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Baron Funds Commentary: Finding Secular Growth Stocks in Industrials

The U.S. economy has come a long way since 1936, when Charlie Chaplin's classic comedy Modern Times depicted industrialization as synonymous with modernity. Today's economic drivers are more readily evoked by films like The Social Network, the 2010 movie about the genesis in a Harvard dorm of the global social network juggernaut Facebook. Most casual observers probably do not regard the United States as a major manufacturing powerhouse anymore.

Yet this perception is, simply put, wrong. It is true that manufacturing as a percentage of overall GDP has steadily declined over the decades, from more than 25% in the 1950s to about 11% today. However, this decrease is more of a reflection of the rise of other sectors - especially technology and internet-related - rather than a drop in manufacturing on an absolute basis. As the graph below demonstrates, even while it may seem like the U.S. has been shifting to an intellectual property-based services-focused post-industrial economy, in nominal terms, manufacturing's contribution to U.S. GDP has actually increased over the past 70 years. The U.S. is still the second largest producer of industrial output in the world, ranked behind only China.

The GICS Industrials sector encompasses a wide range of manufacturers and the companies that work with them. It is broken down into three main categories: capital goods, commercial and professional services, and transportation. The sector is massive and varied, spanning aerospace & defense, building products, electrical equipment, machinery, distributors, airlines, rail and trucking, and service providers to these and other industries.

As stock pickers, we consider the breadth and diversity of the Industrials sector an advantage in finding promising investment

opportunities that others may overlook. For example, conventional wisdom would have it that Industrials is a cyclical sector whose performance is highly sensitive to macroeconomic conditions. In addition, perhaps in keeping with the widespread (but, as noted above, mistaken) notion that manufacturing is declining in the U.S., investors also tend to view Industrials as a mature sector with limited opportunities for growth.

While other investors may accept both these generalizations on their face, we have successfully discovered and invested in numerous Industrials companies that benefit from secular trends driven by fundamental changes that create a wave of new demand and provide consistent growth in the face of market volatility. We look for businesses with sustainable competitive advantages that will help them weather all stages of the economic cycle. We also favor companies with differentiated technologies and/or products or services with high barriers to entry that are leaders in their respective markets.

Continuous Compounders

Within the Industrials sector, one of our key themes centers on what we call continuous compounders - companies that consistently generate incremental wealth for shareholders through a combination of profitable operations and effective capital deployment. While their end markets vary widely, they share a number of features in common.

The continuous compounders we favor generate substantial free cash flow driven by capital expenditure-light business models. They operate a diverse portfolio of niche businesses serving high growth specialized markets. They focus on high quality products with minimal commoditization, which offers the potential for pricing power and growth that is faster than their respective end markets. The products are key to customer operations while representing a low percentage of overall costs, which reduces the potential for switching. Finally, these companies are managed by experienced leadership who emphasize continual improvement in cost structure and the use of free cash flow to acquire and integrate companies to generate additional growth.

Among our investments in continuous compounders, IDEX Corporation (NYSE:IEX) is best known for its expertise in highly engineered fluidics systems and components, as well as in fire and safety products such as the Jaws of Life rescue and recovery tool.

Roper Technologies, Inc. (NYSE:ROP) produces engineered products and solutions that include information networks, medical products and software, and SaaS-based trading solutions. A third holding, Nordson Corp. (NDSN), is a leading producer of precision dispensing equipment for applying adhesives, sealants, and coatings; and technology-based systems for curing and surface treating processes. While its end markets range from food products and diapers to smartphones and semiconductors, precise dispensing technology is the common element marking Nordson's business units. Internationally, we own Bidvest Group Ltd. (BVT SJ), a South African holding company with investments in defensive, asset-light businesses across distribution, logistics, financial services, and other industries.

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This article first appeared on GuruFocus.