In a year of extreme uncertainty caused by the coronavirus, it is not surprising that investors have sought out the relative safety of companies with less economically sensitive and therefore more stable profit streams. The result of this however is that as investors have shunned cyclicality and favoured predictability, so the valuation premium that they now have to pay for relative certainty has increased to levels rarely seen in stock markets. These more predictable businesses are sometimes referred to as ‘bond proxies’ as they are seen to offer a large element of the safety that comes from investing in bonds. They can be found in many different sectors of the market, although most are found within consumer staples (food, beverage, home and personal care), medical devices and technology.
For many of these companies, 2020 capped off a multi-year period of strong investment performance, driven to a large extent by falling interest rates in a period of relatively sluggish economic growth and aggressive central bank action. That is not to say that the companies themselves have not played a part as many have taken active steps to maximise shareholder returns. As a group, they have been disciplined in using price increases to drive revenue growth, whilst maintaining a tight handle on expenses. The result has been margin improvements and operating profits that have therefore risen faster than revenues. Many have further juiced-up returns by using leverage to buy back shares, thereby reducing the share count and further increasing the company’s all-important earnings per share.
Therefore, through a mixture of price increases, margin improvements, increased leverage and a lower share count, the companies have been able to turn sluggish levels of sales volume growth (which is arguably the most important indicator of a company’s underlying health) into attractive levels of earnings per share growth, and this at a time when many investors have sought out the perceived safety that comes from investing in these types of businesses. And as we all know, good growth in earnings per share coupled with a re-rating in the stock market, make for a heady cocktail when it comes to share price performance. However, this is now in the past and the most important question that investors must ask themselves is to what extent these trends are sustainable.
Although this group of companies is less susceptible to the vicissitudes of the economic cycle, they do nevertheless operate in competitive industries, which in many cases are undergoing fundamental change. In the consumer space, this change is the advent of challenger or craft brands which resonate more effectively with the evolving tastes of the modern consumer. It doesn’t matter whether it is breakfast cereals, razor blades, snacks or alcoholic drinks, these new brands are now a force that they just weren’t twenty or even ten years ago. This creates a challenge for the more established companies which need to innovate and thereby invest in their product offering in order to stay relevant.
The dangers of under-investment are most aptly demonstrated by Kraft Heinz, which levered up whilst undertaking an aggressive program of cost cuts. The short-term result was that margins rose to 28% in 2017 and earnings per share grew strongly. In anticipation that these trends would continue, the stock market valued the company at 25x earnings. Unfortunately, in order to deliver that level of profitability, the management had to starve the business of investment, and whilst this is possible for a while, ultimately it will result in stagnating or falling revenues. This is indeed what happened at Kraft Heinz and the company was forced to reset margins downwards. Margins for this year are expected to be around 20% which, when coupled with the additional leverage, has led to a 30% drop in earnings per share. As the stock market is now feeling a lot less optimistic about the company’s prospects, its rating has moved from 25x to around 15x. A combination of lower earnings and a reduced valuation multiple has resulted in a 60% decline in the share price. The lesson here for investors should be that investment to drive revenue growth invariably comes at a cost to margins which when combined with increased leverage can be very damaging to share price returns if prior expectations have become detached from reality.
Although one could argue that Kraft Heinz was an extreme example, are there any signs of this happening elsewhere? Are there straws in the wind which indicate that life is about to get tougher for these companies? We cannot be definitive here of course, but we would make the observation that a number of companies in this space have recently warned of the need for a margin reset in order to provide the ammunition for increased investment. At its full-year results, Smith & Nephew reset margin expectations in order to drive increased research and development, whilst Sage lowered profit expectations saying that its margins would fall because of a need to increase investment in its cloud offering. Meanwhile, the German company Beiersdorf, talked of a second margin reset in two years, reducing margin expectations from 16% to 13% in an effort to reignite growth and even Unilever reduced margin expectations as a result of input cost inflation (which is a potential topic for another day) and the need to reinvest in its product offering. Each of these four shares have fallen by between 10% and 15% in the last few weeks and yet they continue to trade on price to earnings multiples of between 18 and 27 times.
Investors must always be alert to companies that are ‘over earning’ as here the risk is that a profit reset will prove damaging to returns. We therefore actively look to avoid companies which are at risk of being ‘run too hot’; perhaps where management teams have pulled out all the stops to impress a demanding stock market and thereby reap the benefits of generous incentive packages. We worry that this is what has happened amongst many of the stock market’s most dependable performers over the last few years. High starting valuations and some clear signs of margin pressure suggest that in the future these companies may not be as dependable as investors have come to expect.