Finding Inspiration in Transition

 | Jul 27, 2016 | 12:16 PM EDT
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Hey! Surprise! Things are decent. Companies are using their strong balance sheets and historically low rates to acquire. Margins are hanging in there despite rising wages and volatile raw-material prices. Sales are slow but not falling off a cliff. Valuations have expanded as a result. 

What on earth is going on? 

We are in transition. That's what I think is going on. The baton is passing. Some industries, like semiconductors and appliances, are consolidating -- rapidly. Other companies are shrinking, divesting or selling themselves. What an interesting moment in time. 

We are going through a period of time, duration unknown, where companies are restructuring themselves for the future. The innovators are allocating capital to support the demographics of the future. They are looking forward. 

The sellers, or repairmen, are either backward-looking, got rich already or are tasked to fix something that was previously excessive -- whether it be a balance sheet, a business wrought with overcapacity, or a portfolio of companies that simply just do not fit together. 

There is no right or wrong here. It's just where we are in the life cycle of a company or industry and the capitalist right to create future value. The evolution is creative and amazing to observe; especially over long periods of time. 

So is it sustainable? It can be. Regardless of near-term market gyrations and quantitative dependence on quarterly earnings results; many companies are making moves, big, compelling and smart. Remember, the Fed raising rates 12 times and 25 basis points each still represents a historically favorable borrowing environment. 

Demographics are a clear driver. China and the markets emerging have built significant infrastructure for resources and logistics to support a potentially burgeoning middle class. Many have overbuilt; and the collapse in oil prices supports that case in a common-sense fashion. But you know what? The middle class is growing. The millennial effect is a global phenomenon. These folks are using technology in new ways every day. 

Take the acquisition of Linear Technology (LLTC) as a perfect example -- Analog Devices (ADI) sees a future of connectivity, speed and efficiency. 

Joy Global (JOY) , on the other hand, just surrendered to a consolidation move in an effort to sustain a service franchise. In the face of a future where infrastructure spending is shifting to efficiency from resource extraction, it is likely that JOY made a solid long-term decision. 

Neither is wrong. 

Research and development spending is a signal. Companies spending organically to invent and respond to changing demographic tastes are compelling indeed. Take Entegris (ENTG) , IPG Photonics (IPGP) , Mettler-Toledo (MTD) , Nordson (NDSN) or Graco (GGG) as examples of solid organic franchises that invest heavily in themselves.

The future is bright for these well-capitalized and organic-driven companies. They have distinct value propositions and defined market opportunities. Companies not possessing this characteristic will be acquired or competed away "in the next cycle."

That encore, boy, is it difficult. Largely acquisitive companies, ones that have created an eye-popping amount of value over the years, will find it harder to grow. So Danaher (DHR) , which started and successfully implemented the playbook, is ending it as evidenced by the recent spinoff of Fortive (FTV) and the launch of the "new Danaher." AMETEK (AME) and Roper Technologies (ROP) may find themselves in similar situations during this transition period.

There's certainly nothing wrong with the playbook. We just might have to look down the market capitalization range some to find some interesting ones. Idex (IEX) , Hillenbrand (HI) and Colfax (CFX) could be the earlier-stage M&A stars that have more capacity to look forward. 

Let's watch this transition. It is what makes our craft interesting. 

Some may think me desperate, but I'm a happy guy. I'm inspired.

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