I N V E S T M E N T S T R A T E G Y G R O U P

C a p i t a l E x p e n d i t u r e s :Business spending is bound to increase economic activity.

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The 5-year growth rate of U.S. capital stock has dropped to the lowest level in the post-WWII era, and the average age of the capital stock is getting close to the previous two peaks—indicating that pent-up demand for capital spending exists (Figure 1). This lack of spending now seems to be showing up in U.S. productiv-ity data. Figure 2 shows that productivity’s most recent peak occurred around 1999–2000, a time of peak capital spending and new equipment. With the exception of the 2009–2010 timeframe (when only the most productive workers were employed), productivity has been drifting lower toward the current cycle lows.

IntroductionOne of the key drivers of a country’s gross domestic product (GDP) and productivity is the amount it spends on capital stock—the machinery, equipment, and buildings used to create goods and services. Since the Great Recession, Corporate America has been under-investing in its capital stock, which has led to significant pent-up demand across many economic sectors. This provides a source of future economic growth and investment opportunities, as capital expenditures (CAPEX) improve over the coming years. In this piece, we look at the industries and stocks that stand to benefit from improving CAPEX.

Aging Equipment and Weak Productivity

Figure 1: Historically Low Spending on Capital Stock

(Source: Janney ISG, © BCA Research 2014)

Peak spending corresponded to previous productivity peak.

Current spending historically low.

Figure 2: Waning Productivity Growth

(Source: Janney ISG, U.S. Bureau of Labor Statistics)

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Corporate America is Well-Positioned to Spend

While aging equipment, low spending levels, and waning productivity are indicators of the need for increased CAPEX, Corporate America is also well-positioned to execute CAPEX plans. CEO confidence has dramatically improved since the Great Recession, profitability is at all-time highs, and corporations are flush with cash. Corporate debt financing remains very reasonable, the cost of equity capital has declined, and fiscal (tax and regulation) uncertainty has improved. All of this makes it much easier for managers to give the green light to major corporate expenditures.

Healthy Banks are Increasing their Lending

The banks are in great shape to provide credit for businesses at favorable financing conditions, and are now doing so. The most recent (July) Federal Reserve quarterly survey of senior loan officers showed a broadly-based increase in the demand for bank credit, while lending standards continued to ease from the very tight conditions that have existed since the 2008 financial crisis. Commercial and Industrial (C&I) business loan demand is rising sharply—for large firms as well as small and medium enterprises—while loan officers are reporting stronger financing demand related to investment in plant and equipment.

Figure 5: Commerical and Industrial Bank Loans at All-Time High

(Source: Janney ISG, Bloomberg)

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Figure 4: Corporate Cash (% of Assets) at Record Levels

(Source: Janney ISG, Bloomberg)

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All of this makes it much easier for managers to give the green light to major corporate expenditures.

Figure 3: Corporate Profitability at Record High

(Source: Janney ISG, Bloomberg)

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Analysis of Historical Capital Spending Points to Opportunities

Table 1 shows U.S. capital spending by economic sector over the last decade, and includes the S&P 500 Index’s weighting of the sector—a measure of the sector’s size and importance to the overall stock market and economy. Capital expenditures have been led by Energy (35%), Utilities (21%), and Materials (11%).

Table 1: U.S. CAPEX Spending (2003–2013) and Average Age of Private Assets

Sector Capex Spending Weight in S&P 500

Equipment Current Age / Average Age since 1980

Energy 35% 10.4% 3.50 / 4.92

Utilities 21% 2.9% 12.30 / 12.55

Materials 11% 3.6% 7.90 / 9.07

Industrials 8% 10.3% 8.20 / 6.86

Consumer Discretionary 7% 12.0% -

Telecom 6% 2.4% -

Consumer Staples 5% 10.2% -

Financials 3% 15.7% -

Technology 2% 19.8% 5.50 / 4.26

Healthcare 2% 13.2% 4.50 / 3.85(Source: BCA Research and BEA)

The Energy sector is in the middle of the U.S. Shale Energy Renaissance, and this spending has been very productive. We see additional Energy opportunities, and further discuss this sector below. While the Utility sector is historically CAPEX-intensive, it is finally working through all of the capacity that was built early last decade, and we are mildly bullish on the sector’s pros-pects. The Materials sector added capacity just as China and other emerging markets were seeing their growth rates slow—a tough combination that leads us to be cautious on the sector.

The table also shows significant under-investment (relative to economic importance) for Technolo-gy (2%), Healthcare (2%), and Industrials (8%). We see significant investment opportunities for these sectors.

De-Levered Consumers are Gaining Confidence—and have Pent-up Demand

A healthy consumer is critical for increased con-sumption of goods and services produced by Corporate America. Consumers have de-levered, as the housing and financial market recoveries have restored consumer balance sheets to a much better state. Net worth is at an all-time high, and debt ser-vice levels are at historically low levels. The recent Fed lending survey also showed that consumer lending demand has picked up sharply across the board, including credit cards and auto loans.

Net worth is at an all-time high, and debt service levels are at historically low levels. This supports consumption and provides a solid investment backdrop.

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Technology Increased capital spending should benefit many sectors, but the Technology sector stands to benefit disproportionately. Tech investment has fallen close to a 15-year low as a share of over-all investment—underscoring that the average age of its capital stock is particularly high. The corporate sector’s need to address weak pro-ductivity growth (an indication that prolonged under-investment may have begun to take a toll on corporate efficiency) is a key catalyst for Technology spending.

Governments around the world are now in better fiscal shape. Government spending is a significant contributor to overall demand for Tech goods—comprising nearly 20% of total investment. While government outlays on Technology-related goods and services have been extremely weak over the past two years, improvements in federal, state, and local budgets are indicating better times ahead. Personal consumption trends are also a major influence on the Tech sector. Consumer spending growth on Technology products bottomed in 2011, and has crossed into positive territory for the first time in three years. Tech export indicators look healthy and, despite the positive cyclical and secu-lar backdrop, Tech valuations remain reasonable.

Industrials Considerable outlays on industrial equipment need to occur to replace aging infrastructure and support the U.S. Energy Renaissance. Significant under-investment has also occurred for electrical equipment, as well as power and communication. CAPEX on structures is just beginning to rebound from the real estate recession.

Healthcare Healthcare equipment providers should be major beneficiaries of the last decade’s lack of healthcare CAPEX spending and the current favorable health-care trends. We expect the pace of healthcare expenditure growth to exceed that of the overall economy—with an aging population, pent-up demand for healthcare services, lower unemploy-ment levels, and rising commercial insurance membership bolstering the sector.

The current trend of increased paid patient hos-pital visits is providing healthcare facilities with the confidence to continue with their expansion plans, to the benefit of the equipment providers. This is already helping to boost medical equip-ment new order growth.

Energy While U.S. energy investment has been very high over the last decade, we think the U.S. Energy Renaissance has much further to go. We also see global oil markets tightening, as global growth improves and rest-of-world production growth struggles due to geopolitical problems in major oil-producing countries (Iraq, Iran, Libya, and Russia). While the integrated oil companies and the exploration and production (E&P) companies benefit from these trends, the biggest winners of high CAPEX are the oil service companies and the Energy Master Limited Partnerships (MLPs).

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Table 2: Stocks Benefitting From CAPEXCompany NameAugust 13, 2014 Ticker Forward

P/EEarnings Growth

Dividend Yield

Credit Rating Notes Coverage

TechnologyTech investment has fallen to a 15-year low as a share of overall investment. Technology firms are enabling advanced infrastructure development and playing a key role in improving productivity. They are also developing the advanced wireless and wireline communications networks for businesses and consumers across the world.

APPLE INC AAPL 14.18 11.31 1.84 AA+ Providing leading edge wireless productivity solutions for consumers and business. S&P/CS/J

MICROSOFT CORP MSFT 15.69 8.16 2.56 AAA New product releases are just in time to help increase productivity. S&P/CS

ORACLE CORP ORCL 12.67 10.16 1.20 A+ Enterprise technology solutions are at center of corporate productivity enhancements. S&P/CS

QUALCOMM INC QCOM 13.76 13.57 1.97 NR Leading provider of wireless broadband technology. S&P/CS

EMC CORP/MA EMC 14.26 11.38 1.43 A Storage is always at the top of the IT budget list. S&P/CS/J

VANGUARD INFO TECH ETF VGT — — — Cap-weighted basket of 410 info tech stocks.

ISHARES NORTH AMERICAN TECH-SOFTWARE IGV — — — Cap-weighted basket of 59 U.S.-traded software companies.

ISHARES NORTH AMERICAN TECH-MULTIMEDIA NETWORKING IGN — — — Cap-weighted basket of 32 U.S.-traded

multimedia networking companies.

Industrials

Considerable outlays on industrial equipment need to occur to replace aging infrastructure and support the energy renaissance. Machinery firms manufacture construction and mining equipment, engines, and turbines for industrial and transportation use. Railroads are playing a key role in increasing infrastructure productivity.

GENERAL ELECTRIC CO GE 15.03 9.15 3.30 AA+ Leader in Power & Water, Oil & Gas, Aviation, Transportation, and Energy Management. S&P/CS

CATERPILLAR INC CAT 16.22 9.76 1.81 A Enables much of the heavy infrastructure lifting across the globe. S&P/CS

INGERSOLL-RAND PLC IR 17.14 12.50 1.52 BBB Company is participating in the residential and commercial construction recovery. S&P/CS

QUANTA SERVICES INC PWR 16.58 11.75 — NR Designs, installs, and maintains electric, gas and telecom infrastructure. S&P/CS

UNION PACIFIC CORP UNP 16.96 12.62 1.70 A Largest U.S. railroad. Rails are playing major role in many aspects of infrastructure. S&P/CS

Energy

The U.S. Energy Renaissance has a long way to go, and Energy Service & Equipment companies and MLPs are well-positioned.

HALLIBURTON CO HAL 14.27 12.00 0.83 A Leading Oil Service firm at the center of U.S. Energy Renaissance. S&P/CS

SCHLUMBERGER LTD SLB 17.30 13.00 1.69 AA- Bellwether of oil services group, and hence, premium valuation. S&P/CS

NATIONAL OILWELL VARCO INC NOV 12.98 10.51 1.51 A+ Major provider of energy infrastructure equipment and services. S&P/CS

ENTERPRISE PRODUCTS PARTNERS EPD 23.38 8.94 3.78 BBB+ Large, well capitalized MLP operating in virtually all shale basins. S&P/CS

ISHARES U.S. OIL EQUIPMENT & SERVICES IEZ — — — — Cap-weighted basket of 47 oil & gas equipment and services companies.

ETRACS ALERIAN INFRASTRUCTURE MLPI — — — — Provides broad exposure to energy infrastructure MLPs.

Health Care

Health Care Equipment companies are major beneficiaries of an aging population and future high levels of healthcare spending.

MEDTRONIC INC MDT 15.62 7.64 1.78 AA- Very diverse product line, strong cash flow, valuation and dividend support. S&P/CS

CERNER CORP CERN 31.47 17.33 — — Leading health information technology firm is helping to transform healthcare. S&P/CS

ISHARES U.S. MEDICAL DEVICES IHI — — — — Cap-weighted basket of 40 equipment manufacturers and distributors.

Definitions:Forward P/E - Current stock price divided by EPS consensus estimate for the next four quarters.Earnings Growth Estimate - Mean broker estimate of the compounded annual growth rate of the operating eps over the company’s next full business cycle (typically 3-5 years).Dividend Yield - Trailing 12-month dividend per share divided by share price.Credit Rating - Rating assigned by Standard & Poor’s to the long-term obligations of the issuer if repaid in the local currency of the issuer.

(Source: Janney ISG, Bloomberg)

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