Sean Kenney: Hi, I'm Sean Kenney and welcome to the MFS All Angles Podcast. Our topic today is the rapid innovation happening within the industrial industry. Traditionally, investors have though of industrial companies as cyclical businesses that grow at a modest pace. And while AI might be a catalyst grabbing the headlines, the real story here is a broad industrial renaissance driven by multiple durable growth drivers that extend well beyond data centers.

So joining me today to discuss what's driving this industrial renaissance is Erin McCarty. Erin is the sector team leader for our capital goods sector team and is a research analyst covering U.S. industrials. So Erin, thanks for joining me today.

Erin McCarty: Yeah, thanks for having me.

Sean Kenney: We have a lot to talk about. The industrial space is interesting and growing in ways that maybe it hasn't in years past. When we look at the industrial industry, again, I started by saying it has traditionally been thought of as more of a cyclical industry, slower growth industry, but there's a lot of changes happening there. Is this just a new cyclical story or is there actually something different happening this time?

Erin McCarty: Yeah, I think I would characterize it as there's a couple kind of secular growth trends. So we're seeing a super cycle in both commercial aerospace and defense. And then we're also seeing, you mentioned kind of the AI uplift that's kind of pulling through a lot of this power in electrical, industrial companies.

But then there's also kind of a broadening I think we've started to see over the last like six to nine months. We kind of saw a surge, mostly driven by pricing in industrials post-COVID. And then we've had about three years of pretty low industrial production in the U.S. specifically. And we're seeing that broadening. So whether it's kind of infrastructure investments, so road building and bridges, water infrastructure, we're seeing it with factory automation, some reshoring coming back to the U.S., but it's definitely getting a lot broader from the two kind of secular growth drivers that I mentioned up front.

Sean Kenney: So the macro theme is sort of this industrial renaissance with higher growth potential, but you have boots on the ground going out and meeting with company management with you and your research partners. What's the evidence you're seeing that things are changing from the companies you meet with?

Erin McCarty: Yeah, definitely. I mean, from a high level, we're starting to see it when talking with companies, just seeing order growth or backlog growth with some of these businesses or end markets that have been kind of sleepy over over the last few years.

And then we're also seeing it, we took a trip to Cleveland a couple of months ago and the excitement was palpable with these companies. They're kind of core manufacturing companies, but the growth that they're seeing in the order inflection is very exciting and they're starting to add capacity to some of their factories, getting confidence to invest in automation in some of their factories where they can justify the upfront cost because of the kind of demand that they're seeing.

And so I think talking with the management teams within the next level of segment leaders or factory managers, you can really kind of get a sense of the change in production and the change in maybe orders and growth broadening across some of these end markets.

Sean Kenney: When we hear the word re-industrialization, which is the way some people characterize what's happening here, some people think of it's factories just coming back to America. Is that too simplistic? Or when you're out again in the market seeing companies, is there more to the story there or is it just simply manufacturing coming back to the United States?

Erin McCarty: Yeah, I think it's kind of twofold. So we are seeing definitely demand. So I think there's some trends that were started before AI, but that are accelerating. So electrical power growing there. And then there's also supportive policies to drive infrastructure investment. So we're seeing like cement or kind of core aggregate companies starting to see growth and construction equipment, road building starting to see growth. And then there's of course the reshoring narrative that we've been talking about for a while, but we're really starting to see that in companies talking about project pipelines or bidding pipelines that they're seeing and announcements for big investments across like the pharma industry, across defense. There's some new defense companies that are building new facilities and CapEx projects within the U.S.

So I think it's a bit of both, but it's definitely much broader than just I think moving some low cost manufacturing from a region back to the U.S.. I think companies are not going to do that just because of a short term, potentially short term and highly volatile tariff situation. I think they're really seeing increasing demand and a willingness to maybe spend a bit more upfront to be closer to the customer long term.

Sean Kenney: Okay. I mean geopolitics might be like a small part of the story, but a bigger part of the story, even though it's not the whole story, is AI. And if you think about AI within the industrial space, what's happening there? How is that materially changing the industrial space?

Erin McCarty: Yeah. So I think it's driving, I think we talked about in your intro, these used to be very slow growth businesses, and I think AI has really changed the dynamic of growth. So they used to grow like 1 to 2%, they generated a lot of earnings power from margin improvements, so lean manufacturing and had done that over decades. And now I think we're really pivoting to a growth oriented mindset. So they're needing to invest in R&D, looking for new ways to increase efficiency. Efficiency is more important than it's ever been now because compute is very highly monetized. You don't want to be wasting your scarce compute power on cooling or transmission and power conversion. And so companies have tried to innovate and it's driving, I think, a new kind of culture of innovation and new products with these companies that have just kind of been steadier producing what they've always produced with cyclical, but slower growth end markets historically.

Sean Kenney: So part of the AI story is certainly the revenue opportunity because the industrials and manufacturing is creating the infrastructure for AI, but also the productivity gains?

Erin McCarty: Yes, definitely. Yeah, I think longer term, so we have first the data center build out and whatever CapEx is going towards that, specific industrial products there. And then I think longer term, we would think about automation within factories as the next leg of productivity growth driven by AI.

I think you can see it when you visit a factory that was made 30 years ago versus today, it's very different. The automation piece has improved a lot. And I think from talking with people in the industry and different management teams, it's accelerating at a pace that they haven't seen in decades. And so I think AI just accelerates automation more, increases productivity at these factories. And so all the companies that make sensors and connectors that connect all this physical equipment, I think are poised to benefit because more physical infrastructure will need to be connected to be able to utilize AI over the top of it.

Sean Kenney: Yeah, I'd imagine automation, robotics will all require this physical infrastructure as well. But humanoids are a topic of conversation that seems further out, but are there opportunities there for manufacturing companies as well as you think about the ball bearings and just the basic things that go into some of those?

Erin McCarty: Yeah, definitely. And I think this is maybe further out, kind of less well developed and highly valued piece of the AI build out. So it's an area we're really focused on and trying to understand which companies might be best positioned for robotics, for the eventual physical AI build out. And say we talk a lot with our colleagues in Asia because China's a lot further ahead here, so seeing what some of the companies there are doing. Yeah. So like you mentioned, bearings, actuators, just like screws and small components are starting to be really in high demand as they're integrating more robotics into factories and trying to build out an ultimate humanoid or physical AI.

And so this area I would say is further out, but a really exciting part for industrials. And so I think for AI to do real work in the physical world, they're going to need industrial companies to supply the kind of infrastructure for that as well.

Sean Kenney: Yeah. It's really advanced manufacturing to do that rather than necessarily skilled labor always, right?

Erin McCarty: Yep. Yep.

Sean Kenney: When you think about, we talked about how AI is a factor, maybe not the biggest factor. I've heard you talk about electrification as maybe one of the biggest growth drivers for the industrial industry. What's driving that?

Erin McCarty: Yeah. So electrification has been a driver I think looking back to 2018, '19, we were starting to see kind of an inflection in demand for electrical products. And we had flat electrical growth in the U.S. for a long period of time that's started to accelerate. And this was driven by both grid hardening, so having not invested in the U.S. electrical grid for a long period of time. There's just certain components that need to be replaced or hardened. And then also just electric vehicles and building automation, so moving more buildings onto their own micro grid and thinking about sustainability and more efficient building operations. So all of that has been driving electrical demand to increase.

So I think a lot of utilities had forecasted investing more in transmission and distribution and in electrical growth. And then AI accelerated that obviously further and I think forced companies to innovate, focus on productivity just because the demand is so strong and accelerating so fiercely in the last couple of years.

Sean Kenney: Yeah. As an investor, as you evaluate companies, what gives you confidence in a company's durability? So whether it's their growth, duration, the moat around their business, what gives you confidence?

Erin McCarty: Yeah. So multi-industrials historically have been, they've been good businesses long term, even before a lot of this industrial revolution stuff we've been talking about. But I think the best ones have been diversified balanced companies who do have pricing power. So maybe regulatory driven, so if they're spec'd into an A&D platform or a gas turbine or an electrical system, there is regulation involved. So that's important. And reliability, so their customers don't want to try out something on a new entrant just because reliability is so important. And these components generally aren't super expensive relative to what the customer is spending as a whole.

And so I think thinking about companies that are good executors, and I think that's been more apparent recently as demand has increased far above what these companies could have probably forecast and expected. And so being able to ramp new capacity quickly and efficiently.

And then also being really close to the customer. A lot of the multi-industrials I'm thinking about and then I'm talking about here are very sprawling companies with very diverse end markets. And so giving ownership, extreme ownership kind of mindset at the segment leader level has proven to be a very good way for these companies to stay ahead of customer trends, ramp manufacturing capacity where it's needed quickly, versus always bringing capital projects back to the C-suite to go through this. Giving autonomy to leaders deeper within the organization has been a key to outperforming over time.

Sean Kenney: Is it fair to sort of put it in simplistic terms that the old playbook for a lot of manufacturing was go anywhere around the world, produce your product at a high quality you can, but at the lowest cost you can and then ship it back to your end market. And today what you're seeing is more value being created, being close to your customer and sort of building a business model that allows speed to market and customer centricity. Is that a fair way to put it?

Erin McCarty: Yeah, definitely. I think it's much more nimble and innovative today than it's ever been before. And so companies I think historically were rewarded for increasing margins, having great return on invested capital. But I think that has made some companies unwilling to invest in the next round of CapEx or R&D because say it might lower your returns near term, but then thinking about duration of growth and being well positioned for what customers need across the next decade is really important.

Sean Kenney: Okay. So when we think about growth companies, we have to think about bottlenecks, where is there scarcity that will limit growth, that will slow down growth or create some kind of a bottleneck for a company. Where is that happening in the industrial space?

Erin McCarty: So I think labor is the biggest issue today still that we hear across companies, customers, end markets. And so it's skilled labor really. And so a lot of the productivity and automation is helping ease that a bit, but there's still a need for skilled welders and electricians. And some of the companies that we look at actually have either like a trade school themselves or they have a partnership with a trade school where they're supporting the next generation of the skilled workforce. And so that's been a huge bottleneck and a key advantage for companies that are able to have the right labor that's needed for these projects.

Sean Kenney: Does that tend to skew towards larger cap companies that can invest in that or is there something more?

Erin McCarty: Yeah. I think yes, larger cap generally and established companies who have always been. So some of these kind of engineering construction companies that have focused on utilities long term have great pipelines of labor talents and are able to capture this growth opportunity, versus maybe some that would see the supply demand disconnect at this moment and try to get in. I think it's just harder to have like the reliable skilled labor at this point.

Sean Kenney: Yeah. There's a lot of factors that go into evaluating a company. I would imagine. And it's your job going out to visit companies, evaluate companies. There must be value in working with teammates across the platform. How do you evaluate the factors that you have to consider when you're making an investment decision?

Erin McCarty: Yeah. So yeah, definitely lots of pieces to go into it. So yeah, visiting companies, getting to know management, leadership teams. And then we've done so much more cross sector work I feel like in the last three to five years just around a lot of these growth themes. It's pulling from a lot of different sectors.

So for example, we've been looking at, with the energy team, I'm trying to add up the, there's a theme of behind the meter power coming on. So data center operators using, bringing their own power, bringing their own turbines to the site versus connecting to the grid. And so we've been trying to understand kind of how much capacity's coming on. It's coming on from different engine manufacturers across a couple of sectors, so working with the energy team on that piece. And then pairing that with the tech team. So Rodrigo and Matt on the tech team are forecasting the demand side. So pairing the supply with the demand side and trying to understand, is there a point where we have too much supply? Are we balanced? And working across teams there. So yeah, it's definitely a lot of different pieces coming into it.

Sean Kenney: Yeah. We had Jude Jason on a few episodes ago talking about the energy space. And in that conversation it was very clear that energy is becoming a huge input into so many different industries. And clearly with the electrification and the big mega trends within industrials, there's a lot of overlap there.

When you think about being a long-term investor, and in many ways we have the benefit in serving clients as being a long-term investor, you can see through the short term noise and maybe invest through an investment cycle. Over the long term, what do you think are the characteristics that matter most?

Erin McCarty: I think a lot of it comes back to being close to customers. And I know I've said that a couple of times, but just being nimble, knowing what your customers need, helping them to reach their goals long term. And then having a balanced approach to end markets, so not having all of your chips in one basket, so to say. So working with diverse customers, working with diverse end markets has been important for these companies long term.

Another one I would say is they generate a lot of free cash flow, especially now because the growth is accelerating. So making sure that they're using that cash flow to either invest in capacity with strong returns or do acquisitions to increase their product set. And I think those are investments these companies have to make, but long term set them up to participate in a lot of these trends and participate with customers, be partners for decades.

Sean Kenney: Okay. As we look forward, let's look out three to five years and assume the bull case for re-industrialization happens and these industrial companies have this growth that we've talked about. What do you think has changed most materially in three to five years about the industry?

Erin McCarty: Yeah. I think so maybe a lot more industrials that are bucketed in the growth stock bucket. And so I think autonomy I think and automation across factories will be a big driver. And so there's automation today, but I think if you went to a factory, you'd probably be surprised at how kind of rudimentary some of the automation or what's considered automation is. And so I think if there is this driver with AI and with physical infrastructure and looping together the manufacturing automation, I think that can make a lot of manufacturing that maybe didn't make economic sense to do near customers or in a high cost region, maybe make that make more sense. There's just less labor involved. You can have more robotics. And then you have the benefit of having customers be able to come visit and see your facility and work closely with you on new products.

And so I think potentially a lot more automation which could drive a lot more manufacturing into the U.S.. And then I think investing back into the business and kind of a flywheel effect of more new products, better margins for these companies, investing back into new products for their customers.

Sean Kenney: Okay. Maybe the last question will be, when you think about the industrial space as a long-term investor, is there something that you think is underappreciated by the market today or a theme within a business that you think over a longer period of time will play out from a growth perspective?

Erin McCarty: Yeah, I think there's a lot of short-termism today in the market and a focus on next year's earnings or the year after. And so being able to have kind of a long term view and look further out. So I think a couple of key growth drivers that we think are going to be durable would be electrification broadly, and then I think liquid cooling, which does have data center implications. But some of these growth trends, people like to revert to the mean, but I think that a lot of these trends are kind of durable and accelerating from here through the next 5 to 10 years. And so those two would be ones I think that are accelerating now that maybe are still undervalued in years five or six.

And then I would also say on the physical AI piece, a lot of these industrial companies are not very highly valued today and have gone through this industrial recession period over the last three years. And these are the companies I think that are going to participate very broadly in autonomy, automation and physical AI longer term. So these are the ones I think that we're looking at today and trying to make sure that we are well positioned with some of these companies over the next 10 years.

Sean Kenney: And I've also heard you talk about the fact that even just the service contracts to service the infrastructure will become a growth driver for some of these companies. Is that right?

Erin McCarty: Yeah, definitely. And so I think today they're building their install base. So we're selling a lot of new equipment whether it's into factories or data centers, HVAC equipment, or electrical equipment or turbines that have these long term service contracts. So companies can make like 2 to 10 times what they originally sell in equipment to these customers in the service contracts. And so having a reliable service provider, you would have maybe a decade, decade plus contract. And these are kind of higher margin pieces of the business. And so that gives us more confidence and able to pay a bit more for some of these companies that have these long tail service contracts.

Sean Kenney: Yeah, it's repeatable and almost annuity like, right?

Erin McCarty: Yep.

Sean Kenney: Yeah. Well, maybe to wrap up, I'll summarize a few of the key things that I heard and you can either validate or refute them. But the first is clearly industrials are evolving from what was once a very cyclical business to much more of an innovation driven growth business, certainly here in the U.S.. Is that fair?

Erin McCarty: Yeah, definitely. So a couple of my colleagues are now portfolio managers, but have covered industrials and they're like, "This is an exciting time. These are very different companies than I looked at 15, 20 years ago." So yes, definitely changing nature of the industrial companies, industrial landscape.

Sean Kenney: And we talked about AI in this conversation as we. It's hard to not talk about AI when we talk about the markets, but clearly that's part of the driver. But there's actually a number of other durable growth levers that are being pulled in this industry. Is that right too?

Erin McCarty: Yeah, definitely. Yeah. Whether it's infrastructure, investment on road building and bringing factories back to the U.S. or adding new capacity, new factories in the U.S., I think that's definitely a growth driver that's broader than just data center building.

Sean Kenney: Yeah. And then maybe the last one is just reflecting on your comments around almost the new playbook where speed to market, customer centricity and the need to invest in R&D and spend CapEx in order to serve customers more locally is somewhat of a path forward for companies.

Erin McCarty: Yeah. I think that sets them up well for the next decade of growth if they're able to do that.

Sean Kenney: Yeah. Well, thank you for walking me through that. And thank you for listening to All Angles. If you enjoyed the episodes, subscribe so you don't miss any future episodes. And until next time, be sure to consider your investment decisions from all angles.

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