Nick Heymann, Co-Group Head at William Blair & Company, L.L.C., says Graco Inc. (NYSE:GGG) is one of his “outperform”-rated companies given the current environment of modest global GDP growth.
Graco represents our second strategy to outperform the markets for diversified industrials, which is to find the best-run midcap industrial companies with exceptional returns on capital and profitability but that may have temporarily hit perhaps a pothole for their fundamentals or been required to make significant divestitures from their diversified business portfolios. We seek to decipher how these best-in-class small-to-midcap industrials can regain their fundamental cadence. If we can determine how this can be fundamentally achieved, we then seek to buy these exceptionally well-run companies at significant discounts to their historical two-, five- and 10-year relative valuations.
In Graco’s case, it had to divest, based on a Justice Department decree, about 14% of its earnings in 2014. This caused many investors to wonder how they would be able to ultimately replace the earnings from this divested business. In 2015, Graco was able to successfully replace earnings from its divested businesses with five acquisitions and accelerated share repurchase. As the leading producer worldwide for highly engineered fluid management systems, Graco has traditionally been a largely North American-focused business. However, today the company is steadily globalizing and taking their engineered fluid management products and solutions overseas, particularly emerging economies, where they have nominal penetration for their products versus the U.S.
Graco offers its customers a value proposition based on lower labor, material and energy costs, better quality and enhanced environmental compliance. So they offer a multitude of components that comprise their value proposition. With only 10% to 20% of the market penetration in most emerging markets and perhaps 30% to 40% in Europe and Japan that they hold here in North America, Graco is able to grow by selling its products and solutions in less-penetrated overseas markets, particularly now that wage rates are beginning to materially rise in emerging markets.
Brent Puff, VP and Senior Portfolio Manager at American Century Investments, says MarketAxess Holdings Inc. (NASDAQ:MKTX) continues taking market share away from investment banks in its core service as an electronic trading platform focused on fixed income securities.
There are multiple reasons to own [MarketAxess], but effectively, what’s happening is they’re continuing to gain market share in sort of their core areas of trading operation today, and that’s really being facilitated in part by the withdrawal from the market by investment banks, which have been sort of the traditional broker/dealers in these markets. The impact of higher regulation has made committing capital more difficult. Some of these products — which are basically investment-grade bonds, high-yield bonds, emerging-market bonds, and increasingly, they’re starting to get into the municipal bond trading — that’s basically created a void in the marketplace, which MarketAxess has been able to come in and fill very successfully.
They continue to add clients, they continue to add new products to their platform, and they continue to gain market share across all of their platforms. The rate at which they are gaining share is accelerating. And we just think there is a very long runway for MarketAxess to continue to grow profitably from here.
Puff says that MKTX has about 16% of the total share in investment-trade bonds trading because most of the trading still happens using legacy methods such as phone calls, but the platform currently facilities more than 90% of online trading of these securities. And the company continues expanding in its scope and its volume, he says.
The most penetrated market is investment-grade bonds. The second most penetrated product they have is high-yield bonds; their market share there is in the low-teens. And then beneath that, all of their other products are sort of single-digit market share. And they are just starting to get into some new products like municipal bonds, which is going to be a brand-new product. They’ve talked about getting into the leverage loan trading. And if you look at sort of the addressable market for some of these new products that they are beginning to trade, they are very, very large, and obviously, their share position in those products today is effectively zero.
And one of the things that’s happening across their type of client base is, not only are they’re growing their customer base, but if you look at the activities of their existing clients, their clients are increasingly trading more and more products across their platform as they’ve gotten more accustomed to trading on their platform and just more comfortable with MarketAxess. So we just think it’s a very good, durable story, and one that is actually benefiting from some of the turmoil associated with tighter regulations across the financial services industry. I mean, just by one example, we sort of frame what’s going on and sort of the fixed income markets is — we’re looking at this as relatively recently, but if you just look at sort of employment and — employment and revenue base across investment banks and fixed income commodity and currencies is down. I think employment levels are down sort of 30% to 35% over the last five years. Revenues are down around 50%.
George Galliers, Managing Director at Evercore ISI, says car electrification is one of the trends that will continue in the automotive space, but he says it will take better product, support and capacity on the battery side. In the meantime, Tesla Motors Inc. (NASDAQ:TSLA) remains one of the few compelling electric car options.
As a broader trend, clearly the big question today is around electrification. While we see electrification increasing, we don’t expect a massive shift on a three- to five-year view. Part of the reason is that there are very few what we would describe as “compelling” electric cars in the market. In fact, aside from Tesla’s product offering, we think that every other electric car, while it’s not a bad car in its own right, involves some kind of compromise in the purchase decision around performance, range, packaging or styling.
The other constraint on electric car growth in the near term is simply the supply of batteries. We know that Tesla, for example, is building its Gigafactory in Nevada. When Tesla has completed that factory, which is designed to support half a million units of sales a year, they will have the same installed capacity of lithium-ion battery production as the entire rest of the world put together. So if it’s only sufficient for Tesla to produce half a million cars, then the entire rest of installed battery capacity in the world would only be able to support another half a million cars if they had similar-sized batteries to Tesla, so in total you’re talking about 1 million units out of the total global market of 100 million.
We do see electrification continuing, but it will take time.
John Pitzer, Managing Director at Credit Suisse Group, says NXP Semiconductors NV’s (NASDAQ:NXPI) margin upside and mispriced asset are reasons behind his “buy” rating on the stock.
[NXP is] a company that went through a major transformative acquisition at the end of last year when they brought Freescale […] We think it’s one of those unique names where you’ve got a significant operating margin upside. You’ve also got deleveraging opportunities because they put debt on the balance sheet to buy Freescale and generate a lot free cash flow from the acquisition. You also have the ability to buy back stock, thus you are going to have superior earnings growth.
What we really liked about this name is we think the market is fundamentally mispricing the asset. NXP has always been viewed by investors as sort of an Apple play with socket risk. I think that is fair because there was a point in NXP’s history where Apple was about a third of the incremental revenue growth. Apple’s never really gotten to be greater than an 8% customer for NXP core.
Ian Ing, Analyst at MKM Partners, says top stock picks NVIDIA Corporation (NASDAQ:NVDA) and Advanced Micro Devices, Inc. (NASDAQ:AMD) are both exposed to growth areas such as gaming and autonomous driving and drones.
There’s a type of processor that’s very good at doing these functions that’s called a GPU or graphics processing unit, and the companies that are most exposed to these growth areas are I would say NVIDIA. There’s another company called AMD, Advanced Micro Devices, that are also exposed there, but I would say these two are probably exposed the most. NVIDIA probably has enough scale and resources to really pursue the full opportunity that’s available.
I think there’s still a lot of controversy around the gaming companies […] There’s a lot of concerns that the gaming market cannot grow as much going forward. I think they are still misunderstood. Smartphones and PCs are not growing anymore. The new emerging applications need the type of chips supplied by NVIDIA and AMD. I think those are the two underappreciated ones.
Ing says NVIDIA and AMD have the right processing solutions that are being used in many applications.
Core gaming is a really important business and growth driver for these two companies. Longer term, GPUs are useful in autonomous driving, self-driving cars and self-driving drones, etc. There’s just a lot of opportunity in front of primarily NVIDIA, given their resources to pursue much of the emerging opportunities in GPUs, but also AMD.
I think a lot of the new emerging applications are again where AMD and NVIDIA are exposed to because of the type of processing they do […] I mean a lot of the new applications require very repetitive, very homogeneous processing, and these two companies just have the right solutions for those kinds of applications.
Sean Gavin, Portfolio Manager at Fidelity Management & Research Company, says EMC Corporation (NYSE:EMC) has become one of his larger holdings because its merger opportunity and attractive risk/reward.
EMC is being purchased by Dell, which is a private company. It’s become a large holding at our fund because of a merger opportunity that we see in it. We are going to get a large payment of cash along with a stock tracking the performance of VMware. Through this, you are able to buy VMware at a very steep discount as well as getting a nice return on the cash in the meantime, and that’s I think a very interesting risk/reward in the marketplace today.
…Storage is a constantly changing marketplace. I think its becoming a private company is actually going to be a good place for EMC to be particularly matched with Dell over the long term. We are now seeing enterprise storage moving from hard-disk drives to flash, and that’s going to be a big transition. But those transitions I think are lot easier to handle as a private company as opposed to a public company. So I think the future for Dell Technologies overall is quite healthy, particularly in terms of all the transitions they have to handle in the future.
Teva Pharmaceutical Industries Ltd
Portfolio Manager Sean Gavin of Fidelity Management & Research Company says that Teva Pharmaceutical Industries Ltd (ADR) (NYSE:TEVA) is on its way to becoming the lowest-cost and largest generic pharmaceuticals manufacturer.
Another of my larger active holdings is Teva Pharmaceutical. Teva is a generics pharmaceutical manufacturer that also has some specialty drugs in its portfolio as well, namely Copaxone. They are purchasing Allergan’s (NYSE:AGN) generic pharmaceutical business right now, which would make them by far the largest generic manufacturer in the world and the lowest-cost manufacturer in the world in a space that’s growing volumes very nicely.
They generate a lot of cash. They have a year-old management team that is cutting costs rapidly throughout the business. And they also have two drugs in Phase III in their specialty business that could be very additive to the franchise.
The generics business is very competitive. And the only way that you can distinguish yourself is, one, by being the low-cost provider and, two, by getting drugs to market faster than anyone else. When they combine the company with Allergan, they are likely going to be the number-one company in terms of first to file in the world, and they should have a consistent number of drugs that are first to file over the next three to four years. So they could have both speed and cost advantages.
Paula Chastain, Senior Portfolio Manager at Hancock Bank, says the firm has held Southwest Airlines Co (NYSE:LUV) for some time due to its consistent returns and market share.
[Southwest Airlines is] a great domestic carrier and does well within its space. Again, they’ve had very consistent returns; although within the recent months or so, airlines have had some difficulties. We feel, long term, it’s still a good holding, and again, it scores very well in our model.
They have a very good niche in their market. Good domestic carrier. Just their philosophy overall I think and their pricing methods, no unbundling of pricing for add-ons seems to be doing very well for them compared to some of the other carriers. So I think that they have a good space within that industry.
They do seem to know their market very well. They’ve had some recent losses because of fuel hedging, which benefited them at one point, but it’s really not been a benefit to them more recently. But they do seem to know their market and seem to be very consistent in their growth.
Portfolio Manager Sean Gavin of Fidelity Management & Research Company says Alphabet Inc (NASDAQ:GOOG) not only has a high-quality core search business, but is setting up shareholders for the long term by investing in R&D.
One of my biggest holdings today is Google, or so-called Alphabet now. I would say that this is one of the highest-quality business models I’ve ever seen in my years of investing. In fact, I think their core search business might be the best business I’ve ever seen.
[…] Everyone sees it as a search site or site where you go to get answers. But I think what they miss on that is exactly how self-reinforcing their business is. It’s an advertising model that is reinforcing because people go there because they want to be advertised to — as opposed to when you’re walking on the street, and you’re being inundated with ads, or if you’re watching something on TV, you are essentially paying by watching an advertisement to get this content.
When you go to Google, it’s one of those beautiful, self-reinforcing mechanisms. You’re going there to get advertised to. You’re going there to get an answer […]
The return on capital for that business is absolutely phenomenal. Google also has an unbelievable balance sheet with lots of cash. The business is generating a lot of cash every single quarter. And on top of it, you have an amazing R&D facility that you’re paying for as a shareholder but not getting returns from currently. With that, you are get optionality in the future if they were to be successful in Google Health or in self-driving cars or in Google Fiber. These are all things that could be very additive to shareholder value over the long term that you are not really paying for right now.
Giorgio Caputo, Portfolio Manager at First Eagle Investment Management, says Praxair Inc. (NYSE:PX) is firmly established in an industry known for good returns on capital, which is evident by the company’s dividend yield.
[Praxair] is one of our newer investments in the materials space. I think it’s a nice example of the kinds of opportunities that were available in and around the energy, commodity and emerging markets mini panics that we saw both last summer and even earlier this year.
Praxair is one of the leading global providers of industrial gases, which are used for everything from refining — for instance, by companies like CITGO — and in chemical plants to food and beverage production. This is an industry that is in excess of 100 years old, and the companies that dominate this industry have really been there since the start of that.
These are large plants, so your location and your local density is very important to your ability to earn attractive returns, and it’s been an industry that hasn’t been very kind to new entrants and second movers. So we really like that this is a consolidated, rational industry with good returns on capital.
We believe the management team is very disciplined in terms of capital allocation, and when they can’t find attractive projects that meet their return standards, they do return cash to shareholders, which is something that they’re doing right now. Praxair has a dividend yield that is a little north of 2.5%.
