The changing market environment in America is a clear opportunity for US equity investors. Since its launch, the Hermes US All Cap Fund has cumulatively returned over 11% in gross dollar terms against the benchmark return of 8%. Carefully selecting sectors and stocks to take advantage of President Trump's policy rotation is vital to continuing this trend.
The US market is set to finally shift from the ‘new normal’ of low interest rates, low inflation and limited growth that has dominated since the recession. With President Trump vowing to ramp up fiscal stimulus at a time when unemployment is low and wage inflation is increasing, it seems only a matter of time before growth and inflation begin to pick up in earnest.
Figure 1: Performance of the Hermes US All Cap Fund since inception and in 2016
Source: Hermes as at 31 December 2016. Performance shown is the gross Fund performance in dollar terms. The inception date of the Fund is 28 May 2015. Relative return is calculated arithmetically. Past performance is not a reliable guide to future performance. The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
Several sectors were boosted by a ‘Trump rally’ in the two days after the election, driven by the market’s anticipation of this new environment. This included financials, which rose 9%, and healthcare, which rose 7%. However, in our view high-quality companies with dominant market positions will benefit most from this changing environment in the longer term.
As America begins building things again, we believe that the biggest long-term uplift will be found in high-quality industrials across the market capitalisation spectrum. We have used our proven investment process, applied in managing the Hermes US SMID Equity Fund, to select companies with durable competitive advantages in sectors that should benefit from Trump's policy agenda.
Moving beyond infrastructure
The range of industrial stocks that are likely to benefit from President Trump’s proposed fiscal stimulus is broad. While construction spending was 6.1% of GDP at the end of June, the 50-year average is about 8.4%, meaning that there is still significant room for growth (see figure 2).
Figure 2: US construction spending as a percentage of GDP
Source: Census Bureau as at December 2016.
Alongside the planned infrastructure spending, other policy measures should also provide a boost for the sector and, we believe, extend the economic cycle. The reduction in corporate tax rates and repatriation of $2tn in cash balances with one-off low tax rates will provide companies with the resources to invest, and deregulation of the banking sector should encourage more lending.
Further, a smoother political landscape should encourage broader public spending. This has been declining significantly as a percentage of GDP since the 2009 stimulus package was halted by a gridlock in Congress. Now that both Congress and the Presidency are controlled by the Republican Party, already planned public investment should be unlocked.
While many investors are cautious about industrial companies, as the US economy is seven years into an economic expansion, this sector is actually coming out of a two-year recession. This was driven by the collapse in commodity prices in mid-2014 and a slowdown in global growth, which prompted a significant decline in revenues for some industrial companies. There is potential for a strong earnings recovery driven by improved demand after several years of falling fixed costs.
One of the sub-sectors most likely to benefit from a recovery in industrial production is transport. We recently purchased Genesee & Wyoming, the largest operator of regional and short-line railroads. Each railroad is typically the only viable link to mines, timber factories, grain stores and other resources, which provides inherent pricing power. The company is well placed to benefit from a recovery in freight volumes, which seems likely according to leading indicators of transportation demand (see figure 3).
Figure 3: The December NFIB Small Business Optimism Index
The index has often been a good leading indicator for transportation demand, with a 78% correlation to the Cass Freight Shipment Index on a two-month lagged basis
Source: Deutsche Bank as at January 2017.
We are particularly interested in capital equipment companies, which build the vehicles used in distribution chains. Should the demand for transportation increase, revenue growth would accelerate as wear and tear increased the demand for replacement parts. We own rail-brake manufacturer Wabtec and truck-brake manufacturer Wabco, which both supply replacement parts to their respective markets. Both have market shares of roughly 50% and earn attractive returns. They are also mid-cap stocks, demonstrating how we leverage our decade-long experience in US small- and mid-cap investing.
Another company likely to benefit from a rise in transport volumes is large cap Fortive, which was spun out from Danaher, another holding, in July 2016. With a $19bn market capitalisation, Fortive is at the smaller end of the large-cap spectrum and has significant potential for growth. Fortive supplies fuel dispensing and payment solutions to gas stations, particularly those that are upgrading to accept chip payments, among which it has a quarter of the market. Its other business, Fluke, provides electrical testing equipment, the demand for which will rise with an increase in electricity consumption.
Fortive would be one of the biggest beneficiaries of President Trump's proposed policy changes: it holds a substantial portion of its cash overseas, incurs a high tax rate and is one of the largest US-based manufacturing operations in its sector.
We recently purchased WW Grainger, which distributes maintenance, repair and operation (MRO) supplies. Grainger has suffered from declining prices for supplies for several years and has closed branches to reduce costs. A pick up in industrial activity combined with improved pricing environment should lead to accelerating profit growth.
Having discussed it extensively on the campaign trail, Donald Trump seems likely to use fiscal policy to boost economic growth. While the increased spending could still be rejected by voting blocks such as the Tea Party, we believe that a Republican-controlled Congress will be keen to support its President.
Increased infrastructure spending should be particularly beneficial for the domestic industrial sector, as it facilitates increased output, which should be further aided by tax cuts and deregulation. The industrial sector is well placed for such an increase as companies have cut costs and a recovery in revenues is likely to boost profits.
As we mark the first 18 months of the Hermes US All Cap Fund, we believe our ability to select high-quality companies trading at attractive valuations, combined with our experience across the market spectrum, will enable the Fund to benefit from this new investment environment.