Many investors love brands – but often they don’t deliver value in any sense of the word, argues the manager of the Ranmore Global Equity fund.
From Burberry handbags to Heinz tomato ketchup, the story goes that consumers will stick with a brand they love through thick and thin, and pay a premium for the pleasure, even if a rival product is cheaper, better or tastier.
And if investors such as Warren Buffett and Nick Train (more on both later) say so, how can such a theory be wrong?
The trouble is, the numbers don’t add up and the long-term operating performance for many such companies has been rather poor.
Let’s take a closer look.
Crunch time
We analysed many of the largest consumer-brand companies and concluded that low interest rates were the greatest driver of share price performance over the past decade – rather than earnings per share (EPS) growth. Those days are now over.
More worrisome is that this poor earnings performance took place in good times, when the cost of doing deals and repurchasing shares to supplement EPS growth was low.
Today’s tougher economic conditions are also making consumers more price sensitive, accelerating a drive to buy retailers’ private labels, also known as own brands. As such, we think earnings for many of these companies will decline.
That’s why we hold no consumer-brand companies in the Ranmore Global Equity fund.
Unlike many popular ‘brand’ and ‘franchise’-type funds, we think paying high earnings multiples for high and declining earnings is a toxic combination.
You can deconstruct share price performance into the combination of three contributory factors – growth in earnings per share, the rerating/derating of these earnings, and dividends.
Swiss rollover
Let’s take a close look at a couple of companies, starting with Nestlé.
In 2012 it reported a net profit of CHF 10.6bn (£9.38bn today). Ten years later it reported CHF 9.3bn, despite numerous deals that should have augmented growth.
Share repurchases helped to eke out EPS growth of 1% a year but that meant borrowing an extra CHF 29bn and increasing net debt to CHF 47bn, net of some L’Oréal share sales.
Yet your total return was 103%, largely due to the shares rerating from 19x earnings to 31x, providing no less than 71% of the return with dividends pitching in 23% and EPS growth only 6%.
It’s a similar story at US food giant Mondelez, which fills your store cupboards with everything from Ritz crackers to Cadbury Dairy Milk.
Net income has fallen from $3.1bn (£2.5bn today) in 2012 to $2.7bn in 2022. Share buybacks increased EPS growth to 1% but your total return was 200%. The rerating from 15x earnings to 34x was the source of 75% of the return.
Fallen yields
In all the companies we looked at, share price performance outstripped meagre earnings growth handsomely. It all sounds wrong, so why did this happen?
In 2012 Mondelez offered a dividend yield of 3.9% – very attractive to yield-starved investors because 10-year US bonds yielded only 1.8% back then. Earnings growth didn’t matter to these investors, only stable earnings, and Mondelez, like many peers, ticked that box. The ‘bond proxy’ trade was born and enjoyed for 10 years.
The problem today is that Mondelez only yields 2%, far lower than those Treasuries, which now offer 3.9%. This is despite growing dividends faster than earnings.
Any chance of the future share price performance remotely resembling the past is very unlikely – something you won’t hear from the ‘quality’ funds overweight this sector.
So, what kind of ‘long term’ return can investors realistically expect? To reiterate, your return from holding an equity is the combination of your dividend yield, earnings growth and rerating of the shares.
But if the dividend yield only offers low single-digit return potential, then your only hope for any return in this high-inflation environment is earnings growth and rerating.
The trouble is that ratings are already very high, and earnings growth is under threat from both new entrants and own brands. And if earnings fall, ratings usually fall too, exposing investors to the double whammy of a substantial derating on lower earnings.
Walls tumbling down
As mentioned earlier, some top investors think brands are what really matter.
Nick Train’s Lindsell Train Global Equity fund has 41% of its assets in consumer staples, with chunky allocations to brand names such as Diageo, Heineken, Unilever and Mondelez.
Diageo, a favourite of Terry Smith’s Fundsmith fund and Nick Train’s Lindsell Train Global Equity fund has grown net income by 67% (or 5% a year) and EPS at 6%. The share price performance of 7% a year was slightly higher than earnings growth, but the outperformance of earnings was far less than most peers.
Why? Because the starting price-to-earnings ratio of 23 in 2012 was already high and high valuations depress future returns because any contribution from a re-rating is far lower, or worse, negative. Rerating only contributed 18% of Diageo’s total return to shareholders.
Warren Buffett is a brands man as well. In 1993, he wrote of Coca-Cola and Gillette: ‘The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles.’
How times have changed. Back then, the high cost of advertising on national TV used to be a very wide moat. But these days YouTube, Instagram and TikTok provide low-cost drawbridges to any challengers wanting to storm these economic castles.
All you need is a funny video. In 2011, Dollar Shave Club launched on YouTube with a humorous clip urging people to ‘stop paying for shave tech you don’t need’, and it went viral.
Their video cost just $4,500 but substantially disrupted the market, and the firm was bought for $1bn by Unilever five years later. The blade market hasn’t been the same since – P&G’s grooming division revenue has fallen 21% since 2012, despite population growth.
Private lives
Own brands are also seeing a resurgence as consumers trade down to discount retailers, suggesting that price rather than perceived higher quality is what’s driving consumer behaviour today.
Survey after survey suggests consumers are happy to switch. A recent McKinsey survey reported that ‘Consumers are highly satisfied with private-label products, with 84% of respondents saying the quality of private labels is similar to or better than the quality of branded products’.
People may not come back, even if economic times improve.
The same report quoted the CEO of ICA, the leading Swedish and Baltic grocery retail chain, saying that ‘once consumers try a private-label product, they are often pleasantly surprised by the product quality, and some of them stick with private label’.
Saucy pricing
These value gaps may be more substantial than you might think. Try Tesco online and you will find a Gillette Mach 3 with four blades for £9 while the chain’s Essentials triple-blade razor with five blades is just £2.
A recent trip to Morrisons revealed a Patak’s korma sauce for £2.29 against own-brand curry sauce for 45p. Loyd Grossman’s Bolognese sauce was on ‘special’ for £2.99 – just not quite as ‘special’ as the Morrisons equivalent next to it for £1.09.
You get the picture. Supermarket chain bosses are now speaking truth to brand power. In March, the CEO of Kroger, the second-largest food retailer in the US, said that private-label brands were growing double digits, while the CEO of French group Carrefour said in April that ‘private labels gained a record three percentage points and now represented 35% of sales’. Carrefour is now targeting private labels being 40% of sales.
It is entirely rational for consumers to be price sensitive – overpaying for quality is a very bad strategy. But that truism isn’t confined to shopping. It’s also true for investing. Unfortunately, this seems to have been forgotten as low interest rates convinced many that ‘no price is too high for quality’.
Investors should accept that the low-interest-rate period was a generational anomaly and should be cautious about finding too much comfort from seeing familiar brand names in the funds they hold.
Revlon is a global brand but filed for bankruptcy last year, and Estée Lauder is down 22% in 2023 on a collapse in earnings.
At 45 times forward earnings and 27 times the highest earnings in their history, we see no sign of any value in Estée Lauder yet – just a sign of what lies ahead for their consumer-brand peers.