The United States is entering a new industrial investment cycle. Federal funding totaling more than $2 trillion is being put to work improving American infrastructure, as discussed in our Q2 2023 article “The Challenges of US Infrastructure Spending.” On the private side, myriad industries are making large investments at home fueled by a supportive regulatory environment, the race to build AI datacenters, and attempts to prevent another COVID-style supply chain meltdown in the face of declining geopolitical stability.

Our investment committee has been closely monitoring the opportunities created by the current environment, aiming to identify the companies that will best capitalize on it. As we have a long-term investment horizon, we must find quality businesses that will use this windfall to permanently strengthen their competitive advantages. Two of our recent additions to client portfolios – Eaton (ticker ETN) and Ingersoll Rand (ticker IR) – exemplify the qualities required to compound investor capital for years to come amidst the expected surge in spending.

Eaton is a multinational power management company. Historically, it has captured around 30-40% share in its industrial electrical systems end markets. While historically these markets have been cyclical, the emerging secular trends represent a change in conditions for ETN going forward. ETN has always benefitted from increasing construction spending relating to manufacturing, but the differentiating factor in today’s environment is the opportunity in data center construction. This market is estimated at $34 billion today, with an expected five-year annualized growth rate of at least 10%. ETN ended 2023 with $3.3 billion in market share, but is positioned to capture a greater share, as the demands on the US power grid from data centers move from 3% of total demand to more than 8% by 2030. Its backlog has expanded, granting investors greater visibility into the business’s performance for the next several years. When combining the foundational changes to ETN’s end markets with its high margins and history of shareholder friendly capital allocation, we believe there will be upside ahead for investors holding ETN for the long run.

Ingersoll Rand is a diversified industrial company with a portfolio of more than 40 respected brands. Its products – while diverse – can be summarized as market-leading solutions for specialized industrial air, fluid, and gas manipulation. Its portfolio has been built via mergers and acquisitions over the past five years, positioning IR as the go-to player in numerous niche areas of the ongoing industrial expansion. Its management team has proven to be adept at improving the efficiency of its portfolio companies over time, generating incrementally higher margins over time. While other industrial conglomerates employ similar “roll-up” strategies, our investment team views IR as unique among them by virtue of its strong end-market dynamics. Notably, it has an especially robust portfolio addressing the needs of the clean energy and water industries that are substantial beneficiaries of Federal infrastructure spending. Its products, while often a small piece of a large project’s total cost, are crucial. As an example, IR air compression systems are the beating heart of many water treatment plants. Without consistent compressed air production, the plant could be rendered inoperable. Pumps such as these are profitable up front, but even more so over time due to service contracts and strong aftermarket economics. Given the rapid expansion of IR’s total addressable market – from $44 billion in 2021, to $55 billion today, to a forecast $75 billion in 2025 – our team views IR as capable of achieving higher returns on investor capital by merely maintaining its current business. When considering the long-term upside from the evolving expansion of infrastructure, we find the dynamics of the business even more compelling.

Eaton and Ingersoll Rand emerged from our screening of the market for quality businesses. Both companies began to demonstrate fundamental characteristics in line with our three investment process pillars of profitability, predictability, and rational capital allocation. As we analyzed their business models, we found that each company had distinct competitive advantages relative to peers. The attractive elements of the individual businesses intersect perfectly with what we view as a powerful, decade-plus long secular upswing in infrastructure spending. ETN and IR are not just poised to win – we think it will be hard for them to lose.

 

"Written in June 2024 for 2Q2024 Investment Outlook"