Charlotte Moore finds that the consumer sector is no longer all about staples and cyclicals, but rather brands and emerging markets
It may seem counterintuitive to consider consumer goods as a safe haven for investors when the outlook for the economy looks bleak. After all, retail spending is one of the first areas to bear the brunt of a recession.
But not all consumer goods are created equal. Consumers can go without new discretionary items such as white goods and clothing, but the same cannot be said for staples like toothpaste or food. Companies that produce yoghurt and deodorant like Unilever, Nestle and Danone tend to perform well during a crisis and investors often seek refuge in these stocks. That has been no different during this recession: these stocks’ valuations are currently at 35-40% premium to the market.
“The food and drink companies have several positive points in common,” says Frédéric Buzaré, equity strategist at Dexia Asset Management. “They have resilient revenue growth, their margins are improving, and they also generate high free cash flows and have good earnings visibility.”
If times got really bad consumers might have to start cutting back or downgrading their food and toiletry choices. But food is cheap in Europe: the average household spends between 10-12% of their monthly budget on food and beverage. Moreover, food producers will benefit from the likely fall in soft commodity prices next year, which could help protect their operating margin.
“This is such a small proportion of the monthly household budget, compared with the amount spent by emerging market consumers on similar staples, that there is little likelihood that sales would fall dramatically in the developed world,” Buzaré says.
Indeed, these companies enjoy strong pricing power precisely because human behaviour is such that shoppers tend not to react to feeling the pinch by ditching all their favourite brands for cheaper versions, but rather become yet more loyal. Just as consumers are prepared to stump up extra cash for trusted brands in times of uncertainty, investors are prepared to pay a premium for stocks with these financial characteristics.
Didier Rabattu, manager of the Lombard Odier Investment Managers (LOIM) Emerging Consumer fund, says that his largest European holding is Danone. This company has underperformed Unilever and Nestlé over the last three years after its 2007 acquisition of Numico was not well received by shareholders and it mismanaged a capital raising in 2009.
“Danone is the fastest growing of these three companies,” says Rabattu. “While the stock is currently trading at a discount to the other two companies, we believe that it will reverse this position in the coming months.”
There will also be considerable difference in performance between the giants of the sector and the smaller companies.
Aiden O’Donnell, food analyst at Davy Research, says: “Smaller companies, like Premier foods who struggled in 2011, are likely to continue to underperform since they have poor brands, and many of them also have balance-sheet constraints and an inability to generate cash. They may well have to refinance, which remains difficult in the current market environment.”
His colleague, beverage analyst Barry Gallagher, adds that it is not only sellers of consumer staples that are performing well in the US and Europe: “Sellers of premium brand spirits like Diageo are also performing well.”
There are two trends responsible for this strong performance. First, there has been a bifurcation between the different socio-economic groups in the US and Europe. “Those at the top end of the economy have not yet significantly changed their consumption and spending habits - they are still spending on ‘affordable luxuries’ such as premium spirit,” says Gallagher. “The slowdown in discretionary spending looks more pronounced in the middle-income cohort.”
Second, consumers are cutting back on spending in restaurants and bars, but they are spending more on premium brand food and drink to consume at home. “The luxury end of the ready-made meal market is booming,” says O’Donnell.
Food and drink giants, like Unilever and Diageo, do not only sell their products in Europe and the US, they are expanding into emerging markets, which are proving particularly lucrative for drink manufacturers. “I think of Diageo as a sleeping giant,” says Buzaré. “It has not grown in line with the industry - it had too many brands. But they’ve now streamlined their product lines in the emerging markets and we’re just beginning to see the benefits of this strategy.”
It is not only Diageo that is benefiting from the increasing wealth of the emerging market consumer - luxury goods companies are too.
Traditionally, the performance of these companies, which are often referred to as either discretionary or cyclical consumer stocks, was strongly yoked to that of the economy: few regard a new handbag or party shoes as a necessity. But this economic crisis has been different for the likes of Prada and Hermes. The US and Europe may be experiencing an economic downturn but the emerging markets are not, and luxury goods manufacturers are reaping the benefits of the love affair between the Chinese consumer and western high-end brands. During the last recession, sales to emerging markets contributed only 25% to revenues. The contribution has grown strongly since then and shows little signs of slowing.
Anne Le Borgne, manager of Amundi Funds Equity Global Luxury & Lifestyle, says: “Sales to Chinese consumers will contribute 40% to sales for luxury good companies by 2015.”
Jack Neele, fund manager of Robeco Global Consumer Trends Equities, says: “The Chinese are the key consumer of ultra-high end goods. They place so much value on western goods that they are prepared to pay a premium for a BMW that is made in Germany rather than exactly the same car made in China.”
As well as having the disposable income to spend on handbags and sunglasses, Chinese consumers are spending money on trips abroad. In 2010, the flow of tourists from emerging markets grew 8% compared with 5% for developed countries, according to the World Trade Organisation (WTO). And when Chinese tourists visit Via Condotti in Rome, they make sure they drop in at Prada to buy the latest handbag.
Le Borgne says: “There is a slowdown in local [European] consumption but that is being more than compensated for by the strong spending of Chinese consumers. Luxury brands do not disclose the proportion of sales made in Europe by Chinese consumers, but they estimate that 50% of sales are made by tourists.”
The luxury companies have strong balance sheets with either low levels of debt or considerable cash, which is enabling them to continue opening stores in emerging markets, further fueling organic sales growth. Tough overseas sales comparables - sales in Asia-Pacific this year grew by around 30% - will also contribute to lower sales growth in 2012, and some investors fear that these stocks are too dependent on the continued financial health of the Chinese consumer and cannot be immune from the downturn in the developed economies.
But Le Borgne says that the luxury goods companies are expanding into other currently underpenetrated emerging markets. A recent report by the WTO said they expect the spending growth of the BRICs and Asia to rise by 12% per annum between 2011 and 2020. Sales of luxury goods in Russia, the Middle East, India and Latin America will fuel the medium to long-term growth of the luxury sector, says Le Borgne.
All of this positive news is factored into the share prices of these companies: but while they are trading at a significant premium to the market, the current valuation at 16-times next year’s earnings is below the historic valuation of 21-times.
“I think that this sector will manage to maintain its premium to the market,” says Le Borgne. “Share prices could well appreciate further if we get some re-assurance from the companies early next year that they can continue to grow earnings at a double-digit rate despite the slowdown in the European economy.”
The business fundamentals for both the consumer staples and cyclicals still appear to be sound. Investors must ask themselves if they think that the good news is factored into those companies’ share prices or if a higher premium could be achieved.