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As active managers, our sector analysts are constantly working behind the scenes evaluating companies, building shopping lists, and finding opportunities.
So, what do they think could go right in their sector this year? They answered.
Sector: Life Sciences/Healthcare
Within healthcare, an area that has been negatively impacted the last couple of years is the pharmaceutical manufacturing value chain. This includes, among others, Life Science Tools companies – companies that make equipment and consumables used to perform pharmaceutical R&D and manufacture products. Another one is Contract Development and Manufacturing Organizations (CDMOs) – companies that manufacture drugs on behalf of both large and small pharma/biotech companies. We view these businesses as having strong growth prospects, high barriers to entry, and pricing power. However, the stocks had a difficult 2023 due to 1) tightening monetary conditions reducing capital availability for startup biotech companies – a large customer for Life Science Tools and CDMOs, and 2) a roll-off of COVID tailwinds the industry experienced due to increased spend on COVID vaccines/therapy R&D and manufacturing.
With monetary conditions poised to stabilize and, potentially, loosen, along with fading COVID roll-off, we think the pharma value chain should see improving business conditions. This should, thus, translate to strong stock performance.
Notably, pharmaceutical demand is largely independent of economic conditions (people still take their medications in a recession), so this business condition improvement should be largely independent of macro factors. We are capitalizing on this opportunity through investments in the strong Life Science Tools companies, and the strong CDMO companies – and will look to increase our sizing as the risk/reward in the opportunity improves.
Sahil Bhatia, Managing Director of the Life Sciences Group
Sector: Capital Goods
Several capital goods and materials sectors experienced recessionary conditions last year, which caused weak fundamentals and pullbacks in the stocks. This weakness proved to be an opportunity to build positions in high-quality names at attractive valuations and where conditions were indicative that the sectors were near a trough. These are the areas where we continue to see opportunities in 2024 as we potentially exit an industrial recession. The three examples we would point to are in the housing, transports, and chemicals sectors.
Within the housing sector, mortgage rates significantly increased as the Fed raised rates in the last couple of years. This drove housing turnover to recessionary levels as homeowners preferred to stay locked into their existing low-rate mortgages. As a result, fundamental weakness emerged in the building products subsector, where one of the primary drivers of growth is housing turnover. We think the level of turnover is unsustainably low and that it’s likely we have seen the peak 30-year mortgage rate this cycle. We gained exposure with high-quality building products companies that produce low ticket repair and remodel items – such as paint – which we view as a more defensive way to navigate the cycle. There continues to be evidence of bottoming fundamentals in building products stocks levered to housing turnover.
Beyond housing, there was a freight recession last year, which caused weakness in many transport stocks. We took advantage by adding exposure to railroads, which are high-quality monopoly businesses with strong pricing power. We are now seeing evidence that we are exiting the freight recession, as all of the major US and Canadian railroads experienced volume increases last quarter for the first time since 2021. This sets the stage for an upcycle for the rails and earnings are a coiled spring coming out of recession due to inherently high operating leverage, improving labor productivity, resolution of service issues, and a focus on operational efficiencies. We have been adding to our railroads positions in 2024 as conditions look to be bottoming.
Chemicals is the third sector that experienced broad-based recessionary conditions last year, exacerbated by a historically bad inventory destocking cycle. This caused pain for many chemicals companies across the value chain. There’s increasing evidence that the destocking cycle is ending based on data from chemicals producers, customers, and distributors. As a result, we took the opportunity to add to our positions in chemicals distributors, which are high-quality businesses that sell thousands of complex chemicals from a fragmented supplier base to thousands of customers. These businesses have defensive fundamentals, including strong countercyclical free cash flow generation during downturns.
We will continue to look for opportunities to buy into sectors that are experiencing pain where evidence is suggestive of a cyclical bottom. We are seeing weakness in some additional areas this year, including the electric vehicle battery metals space (lithium, nickel, cobalt) and natural gas, all commodities which have declined significantly from their highs this cycle. These areas could be hunting grounds for new ideas in 2024.
Justin Villa, Senior Equity Analyst, Capital Goods
Sector: Fixed Income
The starting point for fixed income markets is very different from where we were a year ago. Sectors within the fixed income market with embedded credit risk have done extremely well over the past twelve months. Credit spreads are near their tightest levels this cycle with a lot of good news already priced in. However, if the “immaculate disinflationary” environment can persist to help ease financial conditions, securities with credit risks should continue to perform well.
Yields across the fixed income space are relatively attractive. An environment with lower economic and market volatility can allow fixed income portfolios to earn an attractive yield. If goods prices continue to fall, at the same time services inflation moves closer to 2-3%, we see scope for yields to move lower without negatively impacting credit, providing suitable absolute returns for the year.
Brad Cronister, Fixed Income Research Analyst
Sector: Tech
The future of tech can be surmised in three points: accelerating growth for SaaS and IT services, Generative AI adoption, and the memory cycle hurdle rate continue to play out.
Accelerating growth for tech subsectors like SaaS and IT services: Enterprises broadly pulled back on the most discretionary parts of IT spend last year due to inflation concerns and cost-cutting initiatives. Ultimately, this caused a significant deceleration in revenue and bookings growth for many software and consulting companies, especially those with usage-based billing models. For example, hyperscale cloud service providers (think Amazon AWS and Microsoft Azure) typically bill customers based on the number of workloads running at any given time, while digital IT service companies bill on a “time and materials” basis. As these companies start to lap easy compares, we should start to see growth reaccelerate again.
Early signs of Generative AI adoption: As use cases for AI “co-pilots” proliferate, we could start to see signs that these new products are driving real efficiency gains for customers. High ROI real-world applications should drive increasing investment in AI, benefitting the “arms dealers” as well as the vendors selling those applications.
Memory cycle Hurdle Rate continues to play out: We own large positions in companies focused on semiconductors given our expectation that memory demand growth will outdo supply in 2024, causing memory prices to inflect higher. Accordingly, we believe memory vendors who lost money throughout most of 2023 will see huge improvements in revenue growth and margins this year, driving windfall profits.
James Slentz, Managing Director of the Technology Group
Sector: Services
Interest rates have marched upward in the last two years. In such an environment, borrowers avoid refinancing debt if possible. Mortgage refinancing volumes have cratered, and some homeowners have even delayed plans to move – who wants to sell a house with a 3% mortgage to buy a house with a 7% mortgage? A similar calculus has taken place among corporate borrowers, as companies with relatively cheap fixed rate debt are waiting as long as possible to pay off those bonds and reissue new ones.
Several financial and business services subsectors profit from the debt issuance value chain. New mortgages require consumer credit reports to be pulled and mortgage origination and servicing software files to be created. New corporate bonds necessitate credit ratings reports and investment banking services.
With interest rates likely plateauing or perhaps even declining, and with many borrowers having deferred refinancing plans already, we think debt issuance volumes are near a bottom. When these volumes recover, several service providers should benefit
Allen Coker, Senior Equity Analyst, Services
Sector: Consumer Goods
What could go right with the consumer in 2024? Well, the biggest unknown is whether the Fed can successfully navigate a soft landing. To the extent inflation can be tamed without engineering a full-blown recession, that would bode well for the general health of the consumer, which would have effects for the broader consumer sector, particularly the discretionary portion of the sector.
Rapidly rising interest rates in 2023 muted and/or destroyed demand for many big-ticket durable consumer purchases that are typically financed, such as buying a home, buying a car, and making home renovations. Eventual rate cuts could unlock latent demand for these areas; we think even a continued high-but-stable rate environment could be a positive.
Should the Fed overtighten and economic activity decline, our staples holdings would likely benefit from investors migrating to areas of relative safety within the market. Lower rates would also force income-oriented investors to rethink their asset allocation decisions and higher dividend-yielding staples companies may once again be en vogue.
Many companies within our coverage area are seeing declining input prices, which potentially sets the stage for more robust profit growth even in a period of slower economic activity.
Something that could go right in 2024 is that we simply return to a more normalized business environment. We’re several years removed from a global pandemic, but businesses are still grappling with some lasting impacts; COVID created a significant bullwhip in demand for many areas of the economy, which was a tailwind in 2020 and 2021, then turning to a headwind throughout 2022 and 2023. As the market tends to over-extrapolate current conditions, we think moving back to a more normalized environment could prove positive for many of our holdings:
- Many parts of our sector over-invested in 2020-2021 and are just now getting back to pre-COVID utilization levels, improving margins.
- The retail sector has finally worked its way through the massive inventory glut, which it had to discount to clear, all of which was at the detriment of margins and asset turns.
- Businesses that throttled back spending on cloud services (such as those provided by Amazon) in 2023 are starting to turn their spending back on.
- Growth rates could improve in alcohol and spirits, where consumers at the margin were drinking less in 2023 (after drinking a lot more during the pandemic).
- Similarly, growth in spend on video games (particularly in mobile) could start to improve, where consumers were gaming less last year after a spike during the pandemic.
- Companies that relied entirely on pricing to drive growth are now returning to a more balanced approach between pricing and volume.
We think a return to normal is something investors will welcome.
Jake Boak, Managing Director of the Consumer Group
With no crystal ball to see into the future, no one knows exactly what the year will bring. All we can do is stick to our time-tested processes, be tactical and calculated, and prepare to take advantage of opportunities as they present themselves.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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