Grossly Impressed – US Industrials Gross Margin Expansion, Suggests Innovation is Alive and Well
In recent work on gross margin trajectories for US Industrials and Basic Industries, we can’t help but be impressed by the positive and stable growth in gross margins for the Industrials group. We were less impressed (but not surprised) by the same data for Basic Materials.
Products, as they mature, have a natural tendency to commoditize; they become easier to make, consumers find ways to use them more efficiently, and they find alternate sources of supply (perhaps not of the same exact product, but of something that is adequate enough). Great examples of materials that have commoditized are; plastics (which Dustin Hoffman was told were the place to be in 1967), semiconductors, flat panel TV components, broadband, compact cars and many more. As products commoditize, it is very difficult to hang on to gross margin as you are continually fighting against falling pricing – economies of scale help, as do lower input costs, but they tend to be cyclical rather than a prolonged benefit.
Rarely do you find industries where restructuring sufficiently changes market structure such that pricing trends reverse. In the chart, a part of the transport story is a market structure story.
The more interesting story behind the trends shown in the chart is innovation, on both the product and process side of the equation. Innovation in the product side helps fight back the natural tendency to commoditize – the new machine is much better than the old machine – high end cars are all about what the new one could that the old one couldn’t. The same is true with Electrical Equipment, Construction Machinery, Helicopters, Pumps etc.
Process innovation, however, is probably more important for this group as it has allowed companies to significantly reduce manufacturing costs over time through more efficient use of materials, increased automation, just in time inventory management, and lower capital costs per unit.
These trends are impressive, but are adequately reflected in valuation for most sectors – in every sector there are specific stock outliers. The sectors where valuation today looks least reflective of the trend would be Conglomerates and Capital Goods.
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