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Observations From The U.S. Markets

11 June 2012


Driehaus Capital Management LLC (“Driehaus”) is an Investment Manager to VAM Funds (Lux) and VAM Managed Funds (Lux). Below please find their commentary dated 6 June 2012.

Since we founded our firm three decades ago, we have actively managed money based on the principle that earnings growth drives stock prices over the long-term. Despite challenging global markets the past few years, our conviction in our approach to equities has not wavered. Nonetheless, heightened periods of crisis-driven market declines do occur, particularly when other factors meaningfully push and pull stock prices and investors wrestle with potential outcomes. Currently, these factors include the uncertainty surrounding the decisions of Greek voters and European policy makers, fears that the U.S. is headed for a policy-driven “Fiscal Cliff” in early 2013, and concerns about economic growth in China.

With hair-raising economic-related headlines seemingly accelerating in shock-value over the last 30 days (a sample of Monday’s headlines includes “Tokyo market slumps to a 28-year low” and “Euro break-up could wipe 50pc off London house prices”), the fragile state of current investor sentiment is not surprising. Frustrating as it may be, to make money in these periods it seemingly matters less what a company’s earnings results are (or will be) and more what the next incremental European update the news cycle brings.

It is through periods such as this one where we appreciate our investment philosophy the most – the resolve it provides allows us to focus on what really matters over the duration of our long-term investment objective, that being companies’ abilities to maintain and grow their businesses at rates that exceed expectations, and to not get overly caught up in short-term noise and negativity. Importantly, it also prevents us from tantalizing yet ultimately counter-productive attempts at market timing (i.e. attempting to outperform by shifting to cash and then back to equities). Our experience has taught us that the hurdles associated with accurately predicting macro economic developments and then tactically positioning portfolios between cash and equities to benefit based on correct predictions of how the markets will react to these developments are unreasonably high thresholds; we believe this activity inevitably produces negative Alpha over full market cycles. In today’s market, with global investors that have itchy trigger fingers and that are frightened of losses, we believe this is particularly true.

There is no doubt the risks of investing in stocks are elevated at present, and we are taking these risks into account with every portfolio management decision we make. However, in the spirit of “the world does not end often”, we would like to take a step back from Europe, China and potential fiscal cliffs, and focus this letter on an unfolding longer-term trend that we are observing in the United States that you may find surprising. It may even provide you with a smidge of optimism to counteract your daily dose of negativity you are being served through other outlets.

A Renaissance in Manufacturing (…. in the United States?) 

Conventional wisdom has it that each year, over a long extended period, the United States is increasingly becoming uncompetitive in its manufacturing sector. Each election cycle politicians decry lost jobs that have been outsourced overseas to lower-wage, developing market countries, and statistics back up this view: U.S. manufacturing employment dropping 35% from 1998 through 2010 according to The Economist.

Notwithstanding the above, conventional wisdom may at times lead to incorrect conclusions. In fact we have been observing a modest comeback in U.S. manufacturing activity over the past few years, with U.S. companies bringing back manufacturing jobs to the U.S. from overseas as well as non-U.S. companies adding manufacturing capabilities within the U.S. This positive trend appears to be sustainable and, if so, has important implications for many companies that operate within and on the periphery of this industry.

Some Reasons Why the U.S. Manufacturing Sector Has Improved 

1. Improving (relative) Costs of Labor 

Although it is still far cheaper to employ factory workers in developing markets than in the U.S., these gaps in wages have been narrowing. For example, upward wage pressure exists in China but not in the U.S. because high U.S. unemployment and intense competition have left U.S. employers in a position to staunch wages.

2. Superior Productivity 

U.S. factories are becoming more efficient due to increased use of technology and automation and more efficient processes. A recent Wall Street Journal article indicated that these factors allow U.S. manufacturing workers to be three times as productive as Chinese workers. As fewer employees are needed, manufacturing costs declines.

3. Logistics 

It is expensive to ship goods around the world. In addition to direct costs, employers need to have workers in both countries to effectively manage the logistics of a global supply chain. Beyond these costs, the time lag associated with a global supply chain also adds opportunity costs to companies in that it slows their abilities to quickly react to changing client end-demand.

4. The U.S. Dollar 

The long-term drop in the U.S. dollar over the past decade relative to many developing market currencies has made U.S. manufacturers relatively more competitive in the global market place.

5. Competitive Energy Costs 

A key input cost to factories and manufacturing facilities is energy and with an abundance of domestic sources, the U.S. now finds itself in an enviable position. This is particularly true as it relates to natural gas, an important input cost for many U.S. factories and chemical facilities. Improved drilling techniques and technologies have unleashed huge amounts of domestically produced natural gas (we have read the U.S. produces more gas than it needs and is running out of room to store surplus gas). Because the infrastructure in the U.S. is not supportive to efficiently deliver its gas to global markets in mass amounts, and because the topic is highly politicized, the result has been a very big spread between natural gas prices in the U.S. and the rest of the world, as illustrated below.

U.S. Natural gas prices are lowest on earth 

Natural Gas ($ / Million Metric British Thermal Units)


Source: Bank of America Merrill Lynch Global Research, Bloomberg

This lower cost of natural gas provides additional incentives for companies to base manufacturing facilities domestically. Additionally, the boom in natural gas creates positive dynamics for manufacturing through increased incentives for innovation, investment and development of the infrastructure related to the delivery and utilization of natural gas, including the transportation industry. Consider that it is estimated that less than 0.1% of vehicles on American roads fuel with natural gas today, yet it burns cleaner than diesel or gasoline and the cost spread between natural gas and diesel is at historically wide levels (a unit of natural gas is roughly 30 times cheaper than a barrel of U.S. oil). At these levels it is not hard to imagine a significant increase of natural gas-fueled vehicles. Such a change would likely have far reaching implications for economic activity, employment, the environment, and possibly for the U.S. trade deficit should these developments begin to alter U.S. domestic demand for foreign sources of energy.

Some U.S. Industrial Companies We Own 

We own the stocks of companies in several VAM Funds (Lux) Compartments which operate within the U.S. manufacturing sector that are benefitting from the trend highlighted above. Below we include five1 representative examples.

Chart Industries, Inc.1 (ticker GTLS, current market capitalization US$1.8 billion) 

Based in Ohio, GTLS is an independent manufacturer of equipment used in the construction of natural gas fueling stations. In addition, it provides critical process equipment for the liquefaction of natural gas and storage of liquefied natural gas or LNG, which is natural gas that has been converted to liquid form for ease of transport. Their equipment is utilized at ports and at other critical exporting stages of LNG. They sell their equipment globally and we believe they are a dominant, well-positioned company that will continue to participate in the build-out of the natural gas industry’s infrastructure in supporting LNG as a transportation fuel. As the use of LNG increases, in the U.S. and globally, it should translate to greater demand for GTLS equipment.

Proto Labs, Inc.1 (ticker PRLB, current market capitalization US$855 million) 

Based in Minnesota, PRLB is a global provider of low-volume custom parts, serving product designers and engineers, which offers a quick-turn solution for prototyping and short-run production. The company is a leader in the niche market of providing new product designers with the easiest, fastest and least-expensive way to obtain low volumes of parts based on their three-dimensional computer-aided designs. The company targets services to millions of product developers who use three-dimensional computer-aided design software to create products across a diverse range of end-markets. Their customers conduct nearly all of their business with them over the Internet and their proprietary technology eliminates most of the time-consuming and expensive skilled labor conventionally required to quote and manufacture parts in low volumes. We estimate the market opportunity to be significant as more than $10 billion is spent on small batch products/quick-turn manufacturing annually. The company does not have any customer concentration issues and their customers range across diverse industry groups including industrial, computing, and medical device companies.

Titan International, Inc.1 (ticker TWI, current market capitalization US$883 million) 

Based in Illinois, TWI manufactures specialty wheels and tires primarily for off-highway applications used in farm machinery, construction and mining equipment. The company operates five manufacturing facilities in the United States and one in Brazil. Despite concerns in Europe, China and the U.S., farm, construction and mining tire demands remain robust and the company is aggressively ramping production to meet its targets. Ultimately, Titan’s goal is to be the number one global farm tire supplier, and the third mining tire supplier.

Triumph Group, Inc.1 (ticker TGI, current market capitalization US$2.9 billion) 

Based in Pennsylvania, TGI engages in the design, engineering, manufacturing, repair, overhaul and distribution of aircraft components, such as hydraulic, mechanical and electromechanical control systems, aircraft and engine accessories, structural components and assemblies, auxiliary power units, avionics, and aircraft instruments. The company is a direct beneficiary of a strong aerospace cycle, one that may prove insulated from global economic activities given the need to upgrade aging airplane fleets in the developed world and expanding capacity requirements in the developing world. TGI acquired a competitor, Vought, two years ago, and execution on the integration of that company has been excellent, allowing it to achieve significant operational improvements in recent quarters.

Stratasys, Inc.1 (ticker SSYS, current market capitalization US $950 million) 

Based in Minnesota, SSYS is a global leader in the manufacturing of three-dimensional (“3D”) printers. 3D printers have been gaining market share in the manufacturing sector and SSYS is well positioned to grow within its existing distribution channels, which include aerospace, defense, automotive, toys and medical devices. Additionally SSYS is well positioned for the nascent desktop 3D printing market, where it seeks to be the affordable, low cost provider. The company’s 3D printers and high-performance rapid prototyping systems provide 3D computer-aided design users a fast, office-friendly and low-cost alternative for building functional 3D parts. SSYS recently announced a merger with a privately held 3D printing manufacturer in Israel. Once the merger is complete, SSYS will have an undeniable leadership position in 3D printing.

Closing Thoughts 

Back to the current market environment…

The tug of war between the bulls and the bears has been and will inevitably give us continued choppy, volatile markets. As such, markets could fall further in the weeks and months ahead if policy makers and economic news disappoint, or they could just as easily rally sharply if their actions are perceived to be bullish. Our closing message is to proceed with caution in the near term. However, if you are looking for reasons to be optimistic, consider this contrarian indicator shown below from our friends at Bank of America Merrill Lynch’s Equity and Quant Strategy Group. Their Sell Side Consensus Indicator is based on the average end of month recommended equity allocation of Wall Street strategists. This measurement, they have found, has historically been a reliable contrary indicator, meaning it has been a historically bullish signal when the reading was extremely bearish (where it resides currently), and vice versa.

Sell Side Consensus Indicator (as of 31 May 2012) 

Source: Bank of America Merrill Lynch Global Research, U.S. Equity and Quantitative Strategy

The information set out herein has been obtained from various public sources and is by way of information only. Broadgate Financial can accept no liability of any sort in relation thereto and readers should obtain their own verification of any statement before making any decision which may have any financial or other impact.

Neither the information nor the opinions herein constitute, or are they to be construed as, an offer or a solicitation of an offer to buy or sell investments.