For decades, companies have stretched their supply chains around the world in a quest to lower costs. Now, trade wars, technology battles, populist politics and the COVID-19 crisis are forcing companies to rethink how they source supplies and where they assemble products. Changes to global supply chains could have a far-reaching impact on corporate profitability and shareholder value. We asked five AB equity investment professionals to talk about how they’re thinking about supply chains when researching companies and investment candidates.
1. How will the experience of COVID-19 affect the repatriation of supply chains?
Samantha Lau, Co-Chief Investment Officer of Small and SMID Cap Growth Equities: If all we were dealing with was COVID-19, companies might have simply needed more buffer inventory for future disruptions. But the confluence of COVID-19 and the US-China trade war together has led to a perfect storm that will necessitate a broader redesign of company supply chains. In technology, for example, a geographically distributed supply chain that has undergone globalization for over 20 years has certainly made it more complicated.
Dan Roarty, Chief Investment Officer—Thematic and Sustainable Equities: According to research from Bank of America, 80% of global industries faced supply chain disruptions as a result of the pandemic, causing many to consider or accelerate existing plans to localize some portion of their manufacturing footprint. Supply chain resilience has quickly become a popular topic on corporate earnings calls. Many US-based companies are employing technology, including artificial intelligence and the internet of things, as well as increased automation to improve efficiency, lower costs, and reduce the harmful environmental impacts of their operations. Given the complexity of relocating supply lines, rapid shifts are unlikely.
Tawhid Ali, Chief Investment Officer—European Value Equities: I think trade war concerns are still the much bigger issue. Many companies were already gradually moving out of China before the crisis, due to increasing labor costs and more stringent environmental regulations in China. This trend has accelerated since the beginning of the trade war, especially in technology. Pharmaceutical companies are “talking” about some repatriation.
In terms of COVID-19, after the initial stress to the system, it’s been remarkable just how well the global supply chain held up. For example, Hubei province in China, which was the epicenter of the pandemic, was a major supply source, yet the province hasn’t lost share to other regions that were not locked down. We did see many companies build additional safety stock, and that’s a change that might be longer lasting.
2. With increasing pressure on US companies to reduce their supply chains in China—amid rising labor costs, political tension, and concerns around environmental, social and governance (ESG) issues—how are companies responding and reconfiguring their global networks?
Frank Caruso, Chief Investment Officer of US Growth Equities: Where there has been activity by US companies, it’s been out of China and into places like Vietnam, the Philippines, Malaysia or Thailand, rather than back to the US. This is particularly true in cases where their customer base remains in Asia. For example, Lam Research recently announced construction of a new technology center in South Korea and a new manufacturing facility in Malaysia. Why these two locations? Korea reflects the increasing importance of being close to Samsung, which has been a beneficiary of US-China political tensions in communications and foundry. The move to Malaysia addresses supply chain redundancy and helps to lower manufacturing costs.
John Lin, Portfolio Manager of China Equities: Chinese companies were already starting to move their own products offshore well before the current trade war with the US, to reduce labor costs. When we visited an Adidas supplier in the coastal city of Ningbo five years ago, the company told us that the shift of production to Vietnam was already well under way. Last year, when our analysts visited the Vietnamese factories for Chinese garment and electronic manufacturers, they found that Vietnam labor costs were about 40% lower than their equivalents in China. During these visits, we also discovered that companies have learned important lessons about modern slavery. We’ve engaged with managers in Vietnam who seem very attuned to global scrutiny of working conditions and understand that employers must be sensitive to cultural sensitivities for outsourced operations to succeed. Investors should pay close attention to these ESG issues as supply chains are reconfigured.
The trade war accelerated the offshoring trend for many Chinese companies. Many textile companies sped up timetables for setting up factories in Vietnam, Cambodia and Indonesia. Interestingly, many US retail brands continue to partner with long-established suppliers, even though the factory locations have now changed, partially to sidestep US tariffs. So for investors to access these cash-flow streams, they’re largely buying the same set of Chinese and Taiwanese companies.
Samantha Lau: In the smaller-cap universe where we invest, the semiconductor industry has had an agile supply chain for some time. Even before COVID-19, many suppliers for the post-fabrication process—cutting, bonding and packaging—were already based in Vietnam, Thailand and Mexico. This trend has continued because all component manufacturers are trying to make sure that manufacturing isn’t dominated by one country, so that the origin of the product can be more ambiguous to avoid scrutiny. For example, Monolithic Power Systems uses some fabs in the US, but enough steps are done in these other countries so the components can be labeled “Made in Vietnam.” Southeast Asia and Mexico will continue to be beneficiaries of this trend.
3. What financial stresses has the economic crisis revealed regarding supply chain risks for companies, and how can investors assess the risks?
Frank Caruso: In some cases, supply chains were revealed to be vulnerable. For example, Arista Networks, a network equipment manufacturer, saw both extended lead times (by two to four weeks) as well as constrained product shipments as a result of COVID-19. In response, the company said it would increase its inventory levels through the end of the year in order to improve lead times and help buffer against future pandemic-related supply chain disruptions.
Companies better positioned were able to mitigate supply chains risks with greater ease. ASML, the semiconductor equipment maker, has been able to pass through higher costs of doing business in this environment to its customers, reflecting pricing power and an oligopolistic industry structure. Texas Instruments has benefited from its large scale, the long shelf life of its products, internal manufacturing and a pristine balance sheet. In mid-2020, the company was able to maintain high utilization in its factories, building “buffer” inventory while its peers cut capacity. As a result, Texas Instruments was able to service better-than-expected orders and picked up market share.
Product flow is definitely a risk. Companies that have relied on steady goods flow (ships, trucks, warehouses) have stumbled. Ironically, fast-turning companies were hit harder in the very short term versus slow-turning companies. There are acute working capital effects resulting from payables and inventories. So during the first couple months of the crisis, they hemorrhaged cash, and as soon as they cut orders, the cash flow partially reversed.
Tawhid Ali: During the early days of the pandemic, investors became particularly sensitive to leverage, worrying about the vulnerability of companies to a revenue slowdown. In order to really assess this risk, we used data science to look at not just our holdings’ leverage, but also leverage along the supply chain that could disrupt operations. It provided a quick way to highlight potential risks that might not be obvious.
4. What types of companies and countries are likely to benefit from the changing global supply chain landscape?
Dan Roarty: We see tremendous opportunity for companies that facilitate the localization, diversification and automation of supply chains. For example, providers of factory automation systems and equipment help manufacturers improve productivity, asset utilization, product quality, resource efficiency, waste production and even employee safety. These are many of the most important issues companies will need to consider as they reconfigure supply chains and face potentially increased costs.
Software providers that facilitate the digitization of manufacturing should also benefit. Core products such as digital engineering design, simulation and product life-cycle management software help customers track and reduce the use of unnecessary materials and improve overall resource efficiency. In the intermediate term, China is likely to lose some share of global outsourced manufacturing as many developed market–based companies reshore or relocate to other Asian or Latin American countries with fewer perceived political and trade issues.
John Lin: COVID-19 made clear to many countries the importance of controlling manufacturing capability of vital industries. From China to Taiwan to the US, governments helped companies set up production lines for surgical masks and PPE. Once the pandemic emergency is over, the push for onshoring or near-shoring of these vital supplies—from masks to vaccines to data centers—is likely to continue. China has long been the “world’s factory” and the location for much of the manufacturing capacity for some of these vital goods. Chinese manufacturers, therefore, are likely to lose market share in many categories of these manufactured goods, as countries around the world ignore the higher costs and set up their own production lines.
For China, COVID-19 both heightened geopolitical tensions with the US and highlighted vulnerability of parts of its supply chain—particularly in energy and food companies. China is pressing ahead with initiatives to reduce its dependence on imports in both areas, which could create opportunities for investors in these sectors.
5. As companies reconfigure supply chains and manufacturing costs rise accordingly, how should investors evaluate the potential impact on earnings and profitability?
Frank Caruso: I think this depends on the pricing power of the company. For companies that can pass on incremental costs to customers, gross profits would be less affected. In the case of Arista Networks—and looking back at tariffs put in place in 2018—the company was able to at least partially push those increased costs to their customers. As a result, their revenues increased, but gross profits stayed mostly neutral.
One way to evaluate the potential impact on profitability would be to investigate how much of a company’s sourcing was already coming from best-cost regions. A shift away from these areas would present a potential relative disadvantage versus peers.
Tawhid Ali: Increased inventories are likely to be a feature going forward. During the last few decades, we’ve seen demand for more efficient supply chains and more efficient working capital for companies. We are seeing companies with higher gross margin products talk about pivoting a bit more from “just in time” to “just in case.” All else being equal, costs are likely to go up. However, it’s not clear whether margins will come down. Certainly, companies with pricing power will be able to push this through to consumers.
John Lin: For Chinese technology companies, the tech war, with the expressed purpose of disrupting the Chinese technology supply chain, must be watched closely. In the short term, US sanctions against Chinese tech firms such as Huawei are seriously disrupting industries from semiconductors to telecommunication equipment manufacturing. In response, the Chinese government drastically increased state support for Chinese tech firms to increase self-sufficiency of its technology supply chain. Over the long term, the global tech supply chain will probably splinter into two camps—one centered in the US, the other in China. This may reduce capital efficiency; for example, hypothetically, if there are two standards for 6G mobile communications a decade from now, tech firms will likely see a lower ROIC for their R&D investments.
Dan Roarty: While localizing supply chains is likely to result in increased costs for many companies, the ultimate impacts are more than just financial. Globalization allowed companies to reduce their labor costs, but that benefit was often accompanied by environmental degradation and poor working conditions. Investors should broaden the lens through which they evaluate changes to supply chains and consider the longer-term implications for all their stakeholders—not just the shorter-term implications for their shareholders. For many companies, higher short-term costs of relocating manufacturing facilities can reduce brand risk, lower regulatory risk, and improve employee productivity and morale. As these trends unfold, investors have a very important role to play by monitoring how and why companies are relocating their supply chains and engaging with them on ESG issues where necessary.
Samantha Lau: Regardless of COVID-19, the automation and utilization of robotics was already rising due to increased labor costs. This is happening not just in technology but in fast-food industry, transportation, etc. If US companies begin to onshore more manufacturing steps back to the US, this will be the most important trend to monitor. Innovation and automation will be a key characteristic for investment ideas in the next cycle. Companies that invest in solutions, both software and hardware, that can drive efficiency and lower their cost structure will differentiate themselves and deliver better margins than the competition. We want to focus on forward-thinking companies that are committed to making investments to automate and reconfigure their supply chains in order to cope with whatever unique challenges they may face. Staying still is unlikely a winning strategy.
- Samantha S. Lau, CFA
- Co-Chief Investment Officer—Small and SMID Cap Growth Equities
- Daniel Roarty
- Chief Investment Officer—Sustainable Thematic Equities
- Frank Caruso
- Chief Investment Officer—US Growth Equities