Consumer Archives - LXV Research

The US Consumer is Not Immune and More

“Progress is impossible without change, and those who cannot change their minds cannot change anything.” – George Bernard Shaw

“The first rule of business is: Do other men for they would do you.” – Charles Dickens

“Globalization and trade liberalization were supposed to make us all better off through the mechanism of trickle-down economics. What we seemed to be seeing instead was trickle-up economics, accompanied by a destruction of democratic politics, as we moved ever closer to a system of ‘one dollar, one vote’ as opposed to ‘one person, one vote.’” – Joseph Stiglitz

The US Consumer is Not Immune from the Trade War

On 6 July 2018 the first tranche of tariffs imposed by the Trump Administration on China went into effect. The first tranche amounts to a 25 per cent import duty on 818 Chinese goods, representing US dollars 34 billion of China’s exports to the US in 2017. The first set of tariffs primarily target industrial goods such as aircraft engines and engine parts, cranes, nuclear reactors, electricity transformers and industrial magnets.

On 24 September 2018 the second tranche of tariffs on Chinese imports went into effect. Import duties on goods targeted in the second tranche started at 10 per cent and will rise to 25 per cent from 1 January 2019. All manner of Chinese goods, constituting roughly US dollars 200 billion of China’s exports to the US in 2017, have been hit in the second wave of tariffs. Targeted products include consumer goods such as furniture and luggage, agriculture products such as fruit and seafood, and industrial products such as chemicals and printed circuit boards.

The imposition of tariffs on Chinese goods has coincided with the gradual depreciation of the Chinese yuan. From its peak in April, the Chinese yuan has dropped by approximately 11 per cent. The drop in the currency is seen by many as a means by which China aims to counter the 10 per cent import duty imposed on its exports.

In reaction to the steady depreciation of the Chinese yuan this year, a narrative has started to take hold amongst those with a pro-tariff / anti-China disposition. That narrative being that the US consumer will be sheltered from the negative effects of a trade war as China will simply continue depreciating its currency in response to the tariffs. And a further 15 per cent decline in the value of the Chinese yuan relative to the US dollar is being anticipated ahead of the increase in import duties to 25 per cent on goods targeted in the second tranche of tariffs.

Chinese Yuan to US Dollar Exchange Rate

Source: Bloomberg

While the currency devaluation argument has merit, we do not agree with the view that the US consumer is immune to the effects of the trade war. A cheaper currency does not solve everything. Raw materials prices for Chinese exporters have increased in local currency terms and pushed up their costs, especially for producers with inputs comprising of commodities or imported products priced in US dollars.

Contrary to the view that the US consumer will not be impacted by trade wars, the recent decline of the Chinese yuan against the US dollar does not mean exporters can cut prices, in US dollar terms, to entirely offset the impact of the imposed tariffs, especially as most exporters operate with very thin profit margins.

In our estimation, under an optimistic scenario, the depreciation of the currency will only support to offset about 50 per cent of the import duties. Implying that, in most cases, the cost of tariffs will have to be shared by Chinese exporters and US consumers.

Prices for US consumers, however, should not start rising immediately. US companies are preparing for the increased tariffs by purchasing higher levels of inventories from Chinese exporters. This also means that Chinese exporters are still to feel the pinch from tariffs. Based on anecdotal evidence we have gathered, Chinese exporters are inundated with orders and are operating at full capacity to ensure US bound orders are fulfilled in time to reach US ports ahead of the 1 January 2019 deadline.

A necessary corollary of the accelerated demand from US importers this year is that the first quarter of 2019 is going to be very tough for Chinese exporters. And US consumer prices are likely to start increasing in the second or third quarter of next year.

US consumer discretionary stocks have had a pretty good run in 2018; the time to start rotating out of the sector is approaching fast.

China Doubles Down on the Consumer

At last year’s 19^th Annual Communist Party Congress Xi Jinping highlighted the need to tackle financial risks as one of the priorities for the Chinese leadership. Following the event, the government took steps to clampdown on the shadow banking sector. New regulations were introduced to close loopholes that were being exploited both by banks and asset management companies to funnel loans under the guise of investment. Consequently, credit growth in China has stalled – possibly even more so than the Chinese leadership may have anticipated.

China Money Supply M2 Year-over-Year

Source: Bloomberg

Facing the escalating trade dispute with the US and the marked slowdown in credit growth, China has been under pressure to use fiscal policy more aggressively to support the economy. The government has so far resisted the urge to ramp up fiscal spending – possibly wanting to hold on to the option to combat further economic challenges in 2019.

Instead of increasing fiscal spending the Chinese government has focused on reducing reserve requirements for banks and providing inducements to Chinese consumers to increase spending.

In our view, reserve requirements cuts are unlikely to change the trajectory of either credit or economic growth in the near term. The government still remains committed to its financial de-risking campaign, and while there have been noises about scaling it back, there is little sign of it happening.

China needs increased spending to spur its economy forward and if it is not going to come from the government, it has to come from the consumer. And this is where it seems the Chinese government is focusing its near terms economic policy.

A sharp rise in consumer and household debt is what drove China’s economic growth in recent years. The build-up in household debt has been quite rapid, and in some coastal areas of China debt levels are now quite high. Consequently, compelling Chinese consumers to borrow more does not appear to be a viable policy option. For this reason the Chinese government has instead opted for tax cuts.

In September, China implemented its first income tax cut in seven years. Moreover, the implementation date of the tax cut was brought forward to 1 October from 1 January. The major change in the new tax regime is an increase in the threshold for paying tax to Chinese yuan 60,000 in annual compensation, from Chinese yuan 42,000 – individuals will not pay tax on their first Chinese yuan 60,000 of income. This change delivers a tax cut at all levels of income.

Further cuts apply for the first four of China’s seven income-tax brackets. The benefits of the tax cuts are highest for those with monthly incomes of Chinese yuan 10,000 to 50,000, with the cuts representing approximately 6 per cent of their income.

In total, these changes, according to the Ministry of Finance, will reduce revenue from the personal income tax by about Chinese yuan 320 billion – equivalent to roughly 1 per cent of annual household income. Also according to the Ministry of Finance, the share of the population paying income tax will fall 44 per cent to 15 per cent as a result of the changes to the income tax law.

More recently, the Chinese government has introduced plans to let households deduct major expenses such as housing and education from their income taxes. An estimated 80 per cent of households stand to benefit from the change and the tax burden on lower and middle class households is expected to be reduced by as much as 25 to 30 per cent

There has also has been news that China is considering a tax cut to revive its flagging automotive market.

There is little reason to doubt that the Chinese government will do more to support growth as and when it becomes necessary. For now, however, it may be time to go bottom fishing in beaten down Chinese consumer plays.

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.

Consumer Stocks: The Long and Short of it

“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather, American publisher and author

“When thinking about the future, it is fashionable to be pessimistic. Yet the evidence unequivocally belies such pessimism. Over the past centuries, humanity’s lot has improved dramatically – in the developed world, where it is rather obvious, but also in the developing world, where life expectancy has more than doubled in the past 100 years.” – Bjørn Lomborg, Danish author and President of Copenhagen Consensus Center

“What day is it?” asked Pooh.

“It’s today,” squeaked Piglet.

“My favourite day,” said Pooh.

– Alexander Alan Milne

American consumers are the driving engine of the US economy – consumer spending is estimated to represent about two-thirds of US economic output. If sentiment surveys and retail sales are anything to go by then the American consumer, and by extension the US economy, is in rude health.

Consumer sentiment, as tracked by the University of Michigan, in September jumped to its second-highest level since 2004.

According to the Commerce Department, US retail sales increased by 6.6 per cent year-over-year in August – running well ahead of inflation. Month-on-month growth, however, was disappointing with August sales only increasing 0.1 per cent over July – whilst somewhat unsatisfactory, monthly comparisons tend to have a very low signal-to-noise ratio and are therefore misleading to read into, in our opinion.

Given the robust retail sales and soaring consumer sentiment, one would expect investors to be all bulled up on consumer stocks. Yet, as we compare the level of short interest across the constituents of the S&P500 Index we find that the greatest concentration of shorts (relative to free float) is in consumer related stocks. Investors remain circumspect about the prospects of consumer focused companies due to the potential impact of (i) rising interests on the disposable income of US consumers, and (ii) escalating trade tensions between the US and China on the companies’ supply chains, which in turn could meaningfully increase their cost of goods.

The below chart shows the average level of short interest (as a percentage of free float) by industry group. (Consumer related industry groups are highlighted in yellow.)

Average Short Interest across S&P500 Index by Industry Group Source: Bloomberg

The above chart shows that all but one of the consumer related industry groups has a higher level of short interest than the average level of short interest for a stock in the S&P500 Index. Moreover, the top three most shorted industry groups are all consumer related.

To further dissect the level of short interest across consumer related stocks, we focus in on the constituents of the SPDR S&P Retail $XRT and iShares US Consumer Goods $IYK exchange traded funds.

Retail

The average level of short interest for $XRT constituents is 7.5 per cent of free float. The most shorted sub-industry groups are food retail (something we have written about recently in The Challenge for Food & Beverage Retail Incumbents), automotive retail, and drug retail.

Average Short Interest across $XRT by Sub-Industry Group Source: Bloomberg

American department store chain Dillard’s is the most shorted stock amongst the constituents of $XRT with short interest making up a whopping 66.2 per cent of free float. The high level of short interest in the stock has not been rewarded by a declining price this year – the stock has generated a total return of 31.5 per cent year-to-date (as at market close on 19 September, 2018).

A further seven constituents have short interests that exceed 30 per cent of their free float, namely: Overstock.com (45.7 per cent), JC Penney (45.7 per cent), GameStop (39.6 per cent), Camping World Holdings (39.3 per cent), Hibbett Sports (36.4 per cent), The Buckle (36.0 per cent) and Carvana (31.3 per cent). The performance of these stocks has been more mixed with online retail company Overstock.com down 58.8 per cent year-to-date while online car dealer Carvana has generated an astonishing 208.3 per cent return year-to-date.

Many of the heavily shorted retail stocks appear to us to be the companies investors view as the mostly likely to be “Amazoned” in the near term.

Top 30 Most Shorted $XRT Constituents Source: Bloomberg

Total Return Year-to-Date of the Top 30 Most Shorted $XRT Constituents Source: Bloomberg

Generally, being short retail stocks has not been rewarding this year. The price return of $XRT is 14.2 per cent year-to-date versus 9.6 per cent year-to-date for the S&P500 Index.

Scatter Plot of Short Interest versus Year-to-Date Total Return for $XRT Constituents Source: Bloomberg

Note: Chart excludes Dillard’s and Caravan

Consumer Goods

The average level of short interest for $IYK constituents at 6.2 per cent of free float is lower than for $XRT constituents but still significantly higher than the average for the S&P500 Index. The most shorted sub-industry groups are tires & rubber, home furnishings and housewares & specialties.

Rising mortgage rates and the home buyer affordability index at ten-year lows are the likely reasons for the high levels of short interest in the home furnishings and housewares & specialties segments.

Average Short Interest across $IYK by Sub-Industry Group Source: Bloomberg

Only two stocks amongst the $IYK constituents have a short interest to free float ratio exceeding 30 per cent: B&G Foods (32.7 per cent) and Under Armour (31.8 per cent).

Generally, being short consumer goods stocks has been more rewarding than being short retail stocks. $IYK is down 3.5 per cent year-to-date. (We wrote about our concerns relating to the consumer goods sector last year in Unbranded: The Risk in Household Consumer Names.)

Top 30 Most Shorted $IYK Constituents Source: Bloomberg

Total Return Year-to-Date of the Top 30 Most Shorted $IYK Constituents Source: Bloomberg

Scatter Plot of Short Interest versus Year-to-Date Total Return for $IYK Constituents Source: Bloomberg

Investment Perspective

There is, we think, no clear playbook when it comes to heavily shorted stocks. Some portfolio managers we have interacted with in the past have occasionally gone long ‘consensus shorts’. Their track record is middling; they have done very well at times but also been burnt badly at other times.

Our approach is to identify heavily shorted stocks where we have a differentiated view on the prospects of near term earnings, valuation or the potential for the company to be acquired and to go long those stocks. (These lessons have been hard learned over time as in the past we have found ourselves far too closely aligned with consensus – as George S. Patton is known to have said: ‘If everyone is thinking alike, then somebody isn’t thinking’.)

In the instances our positioning and views prove correct, the high level of short interest acts like leverage and greatly amplifies returns in a relatively short amount of time.

Earlier this year we went long Under Armour based on our view that consensus earnings expectations had been deflated to such a degree that there was very little chance for the company to disappoint – with the stock price languishing at multi-year lows we deemed there to be little downside even if the company disappointed. As it transpired, the consensus view was indeed far too bleak and the stock quickly re-rated higher as the company outdid lowball expectations.

More recently, on 24 July, we went long and remain long kitchenware and home furnishings company Williams Sonoma $WSM. Short interest for the stock stands at over 20 per cent of free float, the company generated a best-in-class operating return on invested capital of 18.4 per cent in 2017 and trades at around consensus forward price-to-earnings of 15.4 times.

The retail and consumer goods sectors remain our preferred areas to search for heavily shorted stocks where we may have or develop a differentiated view.

Consumer Staples: Niches and Acquisition Targets

“You can say Pizza Hut is terrible pizza, but they also sell more pizzas than anybody else.” – Jimmy Kemmel

“Mergers are like marriages. They are the bringing together of two individuals. If you wouldn’t marry someone for the ‘operational efficiencies’ they offer in the running of a household, then why would you combine two companies with unique cultures and identities for that reason?” – Simon Sinek

“One thing I love about customers is that they are divinely discontent. Their expectations are never static — they go up. It’s human nature. We didn’t ascend from our hunter-gatherer days by being satisfied. People have a voracious appetite for a better way, and yesterday’s ‘wow’ quickly becomes today’s ‘ordinary’. I see that cycle of improvement happening at a faster rate than ever before. It may be because customers have such easy access to more information than ever before — in only a few seconds and with a couple taps on their phones, customers can read reviews, compare prices from multiple retailers, see whether something’s in stock, find out how fast it will ship or be available for pick-up, and more. These examples are from retail, but I sense that the same customer empowerment phenomenon is happening broadly across everything we do at Amazon and most other industries as well. You cannot rest on your laurels in this world. Customers won’t have it.” Jeff Bezos in this year’s letter to Amazon shareholders

“If you don’t like what’s being said, change the conversation.” – Don Draper, Mad Men Season 3, Episode 2

June 2017: Amazon announces it is acquiring Whole Foods. The market cap of twenty companies in the food and retail sectors declines by almost US dollars 40 billion.

August 2017: Amazon announces that it will be cutting prices at Whole Foods. The market cap of Kroger, Wal-Mart, Target, Costco, Supervalu and Sprouts Farmers Markets drops by nearly US dollars 12 billion.

May 2018: Walmart announces acquiring a controlling stake in India’s largest online retailer. Walmart shares decline by 4 per cent in response.

May 2018: Kroger announces that British online supermarket Ocado’s technology will be used in the US exclusively by Kroger and that it will also take a 5 per cent stake in Ocado. Ocado’s share price surged by 44 per cent subsequent to the announcement.

Are Walmart and Kroger trying to change the conversation or do they want to be seen to be doing something?

One year, while we were working at a boutique asset management firm, our flagship fund was underperforming both its benchmark and peers by a significant margin. We had suffered two straight quarters of underperformance and were on track to record our third consecutive quarter of underperformance – a humiliation hitherto avoided by the organisation in its 10-year history.

The CIO’s response to our continued underperformance was to get the team to work harder: longer hours, more meetings with management teams of our various holdings, more research, more analysis, more detailed financial models, more team discussions, more, more, and more. The end result: more underperformance.

Given the underperformance, each team member knew bonuses were going to be bad, everyone expected a significant cut. Despite this knowledge, not one single team member took time-off in the two months leading up to date bonuses are distributed. Each and every one of us worked even longer hours, sent out more emails, and upped our contribution during team discussions. We were all guilty of wanting to be seen as contributing positively to the investment process.

Working harder does not always lead to better results, especially when it comes to investing.

To be seen as contributing is not the same as actually contributing.

S&P 500 GICS Level 1 Consumer Staples Index

Staples Source: Bloomberg

We have written about the challenges faced by consumer staples and consumer packaged goods companies on a number of occasions (see Unbranded: The Risk in Household Consumer Names, The Incumbent’s Challenge, and Containers and Packaging Companies: Challenges Aplentyhttps://lxvresearch.com/2018/03/01/containers-and-packaging/). The narrative of the decline in consumer staples, we think, has gradual come into acceptance and this acceptance is being reflected both in the share prices of many of the leading consumer staples companies as well in the types of articles appearing in broadsheets such as the Wall Street Journal and the Financial Times. Take for instance the following excerpt from ‘Amazon Effect’ Stings Consumer-Staples Stocks as Pricing Woes Mount published on 25 April, 2018 by the Wall Street Journal:

The industry’s pricing issues have many money managers wondering whether the biggest makers of household staples have already seen their best days.

“What’s happening is that these firms are struggling to pass on rising costs to consumers,” said Shawn Cruz, manager of trader strategy at TD Ameritrade. “Big brands have counted on their brand name drawing customers in, and that’s not necessarily happening anymore.”

To date, as it relates to the consumer staples sector, our focus has primarily been on avoiding losers and identifying potential shorting opportunities. All is not doom-and-gloom in the consumer staples sector, however. As the cliché goes, where there are challenges, there are also opportunities. And we are starting to see opportunities.

Investment Perspective

Management teams at the leading consumer staples companies have responded to the challenges they face and to declining share prices by looking inwards. Management teams can be inward looking in many ways.

One way is to hire strategy consultants like McKinsey & Co. to help identify areas of inefficiency and procedural optimisation, or to devise cost cutting initiatives that can rid the businesses of unnecessary costs. Another way to double-down on what has worked in the past: to increase investments into their brands i.e. to advertise more, to increase awareness of their brands. Yet another way is to increase research & development budgets to develop new, better, and more “on-trend” products.

Eventually, we suspect, a number of the large consumer product companies will come to realise that (1) cost-cutting only goes so far and that it does not really excite would be shareholders, (2) doubling-down no longer works in the internet-era, and (3) they lack the creativity to deliver “on-trend” products. As companies come to these realisations they will become increasingly outward looking i.e. they will look to acquire that which they do not have and that which consumers desire.

Unilever has already done this by acquiring Dollar Shave Club. Coca-Cola and Procter & Gamble too by acquiring kombucha tea brand Honest Tea and all natural deodorant brand Native, respectively.

While a number of the acquisitions will be made in private markets, we believe owning a basket of small- and mid-cap food and retail companies that have carved out successful niches can provide investors with exposure to potential acquisition targets and the promise of outsized returns.

With this perspective, we think a basket of names such as Natural Grocers by Vitamin C $NGVC, Village Supermarket $VLGEA, Weis Markets, Alico Inc $ALCO, Cal-Main Goods Inc $CALM, Primo Water $PRMW, and Natural Health Trends Corp $NHTC can provide just that kind of exposure.

Consumer: Long Stuff / Short the Experience Economy

“I think if you give in and accept society’s stereotypes, then you start thinking, ‘I cannot dance till late at night because I’m 70.’” – Yoko Ono

“Through most of human history, our ancestors had children shortly after puberty, just as the members of all nonhuman species do to this day. Whether we like the idea or not, our young ancestors must have been capable of providing for their offspring, defending their families from predators, cooperating with others, and in most other respects functioning fully as adults. If they couldn’t function as adults, their young could not have survived, which would have meant the swift demise of the human race. The fact that we’re still here suggests that most young people are probably far more capable than we think they are. Somewhere along the line, we lost sight of – and buried – the potential of our teens.” – Robert Epstein, American psychologist, professor, author, and journalist

“The theory of Economics must begin with a correct theory of consumption.” – The Theory of Political Economy (1871) by William Stanley Jevons

The human brain is predisposed to stereotyping. Stereotyping serves as a social heuristic that reduces the amount of thinking we have to do as it allows the brain to cluster people into groups with a whole range of expected characteristics and abilities. Scientific studies have gone as far as to show that that the brain responds more strongly to negative stereotypes – something the mainstream media has long understood with programming and messaging tilted towards negativity to exploit the human predisposition.

One population group that has become much maligned by negative stereotyping are the millennials – the generational cohort typically recognised as having birth years between the early eighties and the early 2000s. Stereotypes depict millennials as a generation of entitled, fame obsessed, narcissistic and lazy young adults that continue to live off of their parents with the aim of postponing the rites of passage to adulthood as long as possible.

Millennials also have a reputation for being over-indulgent spenders that do not save for retirement. A recent report issued by Bank of America Merrill Lynch in partnership with Khan Academy, however, discredits some of the widely held stereotypes about millennials, particularly those relating to financial matters. For starters, the report shows that almost half of millennials in the United States have managed to save at least US dollars 15,000, while one out of every six of them have US dollars 100,000 stashed away in a savings account, investments, individual retirement accounts, or pension plans. Millennials’ financially savvy – it appears from the report at least – is on par with or exceeds that of the baby boomers and Gen Xers.

Millenials are even driving home ownership higher in the United States – the cohort make up the largest segment of American home buyers today. Economic recovery is the simplest explanation for why more millennials are buying homes. Millennials started entering the workforce just as the Global Financial Crisis hit. A significant portion of the generation found itself unemployed, underemployed, or underpaid. And only now that the economic and psychological overhang of unemployment and underemployment has worn off meaningfully, has it become possible for the generation to step into home ownership at large.

A second reason is that marriage rates amongst millennials have also risen slightly as they have gotten older and achieved a degree of financially stability. Irrespective of the generation, marriage is widely accepted as being the number one indicator of whether people buy homes or not.

Beyond these obvious reasons we also believe that there is growing disillusionment amongst young adults today when it comes to the gig economy, big tech, and the echo bubbles that exist within Silicon Valley and popular social networks. This change can be seen with Peter Thiel ditching Silicon Valley for Los Angeles, increasing hostility towards Mark Zuckerberg and Facebook, and the gradual exodus of residents from San Francisco.

One cure to disillusionment is to lay down roots. And nothing establishes roots quite like buying a home.

Investment Perspective

Capital markets are not averse from stereotyping either. Markets in recent years have bought into at least one of the millennial stereotypes and put capital to work behind it. One such stereotype being that young adults today prefer experiences over goods. While this may indeed hold true, we believe that a larger change is afoot and that millennials are reaching a stage in their development where priorities will shift away from spending on experiences to accumulating assets and goods.

The rise of social media gave rise to the increasing trend toward experiential consumption. Conspicuous consumption amongst millennials as compared to Baby Boomers and Gen Xers was less about “stuff” and more about experiences. Social media both explicitly and implicitly rewarded the sharing of experiences – users receive positive feedback and increased network engagement from sharing photos, videos, and comments. The positive feedback incentivised users to share more and sharing more required engaging in more experiences – attending more concerts, going to more trips to far off places and trying out more restaurants. While we do not see a wholesale change is this behaviour to take place anytime soon, we do think that the marginal user is decreasing social media engagement, reversing the trend of the last decade of increasing marginal engagement.

Increasing social media disengagement – however small it may be – also means that the marginal dollar of conspicuous consumption will no longer be going toward experiences, it will be going elsewhere.

Millennials are stepping into homeownership and the wave of home buying is only getting started. With increasing homeownership comes increasing consumption, new homeowners have to fill up their houses with everything from furniture to lawnmowers. The marginal dollar of conspicuous consumption will be spent on stuff. For the homeowners this will be household goods. For the non-homeowners this will be on clothes, shoes, sports equipment, and health and beauty products.

In our recent trade ideas we added a long in Lululemon Athletica ($LULU). The idea was based on our thesis of increasing consumption of stuff. We consider the likes of Nike ($NKE), Ralph Lauren ($RL) and Under Armour ($UAA) as names that we see as beneficiaries of increasing conspicuous consumption by millennials both in the United States and overseas.

On the other hand, we consider restaurants and other experiential economy companies to be prime candidates to short. We certainly would avoid stocks of companies such as McDonald’s ($MCD), Starbucks ($SBUX), Darden Restaurants ($DRI) and cruise ship operators such as Carnival Corp ($CCL) and Royal Caribbean Cruises ($RCL).

We are getting long $UAA and $RL and short $CCL.

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 (%)

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 Ratio

Source: Bloomberg

Silgan Holdings Trailing Price-to-Earnings Ratio

Source: Bloomberg

Bemis Co Trailing Price-to-Earnings Ratio

Source: Bloomberg

Tredegear Corp Trailing Price-to-Earnings Ratio

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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Unbranded: The Risk in Household Consumer Names

“Advertising is based on one thing, happiness. And you know what happiness is? Happiness is the smell of a new car. It’s freedom from fear. It’s a billboard on the side of the road that screams reassurance that whatever you are doing is okay. You are okay.” – Don Draper, Mad Men season one

“Identities are the beginning of everything. They are how something is recognized and understood. What could be better?” – Paula Scher, first female principal at Pentagram, the world’s largest independently-owned design studio

“A brand is the set of expectations, memories, stories and relationships that, taken together, account for a consumer’s decision to choose one product or service over another.” – Seth Godin, bestselling author

A wise man was he Don Draper. He understood the human need to belong, to feel safe. And his contemporary would understand, that today, reassurance comes from counting the likes for your Facebook status update, having an Instagram following that exceeds the following enjoyed by your friends, or your ramblings on Twitter being retweeted by someone even moderately famous. The lowly billboard barely gets a look anymore. And household consumer brands, not unlike many of Don Draper’s fictitious clients, are none the better for it.

On 15 August, 2017 the Wall Street Journal ran an article titled “This Isn’t An Advertisement: Time to Buy Shares in WPP” in which they argued that “As the stock market climbs ever higher, traditional advertising agencies look like a rare pocket of value – none more so than the largest, WPP”. And as if almost on cue, WPP cut its revenue forecast – blaming weak client spending – and sent its stock price crashing.

WPP’s announcement received all manner of reaction. The idea that it is only a matter of time before the rot spreads to digital advertising juggernauts Facebook and Google, in particular, received plenty of airtime. This conjecture resonated with those calling for the FANG “bubble” to pop. For many, Procter & Gamble’s revelation that it had cut digital marketing spend by over USD 100 million with it having very little impact on its business, only a few weeks prior to WPP’s announcement, only further confirmed this hypothesis. A chart not too dissimilar to the one below may also have been used to argue that the disconnect between FANG and WPP stock price performance will duly close. We consider this type of thinking to be a formulaic type II error.

WPP and Google Share Price Performance (Normalised)Source: Bloomberg

An advertising agency’s business model is to aggregate advertisement placeholders across disparate media outlets and to provide an access point for advertisers to its network of placeholders. As the advertising market is becoming increasingly concentrated, with Facebook and Google grabbing all advertising spend growth, aggregating ad space is becoming a redundant competitive advantage. Especially when there is limited need for human interaction, and by extension privileged access, to place adverts on Google and Facebook. Advertising agencies have increasingly been disintermediated as access to ad space has become democratised.

Internet Share of Total Advertising Spend Source: Bloomberg Intelligence

Advertisers use ad agencies to communicate a uniform message about their product or brand to reach as much of their target market as is feasible. They typically focus on two types of advertising, one is the promotional kind to boost sales over a short period of time and the other is to increase awareness of their brand and to shape consumer perception – to create, in essence, a halo effect to drive long-term brand loyalty and sales. Household consumer brands, the likes of Andrex, Kleenex and Tide, produced by consumer goods corporations such as Procter & Gamble and Kimberly-Clark, generally spend the majority of their advertising budget on trying to create strong brand identities for their products.

Consumer goods companies combine their products’ strong brand identities with far reaching distribution. In turn, making their products available to as many consumers as is feasible. Awareness and availability have been the moats exploited most effectively by the largest and most successful consumer product manufacturers.

At a time of scarcity of information, consumers relied on brands as proxies for reliability and of quality assurance. You could be pretty much anywhere in the world and be comfortable with the fact that if you bought your regular brand of coffee, cereal, or soda that you would get what you expected. There would be no discovery, no adventure but there would also be no disappointment.

Today, however, the brand too is being disintermediated. We no longer need proxies. We have smartphones giving us access to a plethora of information at all times. We can instantly check reviews or recommendations for products, restaurants or hotels made my people who have experienced them. And being socially conforming animals, we tend to trust the judgement of other people over perceptions created by brands. Access to information has freed us to discover and try new things, which further frees us to make choices based on preference over perception.

Household consumer brands have been the mainstay on shelves across all major retail grocery and supermarkets chains for decades. Limited availability has made it difficult for little known brands to get much shelf space, especially as purchasing managers tend to take the low-risk decision of sticking to the tried and tested. Amazon and online retail in general, however, has no such constraints. There is no limit to the number of products that can be promoted on an online platform. At the same time, door-to-door delivery and third party logistics solutions have become far more affordable, enabling small businesses and sole proprietors to match delivery solutions offered by the largest of companies.

Distribution, too, is losing its lustre as a source of sustainable competitive edge.

The design services ad agencies offer their clients are a tax on the advertiser to gain access to an agency’s ad network. Advertisers have been willing to bear this tax historically. However, the effectiveness of traditional media outlets, particularly television, in getting the message across to the masses is being challenged by social networks and other disruptive technologies. It is unsurprising that advertisers are reigning in their ad spend budgets.

If digital advertising platforms have been so effective at disrupting traditional advertising channels, how does one reconcile that Procter & Gamble cut digital spending and it had minimal impact on their business? Firstly, the company has long been the largest spender on advertising in US and the cut represents less than 5% of their total annual ad spend. Secondly, and more importantly, the company has spent billions year in and year out for decades in building brand identities for its product. Consumer behaviour patterns suffer from inertia. Brand loyalties and affinities will not be wiped out immediately but are likely to gradually fade away. Somewhat akin to the explanation on how one goes bankrupt in Ernest Hemingway’s The Sun Also Rises:

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

Lastly, digital advertising platforms’ major strength is targeting specific consumer groups based on precisely defined criterion. Such platforms are best suited to products that have a great deal of appeal to a select group of consumers. In such instances, the return on investment will tend to be high. In contrast, household consumer brands have been built upon creating mass awareness and offering acceptable levels of quality – traits that are unlikely to garner much consumer enthusiasm and therefore likely to result in a low return on investment on digital media spend.

Investment Perspective

In our opinion, the decline of WPP is not a signal for the coming decline of Facebook or Google but rather a confirmation of their strength as legitimate advertising platforms. We expect the demise of the traditional advertising agency model to accelerate. The next great businesses of our generation are unlikely to rely on the advertising models of the past. While existing clients of ad agencies will continue to cut back spending or take away their business altogether. Neither outcome supports the flow of talent into the advertising industry. Without fresh and new talent entering to disrupt the industry, the industry is likely to cling even more strongly to the past. Traditional advertising agencies do not represent pockets of value, in our opinion, they are value traps.

The weakness in traditional advertising agencies also represents potential for deterioration in household consumer names, much like many of the constituents of the Consumer Staples Select Sector SPDR ETF ($XLP) and iShares US Consumer Goods ETF ($IYK). We would avoid investing in either of these ETFs at present and potentially look to get short some of the weaker names within the sector.

WPP vs. Consumer Staples Select Sector SPDR ETF (Normalised)Source: Bloomberg

Our analysis suggests that well-known consumer stocks such as PepsiCo ($PEP), Philip Morris ($PM), Kimberely-Clark Corp ($KMB), The Clorox Co. ($CLX), Dr Pepper Snapple Group ($DPS), Pinnacle Foods ($PF) and Tupperware Brands Corp. ($TUP) are susceptible to significant deterioration in fundamentals. We may cautiously look to short a basket of these names opportunistically.

To counterbalance our negative stance on a number of consumer stocks, if one is to get long consumer plays we find that the greatest upside potential is in aspirational brands.

We define aspirational brands as premium products that have appeal not only in the US but beyond its borders also. These brands have far more potential to benefit from the rising disposable incomes of consumers in emerging markets than do household brands. Companies that fall in the aspirational brand category include the likes of Michael Kors Holdings ($KORS)*, Estee Lauder ($EL) and Tempur Sealy International ($TPX).

* Note: We recommended $KORS as a long idea to LXV Research subscribers on 13 September, 2017

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.