Straws in the wind?

March 10, 2021

3:15 pm

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. 

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. This article does not constitute investment advice and the names shown above are for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.
In case you missed it…

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland

The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) FIRST INDEPENDENT FUND SERVICES LTD, Klausstrasse 33, CH-8008 Zurich. Swiss Paying Agent: Helvetische Bank AG, Seefeldstrasse 215, CH-8008 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

Ready to start talking?