FEATURE

American Made

U.S. companies are benefiting from technological innovations and growing demand for their products in the global marketplace.

ver the last three decades, American manufacturers steadily outsourced their production to China, Mexico, and other countries with lower labor costs. U.S. manufacturing employment peaked at 19.6 million workers in 1979. Now the figure stands at 11.9 million workers—a 40% decline. Yet these numbers mask a recent shift. The manufacturing sector has grown since 2009, according to the Bureau of Labor Statistics.

With gains in efficiency and automated systems, the number of American manufacturing jobs likely will never return to its historical highs. However, industry leaders say the continued weakness of the U.S. dollar, rapidly rising wages in China, high energy costs, and intellectual property concerns are fostering a rebound in U.S.-based production. To a remarkable degree, technological advances have enabled many U.S. companies in nearly every industry—from aerospace to medical devices—to produce goods more efficiently than in the past, thereby saving on labor costs. This pronounced development presents opportunities for investors in a number of manufacturing areas.

A CYCLICAL SECTOR

Manufacturing encompasses a wide range of goods, from beer to eyeglasses. But, for many investors, manufacturing is synonymous with large-scale industrial companies. Share prices of these companies tend to outpace the broad U.S. market immediately following a deep recession. Curt Organt, an analyst with T. Rowe Price, believes that shares of companies in many early cycle industries, such as machinery and construction equipment manufacturers, have bounced back to near-full valuation.

When the economy enters the later stages of the business cycle, sectors such as aerospace, defense, and construction services—which largely operate on U.S. soil—often perform better. "When jobs come back, construction typically comes back," Organt says. "The population shifts, and people need to move to new jobs, so that spurs some investment in housing."

 
"These trends indicate that the American economy is somewhere in the middle stages of its recovery," says Sudhir Nanda, portfolio manager for the T. Rowe Price Diversified Small-Cap Growth Fund. "We have been in a recovery for a year and a half," Nanda says. "Normally the speed of growth is much higher coming out of recession, but this period has been very slow. "American firms cut their expenses drastically during the prolonged recession and through the slow recovery period by delaying the replacement of outdated equipment, reducing their workforces, and cutting back on production. These trends have clearly reversed, says Organt, who expects this cycle to accelerate as consumer demand picks up.

"[The U.S.] has a good system for monetizing research. If you invent something new, you can make money from it. Patent protection is good, and some companies offer employees a lot of freedom to do unstructured research—[We] have a leg up on other countries..."

Sudhir Nanda, portfolio manager, T. Rowe Price Diversified Small-Cap Growth Fund

INTELLECTUAL CAPITAL IN THE U.S.

This country is the world's premier incubator for innovation in computer hardware and software, pharmaceuticals, and other advanced products. "We have very well-established labs and industrial research centers and a good system for monetizing research," Nanda explains. "If you invent something new, you can make money from it. Patent protection is good, and some companies offer employees a lot of freedom to do unstructured research. Because of these advantages, we'll have a leg up on other countries, and we'll keep innovating."

The U.S. is projected to spend $436 billion on research and development (R&D) in 2012, nearly as much as the combined spending of its next three global competitors—China, Germany, and Japan1. An abundance of available capital in the U.S. provides the liquidity necessary for investors to support American ideas. Asian manufacturers, long considered followers rather than innovators, are beginning to ramp up their investments in research, but efforts remain significantly behind those of their U.S. counterparts. "Capital flows to where there is opportunity," Nanda says. "And if you look at the numbers, the opportunity is much bigger here."

Tax policies also support innovation, and additional measures to bolster manufacturing are under discussion. The Obama administration's framework for business tax reform would reward American companies that manufacture on U.S. soil with a 25% tax rate, compared with a 35% rate for companies that make goods outside the U.S.2 In addition, the United States offers a high degree of legal protection to innovators. U.S. laws are designed to protect intellectual property rights, the legal system is transparent, and the regulations that govern commercial businesses are well established.

Investing in Domestic
Industrials

T. Rowe Price portfolio managers are investing in the resurgence in U.S. manufacturing. While some U.S. manufacturing firms—including companies in the energy and industrials sectors—have already experienced a surge in their businesses and share prices, other firms look promising.

Companies that supply large firms with parts and components often benefit as demand increases. "A company with a strong distribution network, a strong sales force, a good brand name, and a good product has a good chance of benefiting from any renaissance in industrial manufacturing in the United States," says Curt Organt, an analyst with T. Rowe Price. "And, as growth slows, industrial firms tend to reinvest cash reserves. Companies with a strong position in the U.S. and a history of making smart acquisitions are often rewarded."

THE "INSOURCING" TREND

An increasing number of U.S. companies say that "insourcing" products that were previously made in China and other emerging markets is becoming more economical. They note that Chinese wages, for example, are rising more than 15% a year and the country's currency continues to strengthen against the dollar, which makes their goods more expensive. The turnaround time for receiving orders has become a pressure point, too, as many U.S. retail companies want more flexibility and a faster delivery of their products. High fuel costs also cut into profits. Indeed, many American companies say that these factors favor locating manufacturing facilities near departments such as R&D and sales and marketing.

Organt says that the insourcing phenomenon should have a positive effect on economic growth and job creation. He cites an Economic Policy Institute estimate that for every 100 manufacturing jobs, 291 more workers are needed to support them.

THE AMERICAN EDGE

U.S. manufacturing firms are likely to benefit from a confluence of domestic advantages, including energy affordability, a weaker dollar, and an educated workforce. U.S. energy production is undergoing a seismic shift. New technologies that release natural gas trapped in shale rock, which experts once considered unreachable, have changed the domestic energy landscape. The U.S. and Canada now have a strong competitive advantage thanks to low costs for extracting reliable, available energy—as much as 100 years—worth, by some estimates.

In the past dozen years, shale gas has risen from 1% of U.S. gas production to 35%—and the level may reach 49% of production by 2035.3 Investments in new, more efficient ways to extract shale gas are leading to higher employment with good wages. Meanwhile, production of industrial materials, such as steel and shale gas equipment and components, will likely grow to meet rising demand.

America's weak dollar is another advantage for domestic manufacturers. The dollar has depreciated more than 50% against the euro since 2000, making U.S. wages far more competitive. In the early 2000s, hourly compensation at manufacturing firms in the U.S. and Germany was comparable, at about $25 per hour.

Today, Germany's average hourly manufacturing wage has jumped to $46 per hour, 33% higher than the $35 average U.S. rate. America's demographics work in its favor, too. China's working-age population is likely to decline in the next five to 10 years; Europe' appears to be peaking now. The U.S. is one of the few developed nations with a replacement-level birth rate—which indicates that the domestic working population should continue to grow.

THE ROLE OF EMERGING MARKETS

Emerging economies continue to grow faster than developed markets. Expanding economies need to import advanced machinery, chemicals, and equipment from developed countries like the U.S. in order to build new factories and improve their expanding infrastructure. In fact, emerging markets now import more than they export—they account for almost 60% of all U.S. exports, double their share in 1990. This year, emerging markets will represent nearly half of global retail sales.

As emerging countries have developed, their workers have demanded higher wages. Rapidly rising wages are making China and other labor markets less competitive with U.S. manufacturers. "Their rising labor costs are one of the key things that should benefit the U.S. manufacturing resurgence," Nanda says. Companies in China increasingly are addressing rising labor costs by boosting efficiency through robotics and other automation. Ironically, the skilled labor force that can produce those efficiency-boosting robots is often found in the U.S. So while the manufacturing jobs that once dominated the U.S. economy are unlikely to come back, other positions—requiring different skills—may partially replace them.

Nanda says he expects that innovation will continue to drive domestic manufacturing growth. The trends should provide opportunities for investors who understand the global dynamics of the sector, including its costs and sources of demand. "The history of innovation shows that it leads either to a better product or lower costs," Nanda says. "Innovation is in a nearly continuous state of flux."

The T. Rowe Price Small-Cap Stock Fund

Small-cap stocks tend to perform well early in the economic cycle and generally react quickly to changes in the market, explains T. Rowe Price Analyst Curt Organt.

Greg A. McCrickard, portfolio manager of the T. Rowe Price Small-Cap Stock Fund (OTCFX) expects to see a round of merger and acquisition activity this year, as cash-rich, large-cap companies buy growing firms to augment their slowing revenues. One reason is that small companies are the source of many of the economy's innovations. "Small companies often have a better idea of what their customers need and want than their larger peers do," McCrickard says. "So they generally compete a little smarter." The T. Rowe Price Small-Cap Stock Fund uses both growth- and value-focused strategies to invest in the stocks of small companies, which typically offer greater long-term return potential than larger, established companies. However, many small companies have less experienced management, unpredictable earnings growth, and limited product lines, which can cause their share prices to fluctuate more than those of larger firms.

Illustrations by Michael Austin
1 Battelle Memorial Institute, 2011.
2 U.S. Department of the Treasury, The President's Framework for Business, 2012.
3 International Strategy and Investment, 2012.

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