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Are There Attractive Automation Opportunities?

Where the first-quarter sell-off has left this sector.

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Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Denise Molina. She is an equity analyst at Morningstar.

Hello.

Denise Molina: Hi.

Black: So, a common phrase we hear in investing is that we should be greedy when everyone else is fearful. And I think people are quite fearful at the moment with stock markets falling, but you're seeing opportunities in the supply chain side of things. Can you tell us a bit more about that?

Molina: During troubled times in the economy, when we have recessions, companies, like other people in the economy, tend to hoard cash. So, the first thing that happens with supply chain and with capital goods companies is they see a drop in demand for orders that are called short cycles. So, there's a large part of cap goods that is ordered and delivered within a quarter. And if you're a company that's uncertain about your cash flow outlook, you're going to cut capex and, within the capex budget, it's going to be all those cap goods products.

What we're anticipating is a pretty steep drop in earnings for capital goods companies coming up in the second quarter because this particular go around is not just like a recessionary environment, it is literally the spigot being turned off. So, plants are being shut down because of social distancing. So, that means that the supply chain is severely disrupted, and orders are not getting through, and they're not being produced. So, what we're going to see is something pretty dramatic in the second quarter. And it could lead to some share prices declining to levels that we think could become more attractive than they are right now. So, with the caveat that we've got earnings volatility ahead of us and potential further declines in share prices, we see some really nice companies that haven't been cheap for a while potentially coming on sale that we'd be looking at and watching for good opportunities to get into.

Black: When you talk about capital goods, what sorts of companies are you looking at? Where are we seeing those opportunities?

Molina: Right now, we've seen some of the companies that are exposed to automotive end markets and to the oil price end markets. And so, one of the things that we look at it is, diversified like ABB and Schneider, these companies supply into refineries, into utilities, into general manufacturing, and those orders are going to be cut severely, as we all know that refiners, the integrated oil companies, have already announced capex budget declines. So, we know that 2019 is going to be pretty horrific in terms of earnings. But those companies will see those orders come back. And if you look at the Great Recession, if you look at the pattern of capital goods spend, the drop-off in 2009 was pretty dramatic. But then that same volume of demand came back within two years' time. So, capital goods are things you can hold back on in the short term but not in the long term because equipment ages; it basically runs your plants or refineries. So, you need to spend on it eventually. You can only hold off for so long.

ABB we like because it not only has a really strong portfolio of moaty products, but it also has the number-two robotics company in the world. So, they are the number-two supplier of robotics. Robotics has a long, long runway of growth. It's really only used heavily in automotive. So, we like that long-term in terms of the automation trends and adoption rates for robotics to offer promise long term. It also has exposure along with Schneider to ESG theme. So, if you think about building automation--you can think about how to control energy costs, make sure that the lights aren't on when nobody is in the building, make sure that you're not powering up equipment that's not being used. So, that kind of spend is something that we see as also a long-term trend. And ABB and Schneider both supply a lot of software and components that help companies become more ESG-compliant.

Black: You said you're expecting a bit of a horrific 2020 before a bounceback? How do investors handle this? Do they buy in now? Or do they wait, or should they already be invested and just waiting for the recovery?

Molina: Well, we're certainly not market-timers. And we don't think we can be precise about where the bottom is. But we do think that there's potentially more volatility to come that the sector hasn't sold off as much as it did during the GFC. And it certainly was expensive before we went into this situation. So, we've seen some pretty decent drops in some of the companies, and we think that there could be further declines as the second quarter comes out. As you said, there's going to be probably some pretty dramatic earnings declines from these shutdowns, and that's maybe not fully appreciated yet by the market, especially when the U.S. starts to put out their numbers.

Black: Denise, thank you so much for your time. For Morningstar, I'm Holly Black.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Holly Black does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.