The Price of Growth

 

“To act wisely when the time for action comes, to wait patiently when it is time for repose, put man in accord with the tides. Ignorance of this law results in periods of unreasoning enthusiasm on the one hand, and depression on the other.”  – Helena Blavatsky, Russian esoteric philosopher, and author who co-founded the Theosophical Society in 1875

 

“Intelligence is the ability to adapt to change.” – Stephen Hawking

 

“As soon as you stop wanting something, you get it.” – Andy Warhol

 

One of the universally accepted ideas in sport is that of home court advantage. The idea, after all, is not a difficult one to accept: Home teams have the crowd behind them, cheering them on, filling them with confidence; visiting teams, on the other hand, have to deal with the home crowd’s hostility, which saps energy. And the stats seemingly reinforce the idea. For example, over the course of the NBA’s history, home teams have won roughly 60 per cent of the games played in almost any given season.

The crowd is powerful.

When it comes to capital markets, the crowd has unquestionably been cheering on growth and mocking value. Leaving many a value investor confounded by the apparently unstoppable rise in the likes of Netflix, Amazon, and NVIDIA. While valuations may be stretched and fundamentals in some cases appear questionable, if we take a step back and consider the secular trend, the continued outperformance of technology becomes less puzzling.

Plotting total business sales of US corporates against the ratio of Nasdaq 100 Index to the S&P 500 Index, we find a strong correlation – 74.1% using monthly data – between the two data series. That is the outperformance of the technology focused Nasdaq 100 Index relative to the broader S&P 500 Index is positively correlated with US business sales.

Total US Business Sales versus Nasdaq 100 Index to S&P 500 Index Ratio Business SalesSources: Federal Reserve Bank of St. Louis, Bloomberg

Given the latency between data releases, this relationship does not provide a trading signal. The relationship, however, does appear to suggest that US business sales growth has largely been dependent upon the growth in sales at technology companies and the market accordingly has rewarded technology stocks.

Our goal here is not to espouse the merits of investing in technology or in growth. Instead, we want to focus on what we consider to be the most interesting part of the above chart – the period from 2003 through 2006. During this period US business sales grew strongly yet the ratio between the two indices flat lined i.e. the S&P 500’s price performance roughly matched that of the NASDAQ 100.[i]

Digging a little deeper, we plot the ratio of per share sales of the S&P 500 to per share sales of the NASDAQ 100 against the relative price performance of the NASDAQ 100 Index to the S&P 500 Index. Zooming in on the period between 2003 and 2007 we find that the comparable price performance of the two indices during this period coincided with the quarterly fluctuations in per share sales also being comparable. Similarly, during the years of significant relative outperformance by the NASDAQ 100 Index, we find that per shares sales of the index were increasing relative to the per share sales of the S&P 500 Index.

Nasdaq 100 Index T12M Sales to S&P 500 Index T12M Ratio (Quarterly Data)Per Share RevenueSource: Bloomberg

Next, we consider the relative performance of S&P 500 Growth Index to that of the S&P 500 Value Index. Comparing the performance of these two indices we find that while the Nasdaq 100 Index and S&P 500 Index achieved comparable performance during the period from 2003 through 2006, the value index significantly outperformed the growth index during this period. The value index peaked relative to the growth index in 2007.

 

Ratio of S&P 500 Growth Index to S&P 500 Value Index (Monthly Data)growth to valueSource: Bloomberg

At the time of the dotcom bubble the ratio of the growth index to the value index, on a monthly basis, peaked at 1.56. Today the ratio stands at 1.47.

The crowd may well be at the cusp of switching loyalties.

We look for clues in and around the period between 2003 and 2007 to help us determine whether the time for value is coming or not.

The cyclical low in the effective US Federal Funds Rate registered a cyclical low in 2003.

US Federal Funds Effective RateFed funds rateSource: Bloomberg

The Commodity Research Bureau All Commodities Spot Index registered a cyclical low in 2001 and MSCI Emerging Markets Index started its multi-year ascent in 2003.

CRB Spot All Commodities IndexCRBSource: Bloomberg

MSCI Emerging Markets IndexMSCISource: Bloomberg

The US dollar had its cyclical peak in 2002, the same year in which the Bush Administration imposed tariffs on imported steel.

In 2004, Congress approved a one-time tax holiday for US corporations repatriating overseas profits.

In 2005, George Bush signed a USD 286 billion transportation bill.

If we compare the events and market action that preceded and coincided with the relative outperformance of value during the years from 2003 to 2007 to that of today, we find many similarities across both policy-making and market action. With growth’s outperformance relative to value reaching levels last seen during the very same period, the signs are difficult to ignore. It may not be time to bail on growth as yet, but it certainly is not the time to have a 100 per cent allocation to it either.

 

Investment Perspective

 

Human nature is such that we desire that which is rare and take for granted that which is common. In the recent past growth has been elusive – and that which has been available has been heavily concentrated in the US and in technology. It is no wonder then that investors have rushed into US technology names without abandon.

Growth is no longer as elusive. We can find growth in Asia, Europe and other parts of the emerging world and across both old industries and new. With its abundance the price of growth should de-rate. Value, however, has become hard to find and it is this scarcity of value, we believe, that will bring about the inevitable shift in market leadership away from technology to other sectors.

Forewarned is forearmed.   

 

[i] The total return for the NASDAQ 100 Index for the period was 80.9% versus 74.05% for the S&P 500 Index.

 

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

 

 

Containers and Packaging Companies: Challenges Aplenty

“It is not inequality which is the real misfortune, it is dependence.” –  Voltaire

 

“The strength of criticism lies in the weakness of the thing criticised.” Henry Wadsworth Longfellow, American poet and educator

 

“The only thing we know about the future is that it will be different.” – Peter Drucker

 

“Instead of working for years to build a new product, indefinite optimists rearrange already-invented ones. Bankers make money by rearranging the capital structures of already existing companies. Lawyers resolve disputes over old things or help other people structure their affairs. And private equity investors and management consultants don’t start new businesses; they squeeze extra efficiency from old ones with incessant procedural optimizations. It’s no surprise these fields attract disproportionate numbers of high-achieving Ivy League optionality chasers; what could be more appropriate reward for two decades of résumé-building than a seemingly elite, process-oriented career that promises to ‘keep options open’?” – Excerpt from Zero to One by Peter Thiel and Blake Masters

 

 

The Fractal Geometry of Nature by Franco-American mathematician Benoit Mandelbrot is a mathematics book that behind all the Greek symbols holds within it explanations of the elegant shapes, sequences and patterns that repeatedly occur within nature. In this book Mandelbrot outlines a theory called the Lindy Effect – a theory he developed but that was named after a New York diner where stand-up comedians used to gather – that advances the idea that the longer a technology or concept has survived, the longer it is likely to survive. More specifically, the future life expectancy of non-perishable items such as a technology or concept is proportional to their current age, such that each incremental period of survival implies an increasing remaining life expectancy.

Consumer packaged goods (CPG) companies, relatively speaking, have been around a long-time.

CPG companies have had a great run for well over five decades. During that time the well-established CPG companies – like The Kraft Heinz Company, Kimberley Clark, Procter & Gamble, Unilever, and PepsiCo to name but a few – have each created their very own ecosystems. These ecosystems are comprised of retailers, advertising and public relations agencies, media companies, trucking and warehousing solutions providers, container and packaging producers, and many other ancillary businesses that are almost entirely focused on servicing the dominant CPG company within the ecosystem they exist.

As CPG companies have thrived over the decades so too have the businesses that are focused on servicing them. And the larger the CPG companies have grown, the more dependent these businesses have become on them.

These dominant companies are now under threat. The threat comes from multiple angles including changing consumer tastes and shopping patterns, demographics, technological disruption, rising commodity prices, and more responsive niche competitors. The CPG companies have responded to these threats by becoming increasingly inward looking. That may appear to be a strange way to describe their behaviour but as we read through transcript after transcript of these companies’ earnings conference calls we find one common theme across all of them: cost savings. Some companies have hired strategy consultants like McKinsey & Co. to help identify areas of inefficiency and procedural optimisation, while others have launched clumsily named cost cutting initiatives such as “FORCE”, “SPORT”, and “Agility”. Many of the companies in face of investor scepticism are going out of their way to trump up their research and development capabilities and their focus on innovation; for the most part, however, the supposed innovations appear to us to be a doubling down on what has worked in the past or playing catch-up with niche brands that have blazed a trail in new market segments. Based on airtime given during the conference calls cost saving not innovation is obviously the key area of focus for most, if not all, of the major CPG companies today.

The focus on cost saving and efficiency is not surprising. The management teams at the leading CPG companies are comprised primarily of, in Peter Thiel’s words, “indefinite optimists”. And the consultants they hire too are likely to be indefinite optimists.  These indefinite optimists, as Thiel describes them, are far more like to alter and try to improve that which already exists than to create new products that will deliver meaningful revenue growth. Take for instance PepsiCo CEO Indra Nooyi’s response when asked about the company’s conservative expectations relating to their innovations in 2018 (emphasis ours):

“Internally, we’d like to do more, but we want to be very, very cognizant of the headwinds around us, some of which we don’t even understand at times because the consumer is not consistent.”

And The Kraft Heinz Company’s Chief Operating Officer Georges El-Zoghbi’s response when asked about the importance of brands to consumers in food and the investments they are making into brands (emphasis ours):

Brands matter most because the investment behind advertising, the investment behind promotions, the investments behind new products that come to market not only helps the brand, but stimulates overall category demands for everybody who is operating in those categories. So in an environment where there is changing consumer needs and changing go-to-market model, brands become a lot more important.

However, brands need nurturing and nurturing means investment and staying relevant with what consumers’ needs are and what consumer wants to buy. So for us, an investment in the brand has always been important. Now we’re even accelerating that to deal with an environment where consumers changing what they buy and where to buy it from. And we are accelerating the investments to deal with that. So we see now increasingly important to have stronger brands in those categories for everybody.

In an environment where LaCroix has become the leading carbonated water brand in the US without advertising, we see the above comments from PepsiCo and the Kraft Heinz Company as being symptomatic for management teams that are still coming to terms with the scale of the challenges they face in growing their revenue.

As the CPG companies’ face up to the challenges on the revenue side, we think their focus on cost savings and efficiency will only increase further. And this is bad news for businesses that exist almost entirely to serve these companies. As a case in point consider Procter & Gamble’s comment on rationalising costs relating to media spend (emphasis ours):

Looking ahead, we see further cost reduction opportunity through more private market placed deals with media companies and precision media buying, fueled by data and digital technology. We continue to reinvent our agency relationships consolidating and upgrading P&G’s agency capabilities to deliver the best brand building creativity. We’ve already reduced the number of agencies nearly 60% from 6,000 to 2,500, saved $750 million in agency and production costs, and improved cash flow by over $400 million additional through 75 day payment terms.”

 

 

Investment Perspective

 

Businesses providing undifferentiated, commoditised products with increasing production capacities are the most at risk of being hit by the cost saving drives being undertaken by CPG companies. Containers and packaging companies are, in our opinion, amongst the most vulnerable.

By containers and packaging companies we are referring to the likes of Ball Corporation, Crown Holdings, Bemis Company, Silgan Holdings, Sealed Air Corporation and Tredegar Corporation. These companies manufacture products such as flexible and rigid plastic packaging, metal packaging and steel cans for the consumer packaged goods industry.

The table below provides the share of revenue coming from major CPG companies for a number of the containers and packaging companies

Company Major CPG Companies’ Share of Revenue
Ball Corporation 27.9%
Crown Holdings 17.1%
Silgan Holdings 48.9%
Bemis Company 42.3%
Sealed Air Corporation 7.2%
Tredegar Corporation 12.0%

Note: Based on Bloomberg data as at 1 March 2018, revenue shares are calculated based on sales to The Coca Cola Company, PepsiCo, Unilever, Procter & Gamble, Nestle SA, Conagra Brands, Johnson & Johnson, Reckitt Benckiser, Dr Pepper Snapple, Campbell Soup, The Kraft Heinz Company, General Mills, Hormel Foods, TreeHouse Foods, Dean Foods, Mondelez International, Kimberly-Clarks, Kellog Company, and Tyson Foods

 

Most of the containers and packaging companies highlighted above sell largely commoditised products and are operating in highly competitive market segments, giving them little power when dealing with customers that in and of themselves possess a significant amount of marketpower. Moreover, the containers and packaging companies’ largest markets – namely developed economies – are characterised by excess capacity while their growth markets – emerging economies in Asia and South America – are witnessing deliveries of increased production capacities. Despite this a number of the companies continue to expand production capacities both in developed and emerging markets. It is then no surprise that return on invested capital for most of these companies is declining sharply.

Annual Return on Invested Capital (%)ROIC

Source: Bloomberg

 At the same time, in terms of trailing price-to-earnings ratios in a historical context, these companies appear to be richly valued with most trading at one to two standard deviations above their historical trailing price-to-earnings ratios.

Ball Corp Trailing Price-to-Earnings RatioBall

Source: Bloomberg

Silgan Holdings Trailing Price-to-Earnings RatioSLGN

Source: Bloomberg

Bemis Co Trailing Price-to-Earnings RatioBemis

Source: Bloomberg

Tredegear Corp Trailing Price-to-Earnings RatioTG

Source: Bloomberg

If one is to invest in the containers and packaging segment, we think manufacturers catering to highly regulated markets or delivering highly complex solutions is where to look. Manufacturers catering to the pharmaceutical segment, for example, would be those operating in highly regulated markets. Suppliers to the pharmaceutical market have to meet very high regulatory standards and their production facilities have to go through rigorous testing and audits to be validated for production. Customers of such manufacturers are unlikely to switch suppliers quickly or easily and are more likely to see validated suppliers as trusted partners whom they are likely to work closely with in developing new and innovative solutions.

The stocks of the more commoditised containers and packaging producers, in our opinion, are clearly ones to avoid and amongst them might even lie some very compelling short opportunities. While stocks of companies – such as AptarGroup $ATR – operating in more regulated segments of the containers and packaging sector or those delivering highly complex solutions may offer relatively more compelling investment opportunities.

 

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable