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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.

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

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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The Incumbent’s Challenge

“Washington is an incumbent protection machine. Technology is fundamentally disruptive.” – Eric Schmidt

“I ordered a soda – caffeine-free, low sodium, no artificial flavours. They brought me a glass of water.” – Robert E. Murray, Chief Executive Officer of Murray Energy Corporation, one of the largest independent operators of coal mines in the United States

“Here’s to the crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently. They’re not fond of rules. And they have no respect for the status quo. You can quote them, disagree with them, glorify or vilify them. About the only thing you can’t do is ignore them. Because they change things. They push the human race forward. And while some may see them as the crazy ones, we see genius. Because the people who are crazy enough to think they can change the world, are the ones who do.” – Rob Siltanen, the creative genius behind the much celebrated commercial “To the Crazy Ones” that launched Apple’s Think Different campaign

When Mr. Warren Buffet decides to buy a stock it is a big deal. When he decides to sell a stock, however, it is a much, much bigger deal. We have just learnt that Mr. Buffet dumped most of his IBM’s shares during the fourth quarter last year. IBM is no ordinary company. It is a stalwart of the technology industry. It generates over sixty percent return on equity. Sixty per cent! Oh and by the way 2017 marks the twenty-fifth consecutive year of US patent leadership for IBM.

Unfortunately for IBM, invention does not always equal innovation. And it most certainly does not equal disruptive innovation.

IBM’s seemingly obsessive pursuit of patents, to us, is symptomatic of a zero-sum view of the world. That is, we think underlying IBM’s hunger for patents, is a convoluted assumption that by having a larger share of patents issued will somehow translate into them capturing an increasing share of the value generated by the technology sector. Value, however, is not finite. And technological progress is certainly not a zero-sum game.

A faltering technology company is not exactly news. Casualties in the technology sector are par for the course. IBM is not the first technology company to struggle and it is unlikely to be the last.

Disruption of long-standing and successful consumer staple businesses, however, is far more interesting. PepsiCo – the bluest of the blue chip consumer staple companies – is one company whose trajectory we are following with much intrigue especially after we outlined our bear case for household consumer brands last year.

When PepsiCo announced its USD 15 billion stock buyback plan, shortly after disclosing full year and fourth quarter 2017 earnings, our toes curled a little. PepsiCo is trading at 21x price to trailing earnings and 20x price to consensus 2018 earnings. Surely there are better ways to put the cash to work? It was only a few days prior to announcing the buyback plan that the company introduced Bubly, its new brand of sparkling water, which in and of itself is not a groundbreaking development but an encouraging sign of the company coming to terms with changing consumer preferences nonetheless. And it also signaled that the company was willing to invest in new markets.

The relatively small size of new or emerging markets is a well-documented hurdle for large companies. Investing in small markets just does not move the needle when it comes to meeting Wall Street’s quarterly earnings expectations; pursuing large-scale share buybacks does . Moreover, executives destined for the C-suite do not get there by slogging it out in risky, small-scale pursuits. As anyone who’s worked in an organisation of meaningful size will tell you, projects that do not have a strong sponsor get orphaned very quickly. The harsh reality, however, is that all great businesses start off small and it is therefore paramount that incumbents find ways to overcome their structural inability to enter small markets.

PepsiCo’s recent introduction of Bubly, while a relatively positive sign, is also yet another example of a large company playing catch-up due to their failure in either understanding or pursuing the potential of a small market. The company is entering the US sparkling water market only after LaCroix has proven that it is a big market and has established itself as a clear market leader.

An inability to timely enter high-growth potential markets is far from PepsiCo’s only challenge. The company is under attack on multiple fronts.

JAB, the investment vehicle backed by Germany’s Reimann family, bought Dr Pepper Snapple (DPS) for USD 19 billion last month. JAB plans to merge DPS with its coffee interests to create a giant distribution network to better compete against the likes of PepsiCo and Coca-Cola.

Consumer attitudes towards sugary sodas are also quickly shifting. Sugar is widely acknowledged as enemy number one when it comes to western dietary habits. We can see this PepsiCo’s soda sales in the US, which continue to decline despite a new marketing blitz to promote the company’s soft drink brands.

Investment Perspective

PepsiCo like other great consumer goods companies has leveraged its products’ strong brand identities in combination with far reaching distribution to make its products available to as many consumers as possible. Awareness and availability are perhaps the company’s widest and most effectively exploited moats. The company has proven to be a great investment for long-term, buy-and-hold type investors over the years.

The second-order effects of technological innovation, however, are such that we think the effectiveness of PepsiCo’s moats is eroding fast. People are watching far less television and spending less time reading newspapers and magazines. Instead, they are on YouTube, Facebook, Snap, or watching Netflix. Traditional mass media is great at creating awareness and shaping consumer preferences at a mass scale, which is exactly what consumer product companies needed to keep their their brands at the top of consumers’ minds. So much so that they came to monopolise advertising slots during peak programming. The sky-high prices paid for Superbowl half-time advertising slots just go to show the value of mass media to consumer products companies. It also demonstrative of the fact that traditional media advertising is deeply rooted in a zero-sum world.

The major strength of social media and digital advertising platforms, in contrast to traditional media, is targeting niche consumer groups based on precisely defined criterion. Such platforms are far better suited to products that have very high levels of appeal to a niche group – making them ill-suited as advertising platforms for large consumer product companies. The increasing popularity of social media and other non-traditional forms of media, in our opinion, will result in the increasing awareness of niche brands relative to the awareness of mass consumer brands. We see this as a secular trend that will have a profoundly disruptive impact on incumbent consumer product businesses like PepsiCo.

We do not, however, expect the incumbents to go down without a fight. Unfortunately, the following quotes from senior executives of PepsiCo suggest that, while they do realise they are in a fight, they are still stuck in a zero-sum world and do not yet understand the new rules of engagement:

“We have patents on the design, the cutter, the mouth experience. This is multiple layers of IP.” – Dr. Mehmood Khan, Vice Chairman and Chief Scientific Officer of PepsiCo

“The consumer has turned the definition [of healthy] upside down. If it is non-GMO, natural, or organic, but high in sodium and high in sugar and fat, it’s okay.” – Indra Nooyi, Chairwoman and Chief Executive Officer of PepsiCo

Active management, we think, is as much about avoiding losers as it is about picking winners. We think PepsiCo and other businesses like it are squarely in the loser camp.

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.