Reimagining Supply Chains: The Investing Challenge

From carmakers to smartphone manufacturers, companies around the world are reorganizing their supply chains amid a wave of disruptions. Equity investors will need to sharpen their analytical tools and engagement skills to determine which businesses are proactively adapting to a new reality.

It may be the biggest business revolution in a generation. After decades of globalization, when companies scoured the planet for the cheapest locations to source components and produce goods, the race is on to redesign supply chains. Company initiatives to rethink the logic of offshoring operations have been accelerated in recent years by the US-China trade war, pandemic-driven shutdowns and more recently by Russia’s invasion of Ukraine.

Cost is no longer the main consideration. Executives must also weigh disruption risk potential in everything from workforces to shipping, and conduct a complex cost-benefit analysis of every stage of a production process. Mounting inflation of wages and input costs makes the exercise even harder.

The New Calculus

The new reshoring calculus throws up a whole new set of questions for investors. How do you identify the weak points of a chain that may include dozens, hundreds or even thousands of suppliers? Should investors demand a greater “offshore discount” to compensate for escalating supply chain risks? What can investors do to understand whether a company is moving in the right direction, given that reporting on supply chains is often short on detail? Questions like these are a starting point for understanding how current disruptions could affect near-term earnings forecasts and how companies are addressing the broader challenge of reimagining a supply chain for long-term resilience.

We believe three key aptitudes are required for an investing team to rise to the supply chain challenge. First, deep fundamental research is essential to understand whether a company can redesign its supply chain to withstand shifting macro- and microeconomic dynamics. Second, data science will play an increasing role in understanding the vulnerabilities of existing supply chains. And third, engagement with management is vital for gleaning insights that can’t be found in standard reports.

For many years, the economic rationale for offshoring was clear. Offshoring generally made sense if a company could produce a good for at least 20% less than in its home country. Today, it’s not just about cost. Companies must strategically calculate the risks of sourcing or manufacturing in a certain location and whether it’s worth paying more to ensure greater security of supply. In addition to the costs of labor and logistics, US companies of all sizes are today considering multiple factors when weighing a decision to bring operations back home, according to a recent survey by consulting firm Kearney. These include the quality of goods, delivery lead times, labor availability and their carbon footprint.

Know Your Company: Fundamental Depth Is Indispensable

As companies and investors reassess the trade-offs, there are no easy answers. Restructuring a supply chain is a process that could take several years, yet cannot be ignored today. We believe long-only investors, whose research processes look several years into the future and aren’t derailed by market volatility, are better equipped to evaluate these changes than those with shorter time frames.

Investors must know a company’s business model, financials and industry dynamics in depth to assess supply chain vulnerabilities and opportunities. How a company invests for the future can indicate whether it’s shifting production toward new regions to avert future disruption. In some industries, we’re seeing huge capital expenditures in manufacturing facilities to improve regional alignment with customers and revenue.

The semiconductor industry is among the leaders. Intel recently announced €29 billion of investments in new semiconductor manufacturing facilities in Germany and Ireland. It’s also spending $40 billion on new plants in Ohio and Arizona. Taiwan Semiconductor Manufacturing is investing $19 billion in Japan and Arizona, with further investments expected in Germany. Some semiconductor buyers aren’t willing to wait any longer and are taking matters into their own hands.

Some companies plan to use cash flow to increase working capital and/or to build more inventory on balance sheets. This could create short-term headwinds to cash flow for manufacturers, as some companies may need to take on more debt to fund the increase in working capital. On the other hand, we believe companies that facilitate the distribution of components and are integrated in supply chains will become more valuable. This trend is already visible. Some distributors across different industries have exceeded expectations in recent earnings reports, suggesting they are beginning to benefit from supply chain changes.

The war in Ukraine has created some acute supply problems. For example, a Russian company is a dominant global supplier of titanium, used for airplane structures and engines. Boeing and Airbus are scrambling for new sources of finished titanium, which could benefit Western suppliers. Investors in aerospace companies should closely monitor these efforts to diversify supply, which are indicative of broader changes in the industry’s supply chain. Sourcing new supply quickly and at a reasonable cost could be a decisive factor in their ability to meet delivery deadlines and earnings expectations.

In the auto industry, many carmakers have faced production bottlenecks because of shortages. Ukraine is a major supplier of wiring harnesses for vehicles, and the conflict led to disruptions that forced some automakers to find alternative manufacturers in Eastern Europe and North Africa. Short-term solutions like these could point the way to longer-term shifts in supply chains.

While recent shortages have pushed the supply chain issue to the top of company agendas, long-term macroeconomic realities are at the heart of the offshoring dilemma. For years, low manufacturing wages in China were a magnet for companies around the world. But now, wages in China are rising (Display), while increasing automation is reducing the higher cost of domestic labor needed to manufacture closer to home. Shipping costs have skyrocketed; one US furniture maker recently told us that freight issues from eastern Europe and China have been its biggest supply chain surprise this year. And for US companies, domestic energy costs are much cheaper than abroad, while tariffs stemming from US-China trade disputes have added another layer of costs.

However, these trends don’t automatically mean that US companies will be bringing manufacturing back home. While there has been a decline in the proportion of imported goods to the US originating in China, from 24.3% in 2018 to 20.1% in 2021, much of that manufacturing capacity appears to be shifting toward other Asian countries, according to the Kearney report. The same report shows an increase of nearly five percentage points in imports originating from elsewhere in Asia over the same period.

Big Data Can Generate Big Insights

The gradual diversification of operations away from China doesn’t necessarily eliminate risks. Yet it can be hard for investors to know when disruptions are developing within a diversified supply chain in real time.

Using big data tools, investors can generate independent quantitative insights that help complete the picture. Drilling down into alternative data sources allows us to fly around the world to examine the bottlenecks and linchpins in the system.

For example, we’ve developed a tool called a supply chain waterfall, which helps monitor bottlenecks from Asia in real time. This allows us to look at COVID-19 death rates as a proxy for policy shutdowns, workplace and transit activity in key markets, shipping activity and port congestion. This supply chain waterfall can indicate when each of these pieces is heating up or cooling down.

In China, we can also monitor activity like traffic congestion or subway passenger levels to understand if key production cities are at risk of shutdowns (Display). The recent increase in subway traffic in Shanghai indicates that the city may be coming out of full lockdown mode, which was imposed earlier in the year in response to a COVID-19 outbreak.

Alternative data can also help us understand the longer-term implications of reshoring. By web scraping company announcements of major reshoring projects, we can track in aggregate and by industry where reshoring is gaining momentum. Data tools can be used to track job postings at manufacturing firms, which provide another indicator of reshoring projects. This analysis helped support a hypothesis that reshoring was increasingly focused on less labor-intensive jobs.

Big data can provide analysts with substantial advantages. Armed with this information, fundamental analysts can pinpoint supply chain vulnerabilities and project how disruptions may affect business performance. Data-driven information and insight can also help frame research questions and underpin an informed dialogue with management about the need to consider longer-term changes.

Mindset Matters: Engaging with Management

The mindset of a management team is equally important in evaluating supply chain strategies. Nearly half the manufacturing executives surveyed by Kearney said they had already brought some manufacturing activities back to the US, while 29% plan to do so in the next three years. For investors to fully understand corporate reshoring strategies, an open dialogue with management teams that are making decisions is essential.

Reconfiguring supply chains is a strategic challenge that requires initiative, innovation and the ability to balance increased short- and medium-term costs with long-term benefits. The first thing investors must ascertain is whether management is taking the issues seriously or not. Are they having daily, weekly or monthly meetings to tackle the supply chain conundrum?

For most companies, rebuilding supply chains is a totally new endeavor. It requires the right people—and the right systems—to identify pain points and to launch transition plans. Discussions with management can help investors find out whether a company is prioritizing supply-chain issues and dedicating the appropriate resources to the problem.

It can also provide important insight on real-time industry dynamics. For example, semiconductors have been in short supply for automakers. This has wreaked havoc with production because vehicles rely on more electronic content than ever before. Yet by mid-2022, macroeconomic trends were beginning to resolve these problems, as demand for smartphones and other consumer goods waned. In discussions with semiconductor management teams, we’ve heard initial suggestions that chipmakers may be starting to repurpose some of their production capacity from more profitable consumer applications toward industrial applications, including autos. Engagements such as these provide important clues for investors to follow. In this case, if a shift in supply does pan out, it could be good news for car manufacturers and other industrial buyers of semiconductors, as chip prices might fall from very high levels. At the same time, it also signals an inventory correction that may reduce earnings for semiconductor manufacturers.

Meanwhile, one semiconductor buyer told us after experiencing ongoing problems sourcing products from a major manufacturer, it decided to diversify the suppliers for chips used in its end products.

Discussions with management can also help investors understand the rationale for diversification efforts. Reshoring back to developed-market sites isn’t always the right move. Vietnam has become an especially popular destination for technology and textile companies seeking to shift production away from China. This trend began well before the COVID-19 pandemic led to shutdowns in China, and even before the US-China trade wars.

In addition to lower labor costs than China, Vietnam’s government offered tax benefits which became a magnet for multinationals such as Nike and Adidas. Our research teams located in Asia have visited facilities in Vietnam to learn more about the business and cultural issues, as well as to gauge the environmental, social and governance issues that are needed to foster successful reshoring operations to the country.

Beyond location, strategic efforts to rethink supply chains in the 21st century require innovation. New automation technologies can be an effective antidote to spiraling wage costs. And innovation can offer solutions to manufacturing challenges in surprising ways.

For example, the science of synthetic biology can offer cost-effective ways of creating raw materials for products such as plastics, fertilizers, pharmaceutical ingredients, food and clothing, which were previously cheaper to source halfway around the world. Yet it’s not always easy to know how companies are embracing solutions like these, which aren’t necessarily featured in public earnings reports. Engaged investors can ask the right questions to discover whether a company is making smart investments in technology or securing patents that can help deliver creative solutions for supply chain fragilities.

It will take years for supply chains to be reconfigured for a less globalized world. As the process plays out, investors will need to compare and contrast companies within and across industries to determine how different types of structures should affect business performance, risk premiums and return potential for stocks. This will be a constant learning process. Creating a robust analytical framework now can help investors stay ahead of the curve and develop conviction in companies that are taking the right steps to ensure that their business advantages can prevail over time.