Over the last 15 years the electronics and electronic equipment space, home to some of the UK market’s highest-quality engineering and capital goods firms, is the best performing sector in the FTSE 350 with an 11.7% compound annual return.

The industrial engineering sector is not too far behind with its own annualised return of 9.7%. For comparison, the FTSE All-Share’s annualised return over the same period is just 3% (excluding dividends).

Many companies have transitioned from industrial engineering to the electronics and electronic equipment sector in recent times and this reflects a real-world shift into higher-tech niches as companies look to tap into themes like electrification and automation.

THESE ARE HIGH-QUALITY BUSINESSES

The UK engineering industry has come a long way in the last 30 years. In the 1990s they could be characterised as low-margin metal bashers producing commoditised products for mature economies. There has since been significant improvement with leaner, more technically skilled companies operating in a far more diverse mix of geographies.

This is reflected in valuations. Many engineering stocks are not cheap. What investors need to decide is whether the high ratings in the sector are justified and what a more pronounced downturn in the global economy might mean for earnings and sentiment.

For those prepared to take a long-term view there are plenty of excellent businesses which could continue to reward shareholders. Two attractive opportunities can be found among firms which have lagged the rest of the sector over the last decade but which are making changes which could allow them to play catch-up, namely Weir (WEIR) and Rotork (ROR).

The wider transformation in the engineering sector is demonstrated by strong operating margins – with many companies generating margins in the mid-teens and some even in the 20s. This is a key metric to watch in the results of companies from the sector.

The finance director of fluid and motion control engineer IMI (IMI), Dan Shook, explains that underpinning a push to increase its own margins from 17.8% to 20% is the company’s pricing
power, namely the ability to charge more without hurting demand.

He says: ‘Our products aren’t the biggest cost in the system, whether it’s a petrochemical facility, power plant or in precision transport, we aren’t the biggest part of the cost but there are great benefits in terms of run cost and safety. We only play where price is more inelastic.

‘Where you’re going to win is by bringing engineering expertise to those problems and challenges which customers face and solve them in a unique way which keeps business quite sticky and generates value.’

This description could be applied to several businesses in the sector and is a reason many have been able to sustain profitability despite inflationary pressures and an uncertain economic backdrop.

THE KEY PLAYERS

At the top of the tree for listed engineers are the makers of scientific instruments: Halma (HLMA), Oxford Instruments (OXIG) and Spectris (SXS).

Berenberg analyst Calum Battersby says: ‘We view the scientific instruments sector as one of the highest-quality segments of the UK industrials universe. Halma, Oxford Instruments and Spectris generate higher (gross and operating) margins, higher returns and, typically, higher growth compared to the wider UK market.

‘In turn, this comes from leading positions in a number of niche, non-commoditised equipment and instrument markets where the growth is typically tied to structural drivers, including improving healthcare, cleaner technology, superior materials performance and increased levels of environmental analysis.

‘Over the medium term, this has resulted in significant outperformance over the wider market, which we believe can continue. Over the shorter term, while valuations have come down, they broadly remain elevated versus history, in a period when there are a range of known macroeconomic pressures that the companies are due to face.’

Along with Halma, the best performing large-cap engineering stock on a 10-year view is Spirax-Sarco (SPX). The company makes products which help regulate the flow of fluids and steam. Spirax-Sarco has shone in this niche, allowing it to generate sector-leading margins. However, its first-half results on 8 August could present a test given a slowdown in demand from the pharmaceutical industry for the specialist pumps and fluid path solutions made by its Watson-Marlow division following the end of the pandemic.

Numis analyst Dominic Convey is still a believer in the longer-term potential of the business. He says: ‘Notwithstanding the near-term Watson-Marlow headwind, we believe Spirax-Sarco is exceptionally well-positioned as a key enabler of industrial decarbonisation, with critical proprietary technology for the electrification of industrial heating and expect this multi-decade conversion to sustain the group’s enviable record for long-term outperformance.’

A SKILLS GAP

A wider issue facing UK engineers is a growing skills gap. Though many of these businesses are international in focus, most still have some operational footprint in the UK.

According to the industry body Make’s recent industrial strategy report, manufacturers have not just been contending with a shortage of highly technical skills, but a shortage of workers able to fulfil jobs in vocational roles like toolmaking as older workers retired early or were reluctant to return to work post-pandemic.

‘Our metric for employment growth shows that since Q1 2020, manufacturers failed to meet their forecast recruitment figures in almost every quarter,’ it comments.

The report notes two thirds of companies which contributed to the report attribute this situation to candidates lacking the required technical skills. It says this is both a potential constraint on growth and a driver of increased costs for the industry.

IMI has a graduate scheme which enables the company to bring in staff with more digital capability to work alongside seasoned engineers. Chief executive Roy Twite was even part of IMI’s graduate programme himself in 1988.

The lack of skilled workers is potentially a larger problem for the smaller companies which do not have the resources for a big graduate scheme like the one IMI runs. Nonetheless, some small and mid-cap firms have done extremely well. Most notably AB Dynamics (ABDP:AIM) – up more than 20-fold on the 86p at which it listed in May 2013. The company has benefited from its own investments in the business, boosting its capacity, as well as from serving an automotive industry in a state of flux and facing a wave of new regulation.

OVERSEAS-LISTED ENGINEERING STOCKS

In a global context, all UK engineering firms remain relatively small. As in many other industries, the US is at the forefront.

Agriculture equipment specialist Deere & Co (DE:NYSE) and diversified industrial outfit Caterpillar (CAT:NYSE) are the big beasts but Eaton (ETN:NYSE) is perhaps the more interesting business. A global leader in industrial and electrical power management solutions the company is guiding for organic growth of 9% to 11% a year over the medium term.

Elsewhere, investment bank Morgan Stanley suggests European engineers might be unfairly neglected. It observes: ‘We often encounter the perception that US industrial companies are higher quality than their European counterparts. We think this is up for debate.’

Some of the big names in Europe include French and Swiss electrical systems and automation and control firms Schneider Electric (SU:EPA) and ABB (ABBN:SWX), and Sweden’s Sandvik (SAND:STO) which specialises in tooling systems for metal cutting, materials technology, mining and construction.

There are several tracker funds offering specific exposure to the engineering sector but investors can gain access to the wider industrials space via a few investment products. iShares MSCI Europe Industrials (ESIN) offers exposure to several names mentioned in this article, alongside some big names in the aerospace, defence and general industrials sectors for an ongoing charge of 0.18%. A similar product tracking US-listed industrials is SPDR S&P 500 Industrials (SXLI). This has an ongoing charge of 0.15%.

WHICH UK ENGINEERING SHARES SHOULD YOU BUY?

Over the last 10 years Weir and Rotork may not have delivered the sort of returns generated by some of their rivals but we think it could be a different story in the coming decade. The sale of Weir’s oil and gas business has left it purely focused on the mining space. The stock trades on a price to earnings ratio of 16 times but we think this is justified.

As Shore Capital analyst Akhil Patel observes: ‘Population growth, the convergence of living standards, urbanisation, ore grade decline (i.e., more materials need to be processed to extract the same amount of metals/minerals) and the demand for metals/battery metals to support the global clean energy transition/decarbonisation all point in Weir’s favour. Especially given the need for mining to become more efficient and reduce its carbon emissions.’

Weir is also a higher quality business following the disposal of the oil and gas arm, with higher margins and less volatility.

Rotork, which provides solutions for the actuation, flow control and industrial markets, continues to have exposure to the energy sector but it could have a key role to play in the energy transition as it helps in areas like reducing methane emissions from oil wells.

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