Are Capital Equipment Stocks Like Deere Worth Buying Despite Rising Interest Rates?

Our theme of Capex Cycle Stocks – which includes heavy equipment makers, electrical systems suppliers, automation solutions providers, and semiconductor fabrication equipment players – has gained about 6% year-to-date, underperforming the broader S&P 500, which remains up by 10% over the same period. Within our theme, Lam Research
LRCX
has been the strongest performer with its stock up by about 42% year-to-date. The company provides wafer-fabrication tools and related services to the semiconductor industry. On the other side, Deere & Company has been the weakest performer with its stock down by about 15% thus far in 2023.

Now, DE stock has shown strong gains of 35% from levels of $270 in early January 2021 to around $365 now, vs. an increase of about 10% for the S&P 500 over this roughly 3-year period. However, the increase in DE stock has been far from consistent. Returns for the stock were 27% in 2021, 25% in 2022, and -15% in 2023. In comparison, returns for the S&P 500 have been 27% in 2021, -19% in 2022, and 9% in 2023 – indicating that DE underperformed the S&P in 2023. In fact, consistently beating the S&P 500 – in good times and bad – has been difficult over recent years for individual stocks; for heavyweights in the Industrials sector including UNP, UPS, and HON, and even for the megacap stars GOOG, TSLA, and MSFT. In contrast, the Trefis High Quality Portfolio, with a collection of 30 stocks, has outperformed the S&P 500 each year over the same period. Why is that? As a group, HQ Portfolio stocks provided better returns with less risk versus the benchmark index; less of a roller-coaster ride as evident in HQ Portfolio performance metrics. Given the current uncertain macroeconomic environment with high oil prices and elevated interest rates, could DE face a similar situation as it did in 2023 and underperform the S&P over the next 12 months – or will it see a strong jump?

The underlying trends for the capital spending theme have appeared pretty mixed. Capital spending by U.S.-based companies has been strong, leading to a focus by companies on boosting capacity to ease bottlenecks seen following Covid-19. Moreover, geopolitical tensions and the trade war with China have created an emphasis on re-shoring or bringing back more manufacturing capacity into the U.S. For perspective, Bank of America
BAC
estimates that nonresidential fixed investment – viewed as a proxy for capital expenditures – for S&P 500 companies expanded by a 7.7% seasonally-adjusted annual rate in Q2, with spending ramping up over the ninth straight month. However, things could soften a bit going forward. Interest rates have surged in the U.S., making it more expensive for companies to fund projects. This could cause corporate companies to rethink capital budgets and potentially use cashflows to repay debt rather than fund expansion. The target Federal funds rate stands at between 5.25% to 5.50% presently, at over 15-year highs.

That being said, there is still good reason to invest in the capex theme. The U.S. government has been incentivizing companies to move production capacity back to the U.S., particularly in strategic areas such as semiconductor fabrication. Separately, automation and productivity improvements have also been key themes for manufacturers, given the surge in labor costs following the pandemic and the worker shortage. This could help to drive demand for stocks focused on capital goods in the long term.

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