Power and resilience: The investment opportunity

The result of what we just talked about and China building itself into this manufacturing powerhouse has been that there has been a willingness to become highly dependent on the Chinese supply chain and now a growing realisation that is no longer tenable and therefore there is a growing political imperative to alter the nature of the supply chains that are in place today and build up one's own capabilities. Welcome to season five of Well Said where we explore the cyclical and secular forces shaping capital markets. You'll hear how Wellington investors apply macro market and geopolitical research in the pursuit of better investment outcomes. I'm your host Thomas Mochup. The last decade was marked by a growing realisation of the need to overhaul our energy and industrial infrastructure and to fortify supply chains and more recently given rising great power competition national defenses. As regular listeners of this podcast know the next decade will be marked by growing investment in those systems. Now the amount of capital needed for resilience and efficiency building measures here is truly staggering it's likely in the trillions of dollars that's with a T for policymakers who I spend a lot of time with this is a logistical and a budgetary quagmire but for investors it's a generational opportunity to deliver alpha by providing capital to companies who are today building safer more durable and more sustainable systems. So as your friendly neighborhood geopolitical strategist I can think of no better topic to kick off season five of Well Said than this one. Joining me today from London is Wellington Global Industry Analyst Saul Rubin an expert on the industrial and automotive sectors. He's been researching and investing in these areas for more than 30 years and probably understands more about the coming power and resilience transition than anybody else I know. Saul thanks for joining us and welcome to Well Said. Thank you Thomas. Now Saul we can't discuss these important topics without first exploring the many underlying geopolitical dynamics. We're recording this conversation just days after the dramatic capture of Venezuelan president Nicholas Maduro by US forces. So with this more unstable structural picture as the backdrop let's start with the theme of resilience and specifically the national security concerns that go along with that. So putting on your investor hats all what are your views on the revenue streams for defense or dual use technologies and how do these factors like export controls procurement cycles or national budget allocations shape your views. I think it's fair to say that geopolitics has been less of a factor in the investment world for for many many years until recently and now I think it's impossible to pursue any sort of investment strategy without understanding what's going on and the kind of things I know you've been talking about for quite some time now Thomas and I think it's not an understatement to suggest that what we're seeing right now is essentially the unraveling of the world order that was created post-World War II and the realization is gradual or like many things it's gradual and then sudden and we're seeing both of those things happen in the sense that it's still gradual in places like Europe and the UK and it's happening very suddenly in the US and yes you could pick probably any day of the last one to two weeks of carrying huge amounts of significance but just take two things yesterday one very prominent and one perhaps less so for people in the states or in other places but we saw President Trump of course date that he wants to see defense spending in the US rise by over 50 percent in 2027 versus this year at the same time here in the UK you had a very specific or moment in Prime Minister's questions to the UK Parliament about whether the pace of spending in the UK was picking up fast enough and I think almost certainly the answer to that is no but you're going to hear this debate occur with greater regularity now not only in the UK but right across Europe and of course just thinking of the US military it is of course by far the most powerful military anywhere and yet it's worth noting as I was just reading today that as a percentage of GDP the US is now spending the lowest proportion of GDP in the past 60 years so you have the greatest military power resting on what is a relatively low level of spend in the US and just underlines the inadequacy of the spend on defense especially in places like the UK and Europe so I think we're in the early stages of this process and this is going to I think lead to an enormous amount of investment opportunities over the coming years how did you come to this realization so I mean as you said this wasn't the focus for most of your career what were the factors that really convinced you that we're in a new era I think it's reasonable to suggest that China is pretty much core to everything we're talking about here and I know it's very easy to look at what's happened in the US in the very recent past as being hugely disruptive to the world order but I think it's only fair to suggest that what we're seeing in the US today is actually a large extent a very rational and reasonable response to things that have been occurring further afield for the last 10 to 20 years that links very critically to China and I would put this in two forms when it comes to China number one again I think it is fair to suggest that China really has emerged as the greatest disruptor to the legacy world order as a result of a longstanding policy of very substantial expansion in its military capability and willingness to project power and on the other hand a trade policy that is essentially tantamount to 19th century mercantilism and the second aspect to China is that partly as a result of that trade policy and the willingness to incorporate and often improve upon Western technologies China has built itself into the preeminent manufacturing and logistics powerhouse and I think it's not unreasonable to say that in that regard China's capabilities are awesome in the true sense of the word massive cheap and super efficient and the world is having to respond to that in many many different ways yeah I can concur that the way you've just framed that sits perfectly with the discussions that I have with policymakers not only in the United States by the way this was true with policymakers in the UK across Europe especially across Asia and so I would agree that the rise of China not only in a military sense but especially in this economic sense China as a pure competitor to the United States in this area has radically shifted the policy backdrop and I think that's likely to continue for not only quarters or years but decades to come I mean that's the sense that I'm getting from the policymakers but let's move to the rest of the world how to other regional policies affect your thinking how are they affecting or reshaping your opportunity sets and the companies that you research because as you say everyone's trying to respond to these structural changes emanating from China you started by talking about national security and let's continue there to start with and when we talk about national security I think we're talking about a very wide arena here I mean most obvious is the direct spending on defense but there's an awful lot more that goes into national security and I think there's a growing realization of that and the result of what we just talked about and China building itself into this manufacturing powerhouse has been that there has been a willingness to become highly dependent on the Chinese supply chain and now a growing realization that is no longer tenable and therefore there is a growing political imperative to alter the nature of the supply chains that are in place today and build up one's own capabilities and make sure that a domestic infrastructure is a lot more resilient and secure and no longer dependent on supply chains linked to China and it's going to take a while to build up the defense capabilities but it's going to take even longer to get this done because that dependence on China has grown to be so enormous and this will mean capital flows into industrial automation names for example are going to continue for years and years to come as many countries look to do two things, right? You're going to need to build up your own capabilities, but you can't just do it that way. You are going to have to rely upon others as well, and if it can't be China that's supplying you with more efficient manufacturing or cheaper manufacturing, let's say, then it's going to have to be other countries. And if it's not your own country, then it's going to have to be countries like India or Mexico, perhaps Central America and South America depending on where you're located and who you want to be dependent on. But I think India in particular, for example, is going to emerge as a huge new manufacturing center or many countries that are going to want to be aligned with the US as opposed to being aligned with China. So, that's a favorite term of here in Washington is not reshoring, it's friend-shoring, relocating these supply chains in countries that are not potential adversaries. But I'm curious, you know, through your investment lens here, which areas do you think are most likely to benefit from friend-shoring, reshoring, and this localization of supply chains that you've just painted? So, I think firstly you're looking to companies that will help in terms of, as I say, industrial automation. You know, a lot of these companies today, well, they exist all around the world, but I mean there's an incredible preponderance of skills that exist, for example, in Japan, but companies that feed into that supply chain, I think, are going to be seeing a lot more demand for many years hence. But it's not just that. I know we're going to get more into energy infrastructure and power, but building up security on that front is going to be just as essential. And today there's a huge reliance upon China when it comes to battery technology, for example, and all kinds of commodities and refining of commodities. And this is going to have to change, and this is going to draw capital into, for example, Korean companies have very good alternative technology when it comes to batteries. And, you know, I'm sure there are alternatives for other kinds of supply chains as well. Yeah, what you're saying there, again, comports with what I hear from policy makers. The way I view this is there are a number of strategic sectors, strategic industries that the policy makers view in this more competitive, great power context. And they're all focused on the industries that they think they need to, quote unquote, win going forward. The semiconductors, artificial intelligence is right up at the top of that list. Critical minerals, robotics, automation, energy, renewable energy is a piece of this. So again, I think the structural backdrop here, you know, this focus on industries as part of a national security orientation on the policy side, is the biggest shift that we've seen in the market narrative really in decades. And, but I do want to shift gears a little bit. And I want to dig down into something you said when it comes to overhauling industrial infrastructure, which sub segments look the most investible to you right now? And what are you really looking at today? And there's quite a lot of them, but let me just throw out some ideas. Today, when you look at critical infrastructure for logistics and you think about infrastructure that's being built in ports, a lot of this stuff today, again, it's coming from China. And that can no longer happen in the future. So, altering the infrastructure and ports to suppliers that are seen as more friendly is going to be important. Obviously, you'll see a huge rise in data centers today and all the infrastructure that's going to be required to go into that. Now, one can argue, maybe it's a bit of a bubble emerging on that front, but the reality is that capital will very likely flow into those areas. And the other big area that I think is most obvious is going to be the grid. We are seeing for the first time in a decade or two a true structural increase in demand for power, in particular electric power right across the world. And there's going to be a greater emphasis on ensuring that those systems are not only a resilient, but also secure. And so a lot of the electrical equipment names are going to be seen as critical in providing these services. And the other area that's linked into that as well is engineering and construction companies. So there are many of those companies right across the West and also in Asia that are going to be called upon in order to allow for the expansion of electrical distribution. There's a lot for you to be looking at these days. I hope you're getting enough sleep. I want to dig into what you just said about the power transition and sort of two related questions. So when you think of energy transition, what are the various pieces of that that you sort of take apart through the investment lens? And then, relatedly to your mind, what's likely to drive the most alpha in this area over the next five years? Where are the areas that we should be focusing on? So let's just talk about the key drivers to power. And I think really we're talking about two aspects of this. And just to emphasis what I said a moment ago, you know, I think it's well known that demand for power is going up today. But I think it's still not quite appreciated how significant a change that is relative to the last 10 to 20 years. I mean, the reality is that power and demand in the US and in most of Europe and the mature economies has flatlined for the best part of 10 to 20 years. And that has led to a massive underinvestment into the resiliency and distribution capabilities of the electric networks. And so today that's changing. Now, I think most would say that you're going to see structural demand growth, let's say 2 to 3 percent and that could well be an underestimation. So we're seeing structural growth for the first time in years and in an area which has been beset by underinvestment. So that's an enormous opportunity. And on the second side, when it comes to power generation, the reality is there's going to be the need for access to a diverse range of power generation capabilities. And yes, I know when you look at what's going on in the US today, it's very easy to suggest that we're seeing a return to oil. But that's not really what we're seeing. I think there is a return to a willingness to utilize oil as a part of the power generation capabilities. But at the same time, there's also a realization that one has to grow dependence upon ultimately longer term, more dependable and safer types of power generation. And so you're going to continue to see a diverse array of power generation capabilities, whether it's nuclear or solar or wind or whatever it might be. Whatever offers the best prospects, the safest prospects and the cheapest methods of power generation. So there are a lot of companies that focus on distribution and then there are others that invest or will serve, let's say, industrial equipment into the companies that actually generate the power. And we see great investment opportunities in both those areas. Yeah, that's a rich infrastructure. I'll just add two other geopolitical national security drivers to what you just mentioned, which is one, you know, the power grids are targets for cyber attacks. In this great power context, I get a lot of concern from Capitol Hill and elsewhere about the vulnerabilities, particularly in the United States in these areas. And so I think that's a driver. And of course, climate change is another massive driver here from the national security lens, which is, I agree, is going to drive even more attention on energy efficiency, emissions reductions globally. So on that last point, efficiency and emissions reductions, what solutions are most attractive to you right now, Saul? And which ones do you think have dang power over a longer or a full market cycle? I think the obvious one is the area of cooling systems, temperature control. And of course, there's a lot of linkage there to the build out of data centers, but not just data centers, I think in general, building efficiency products are going to be greater importance. Also talking about things like water, infrastructure and other types of critical commodities and companies that assess the efficiency of use of any types of commodities, I think are going to be in great demand. And maybe lastly, I'll just mention because there's no doubt that batteries are going to have to play a very significant role in dealing with the intermittency linked to various types of power generation. And the moment no one really is able to compete directly with China when it comes to building those batteries at cost. But regardless of cost, there's going to have to be a greater build out of battery technology through the West and through the Friends of the US, let's say, I think we're going to see very rapid development in that area in order to try to catch up with where China is today. Let's drill down on that topic. I love the topic of electrifying transportation. I am a proud son of Detroit and of the auto industry. So I want to pick your brain a little bit about this. Obviously, it's capital intensive, it's grid dependent. How are you thinking about the biggest bottlenecks as we move down this road of electrifying transportation. And how do you think about underwriting returns for the so-called, you know, picks and shovels investments that are necessary to enact this transition? - So electrification and transportation theme has sort of moved in waves and currently, it's somewhat out of favor. The reality is in the long run, we will see the electrification and transportation, but today there is a two greater dependence upon China for key aspects of that supply chain. And so there will need to be the development of an alternative supply chain, whether it pertains to the manufacturing of battery cells or indeed the mining and refining of critical materials that go into those batteries themselves and the electric motors and other components. So electrification and transportation make sense in the longer run, but it's still gonna take a little while, but for the time being, the opportunities are really gonna rest with those that can provide that alternative solution when it comes to battery cell technology. - So wrapping up, Saul, we've covered a lot of ground here, but these are all areas of widening opportunities for active investors. So from your perspective, where is valuation dispersion greatest right now? And what are the catalysts that you're looking for that could drive re-rating? In other words, what should our listeners pay the most attention to as these themes mature? - I think there are two areas today that are still underappreciated. Defense is one of them. And I know the defense names many of them have run considerably in the last 12 to 18 months or so, but this has come after many, many years of being largely ignored as a sector. Partly down to things like ESG and the popularity of ESG. For one reason or another, the defense names and sector has been hugely unpopular and the change that we've seen take place in the last 12 to 18 months, I think represents the start and only a start. And to put this into some kind of context, to me, the way I think of these companies today, I would turn them as government staples, as opposed to consumer staples. You can think of them similarly to consumer staples because consumer staples are often very popular because people see the demand for those kind of products as very stable and growing over time. And I think the reality is, one is gonna look at defense in the same kind of way. We can see that spend and that demand being sustainable and growing over many, many years. And I think quite frankly, more likely, we'll see faster demand growth then than we do in the consumer staples side. And yet, when you look at the valuations and you look at the multiples, even on multiples that are only two to three years out, you're paying the same or lower multiples for defense companies than you offer the consumer staples, I think that's entirely unreasonable. So yes, you've seen a lot of volatility recently, but I would say, with regards to the defense, we're still at the beginning. - This is not a quarter by quarter development here. This is a long-term structural change in how policymakers are viewing the real world. - I totally agree. And then the other area I think, which I mentioned earlier, is factory automation. There are many devices that go into improving the efficiency of manufacturing. And as countries like the US and Europe and the UK look to reindustrialize, and I think they will, I think you'll see this trend continuing again for years and years, the only way they're gonna be able to do it is doing it efficiently with respect to labor. And that means there's gonna be much higher levels of automation. And I think that today that's still not appreciated. This reindustrialization trend, again, it's at the beginning, very few people really have bought into this kind of idea, but there are companies there that produce wonderful product that can be put into factories today, that improve efficiency. And as those investment dollars go into reindustrialization trends right across the world, those companies are gonna benefit. So I think those are the two areas that I would be looking at today. - All right, so well, I could spend the rest of the afternoon talking to you about these things, but for the sake of our listeners, I think I wanna wrap it up, but I do wanna say that everything you've talked about here today, it's critical to the way that I think about the world, the way I think about how national security policy is shifting investment incentives. And the core aspects of this come down to, can we allocate capital most efficiently across these industries and across these areas to positively benefit that national security environment? So not to put any additional work pressure on you, but you better get this right, man. - I hope so. - Once again, Saul Rubin, Global Industry Analyst here at Wellington, thanks so much for joining us on WellSead. - Thank you, Dolores. - The WellSead podcast is a production of Wellington Management. Our producers are Amanda Dockardy, Mark Murphy, and Dana Wickstead. The show is recorded, mixed and edited by Mark Murphy, production support from Dave Crowe and Rasa Saramount, animation support from Rasa Saramount. You can listen to the WellSead podcast on Wellington.com, Apple podcasts, Spotify, or wherever you get your podcasts. Thanks for listening. - All investing involves risk, including potential loss of principle. Pass results are not a reliable indicator of future results. 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