be surprised to see slow.

How Can Investors Benefit?

Benefits from increased industrial process innovation are broad-based and potentially touch any industry employing automation or sophisticated instrumentation to some degree—from heavy equipment to manufacturing to e-commerce fulfillment to food processing to personal products packaging. However, from an investing standpoint, we believe there are several interesting opportunities that benefit most directly from this trend.

First, we are finding opportunities in traditional industrial equipment manufacturers that have shifted to become hardware/software fused—for example, firms producing industrial robots or machine tools overlaid with next-generation instrumentation and smart automation.

We are also finding opportunities among components designers and manufacturers—for example, firms designing infrared componentry, advanced sensors or advanced location devices used to improve precision and efficiency of heavy equipment. Investing in components providers allows investment in the broader trend of more sophisticated instruments without selecting which software platform ultimately wins.

Managing Risks

We are mindful of inherent risks that could derail the profit-acceleration potential from this trend. For example, competition from lower-cost start-ups, particularly from emerging markets, can eat into profit margins. Also, profit growth could be tempered by a potential slower pace in artificial intelligence which could limit the dexterity that can be achieved by industrial robots.

To mitigate those risks, we start where we always start: By confirming the franchise, identifying and understanding the growth drivers and aiming to invest at reasonable valuations. Then, add to the position in concert with conviction in each firm’s profit-acceleration cycle.

Specific to stocks potentially benefiting from this trend, we look for firms with characteristics such as a large and powerful installed base of hardware with existing clients. A dominant market share can give firms an effectively locked-in audience, aiding in future profits from product-replacement cycles, upgrades and cross-selling.

We also prefer firms willing to invest heavily in research and development now. Such investments do impact margins; however, investing strategically is one way to fend off lower-cost upstarts and amplify scale advantages.

We are also seeing opportunities among firms with scientific research-driven backgrounds. These firms often develop products and/or software for extreme situations and can alter them for more common applications—giving them a technological head start over competitors and/or a low-cost advantage.