Buying manufacturing stocks isn't at the top of many investors' to-do lists these days.
With Detroit in seemingly permanent decline, and the manufacturing workforce facing non-stop layoffs, shares of a manufacturing company sound about as attractive as shares in a blacksmith shop. Even Warren Buffett, who used to buy companies that actually made things, seems to be interested now mostly in insurance companies.
But some market watchers say things may not be as bad for manufacturing companies as the headlines suggest. "Manufacturing is actually not doing too badly," says Roger Ibbotson, an economics professor at the Yale School of Management and chairman of hedge fund Zebra Capital. "What's happening is they're doing a lot of the distribution, planning and design here, and they're doing more and more of the actual manufacturing overseas," Ibbotson says.
And Marc Faber, a Hong Kong-based money manager often called "Dr. Doom" because of his tendency toward bleak prognostications, sounds positively enthusiastic about manufacturing companies. "There are lots of very successful manufacturing companies around the world with high margins: Boeing, Caterpillar Tractor, Lindt & Spr?ngli, Rolex, Hermes, L'Oreal, Johnson Electronics, just to name a few!" he wrote in a recent email.
A closer look, in fact, suggests that although it may not be a good time to look for a job at your local factory, investing in a manufacturing company may not be such a bad idea. There seem to be a number of interesting opportunities for investors in the sector, but only for those who understand three fundamental trends: First, the growth in the world's manufacturing labor supply; second, the enormous gains in productivity the sector is now experiencing; and third, the unexpected consequences of globalization.
Trend #1: More workers
Approximately 150 million people around the world make their living making the stuff the rest of us consume, according to William Ward, a professor of applied economics at Clemson University in Clemson, S.C. Many of these people used to make things that were sold only within Eastern Europe, India or China, but since 1990, those markets have been producing goods to sell on a broader world market.
As the supply of available labor has essentially doubled, manufacturers in developed countries with high labor costs have been quick to shift their production to cheaper places. U.S. companies have been especially quick to pocket that cost difference, either by sending work abroad to a contract manufacturer or by opening their own factories in cheaper locations.
Not surprisingly, the number of people employed in manufacturing in the U.S. has declined dramatically, from about 17.7 million in 1990 to 14.25 million in 2005, according to U.S. Department of Labor Statistics gathered by Ward. Factor in the population growth over those 15 years, however, and the change is even starker: The amount of civilian employment in manufacturing actually decreased from 18 percent of the civilian workforce in 1990 to 11.8 percent in 2004.
Trend #2: Productivity is growing.
Yet there is actually more going on than simply substituting a more expensive worker for a cheaper one. Ward notes that U.S. output actually did not shrink over that period. In fact, manufacturing output increased--climbing 50 percent over that same 15 years. In all, Ward estimates that output per worker actually increased 83 percent.
In the Lou Dobbs, zero-sum world, China might be expected to have made up the difference. In fact, China also lost manufacturing jobs over the same period. In his study, Ward notes that another economist, Judith Bannister of the U.S. Department of Labor, has estimated that manufacturing employment shrank in China from 98 million to 80 million between 1995 and 2002--8 million jobs all told--more than the total number of people employed in manufacturing in the U.S. in 1990. Manufacturing productivity in China grew by 60 percent between 1995 and 2001 alone, according to Ward. In all, Ward estimates that between 15 million and 25 million manufacturing jobs dried up between 1995 and 2005.
These gains have actually led manufacturing to grow in recent years as a percentage of the U.S. economy--from 12.9 percent of the economy in 1992 to 13.8 percent in 2005, according to the Progressive Policy Institute, a Washington think-tank. What's more, America's share of global manufacturing has remained quite stable, according to the PPI: from 21.4 percent in 1993 to 21.1 percent in 2005.
What's happening, Ward says, is that manufacturing productivity is growing spectacularly all over the world, much as agricultural productivity did in the first part of the century.
Between 1900 and 1930, according to U.S. Department of Agriculture figures, farm employment went from being 41 percent of the labor force to 21.5 percent. Those numbers continued to decline throughout the century at a fairly steady rate; by 1945, 16 percent of the workforce was employed in agriculture. By 1970, the number had declined to 4 percent--and by 2002, that had declined to 1.9 percent of the total labor force.
Between the kind of lean manufacturing techniques pioneered by Toyota--which reduced the need for inventory--and the advances in robotics and information technology--which improved efficiencies everywhere from the shop floor to the store shelf--factories are able to produce much more with much less than they ever did before. Some manufacturing centers, in fact, are so automated that a new term has entered the operations lexicon: the "dark factory"--a place where they don't need to turn on the lights because the robots don't need them.
Trend #3: Smart companies are everywhere.
As these productivity statistics suggest, it's not just U.S. companies that have become more efficient lately. According to Ward, most countries that maintain statistics have shown similar gains.
What this suggests is that many companies in Asia and Brazil--far from being merely the sources of cheap labor that the Western press is fond of picturing--are actually keeping pace with companies located in developed countries. In fact, some money managers and business consultants say that they are seeing the emergence of a new kind of company, one that is competitive in terms of both cost and technology. "You're starting to see global champions emerge out of the emerging market," says Arjun Divecha, a partner at Berkeley, Calif.-based Grantham Mayo, Van Otterloo & Co., who oversees the teams that manage the multi-billion dollar GMO Emerging Markets Fund, GMO Emerging Countries Fund and GMO Emerging Markets Quality Fund.
A May 2006 study by Boston Consulting Group identified 100 such companies in major emerging markets such as Brazil and China of which 56 percent were in manufacturing. Collectively, BCG estimated that the companies on its list have combined annual revenue of $715 billion, and are now growing by 24 percent a year. Between 2000 and 2004, these companies earned $145 billion in operating profits, equivalent to a margin of 20 percent over sales, according to reports. The figure is surprisingly close to the 16 percent generated by the S&P 500, but double Japan's Nikkei Index (10 percent) and Germany's DAX (9 percent). On average, these companies returned more than 150 percent for their investors between 2000 and 2006--50 percent more than Morgan Stanley's Emerging Market Index, and more than 150 percent better than the S&P 500.
Among the manufacturers on its list, BCG saluted two in Brazil: Embraco--the world leader in the compressor market with a 25 percent share--and Embraer, the world market leader in regional jets. In China they liked Galanz Group Company which has a 45 percent market share of European microwaves and a 25 percent share in the U.S.; and Techtronic Industries Company, the number-one supplier of power tools to Home Depot in the U.S.
As these names indicate, many emerging market manufacturing companies are now moving up the value chain. Ten years ago, China churned out toys and clothes. Now, Divecha says, a fair amount of the exports are for high-end, high-tech goods and machine tools. As BCG notes in its report on what it calls the "Rapidly Developing Economy 100," research and development is not a foreign concept to these companies: The RDE 100 invested $9 billion on R&D in 2004--enough to support the work of at least 250,000 engineers and scientists.
Divecha says that many companies have followed a similar path to an Indian company run by an old school friend of his. His family's perfume chemical supply business in India had once been protected from global competition by tariffs, but after India joined the World Trade Organization in 2003, those all went away.
"What this forced them to do was to lower their costs to remain competitive and stay in business," he says. But this bad news turned into good news for the company, eventually: "What they didn't realize was that...they were now the global low-cost producer. Therefore, they could be a global player, because they were cheaper than everything else," he says.
Typically, Divecha says, these emerging market companies have an advantage in that they are near their labor. "The disadvantage, typically, is you don't have the market knowledge and the market savvy to be able to sell to the western markets," he says.
Yet some of these contract manufacturers may not be that concerned about developing that expertise. In fact, in Taiwan, some businessmen joke that U.S. companies are not outsourcing production to them, but that they outsource their branding to the U.S., according to Scott Hood, a portfolio manager of First Wilshire, a Pasadena, Calif. fund that invests in small-cap companies.
For some of these companies, in fact, access to the faster-growing emerging markets may trump the value of western brand recognition. BCG notes, for example, that China's Huawei Technologies Company now sells telecom equipment worth $3 billion--all within the borders of its own country.
Yet while access to a market of 1.3 billion whose GDP is growing at nearly 10 percent a year might sound a lot more appealing than access to a market of 300 million growing at 3 or 4 percent, Divecha says that he expects many of these players will eventually try to expand their production globally, in the way that Tata Steel, for instance, recently bought Corus in the United Kingdom. "In a global industry, you can't just be manufacturing locally," he says.
Picking the Right Ones
All that productivity is good news for most people who get to buy cheaper things, but where can stock-pickers find value in such a turbulent market? There are a number of ways to go.
For those who like large U.S. companies, there are still some good choices, according to Christopher Tsai, port folio manager of Tsai Capital Management in New York. Many U.S. manufacturing companies have made money by outsourcing labor, but Tsai says he looks for companies that profit when these fast-growing markets grow. Three of his manufacturing favorites now include United Technologies, which has two-thirds of its workforce outside the U.S. and 20 percent of its business in Asia.
Tsai also likes Danaher Corporation, which makes high-tech instrumentation and medical devices, and a perennial favorite of many investors--3M. The price has been somewhat beaten down of late, but he says that with its free cash flow and dividend it should be trading at a higher level.
Tad Borek, a financial advisor in San Francisco, says that as a value investor, he often looks for strong companies with steady cash flows that are going through some kind of temporary hard time. When it comes to manufacturing companies, the Boeing of three or four years ago might be a good example, he says: A company that was a bit down on its luck, but looked as though it was just at the bottom of a cycle--as it turned out to be.
Right now, though, Borek says he doesn't have any manufacturing companies on his radar screen. A lot of the manufacturing companies that might ordinarily be value candidates currently "are companies with genuine bankruptcy risks."
When it comes to small caps, however, the answer is probably to go west--or south. First Wilshire, a top-rated small-cap money manager that has grown by 20.2 percent annually for 20 years running, no longer finds many good small U.S. manufacturers--and not for lack of trying. These value investors are typically drawn to sectors like manufacturing, the kind of "slower industries that people get less interested in," First Wilshire's Scott Hood says. But these days, they don't find many purely U.S. manufacturers. Looking through his top 30 holdings, Hood says he doesn't see a single purely U.S. manufacturing company--a big change from 20 years ago.
"What's left in the U.S. are things where labor is not a big component or where it's very customized, and delivery times need to be very short," he adds. In fact, so much has moved overseas that Hood believes a little of it may begin to trickle back.
First Wilshire has found more success abroad, particularly in China, where Hood says he finds better valuations and higher growth prospects.
Other market watchers suggest that investors may be better off just saying "no," and letting all this creative destruction take its course. David Riedel, president of the New York-based Riedel Research Group, says that of the 250 stocks his group tracks in 15 markets around the world, very few are manufacturing companies.
"It's a tricky place to invest for a variety of reasons," says Riedel. Manufacturing companies tend to have high capital expenses, low margins, and tend to undercut each other on price just to keep their capacity up, he explains.
One exception to Riedel's general rule is a group of Indian automotive parts manufacturers. He likes them, however, less for the manufacturing part of their story than for the play they offer in the local market where car sales are rising. "Back in the last boom in the 90s, it was all about who had the manufacturing edge... it's kind of morphed this time around into, how can you tap into the domestic demand that those higher [emerging market] incomes create?"
For investors who want an emerging market manufacturing play that side-steps some of the risk in picking the right industries and the right companies, Riedel suggests buying companies involved in developing industrial parks in emerging markets. Many countries try to keep factories confined to particular areas, he says, and this has led to the growth of such real estate developers as Hemaraj Land and Development in Thailand. "These companies own large tracts of land that are close to urban centers but not too close, and connected by good freeways and ports and things like that," Riedel says.
One U.S. company in an analogous business that is on the lists of a number of real estate investors is ProLogis, a Denver-based owner of global warehouse and logistics space. Sometimes called the world's biggest warehouse landlord, the fast-growing industrial REIT owns 375 million square-feet of industrial space in North America, Europe and Asia, serving the warehouse and distribution needs for such companies as DHL, Unilever and Wal-Mart.
In some cases, ProLogis helps clients on both sides of the ocean. It leases a 500,000 square-foot facility in Cincinnati for Adidas' U.S. distribution, and a 650,000 square-foot. facility in ProLogis Park Suzhou, outside of Shanghai. More than 40 of the company's customers--Bridgestone and Coca-Cola among them--now work with ProLogis on more than one continent, according to its annual report.
Investors Without Borders
As the ProLogis example suggests, it may well be that nationality no longer has much to do with how well a manufacturing company operates. After all, a lot of what ends up with a "Made in China" stamp is actually made up of parts that are created in Malaysia, Indonesia, Korea and Taiwan, according to Ward, and only final assembly, which is very labor-intensive, takes place in China.
Something similar happened after the passage of the North American Free Trade Agreement, Ward says. Cars, for instance, did not end up being totally manufactured in Mexico, as many thought would be the case. Instead, auto components may move back and forth across the U.S., Mexican and Canadian borders two or three times before they reach final assembly.
In Ward's view, the key to excellence for manufacturers in the coming years is likely to be the degree to which the company can manage its supply chain. With costs shifting all the time, the company that is nimble enough to profit from those shifts is likely to do best.
Robert Robotti, a highly rated New York-based small and midcap value manager, has a simpler guideline--one which probably reduces a lot of anxiety about macroeconomic circumstances. He uses the same decision-making rule for buying manufacturing stocks as he does for buying anything else: They buy, he says, "if the valuation is attractive."
Bennett Voyles is a New York-based freelancer who wrote about the BRIC countries in the December 2006 issue of Wealth Manager.
