The Value of Predictability


The Value of Predictability


April 2017

Consumer Staples has always been a core part of our portfolios. Facing both a transforming customer profile, epitomized by the globally large millennial generation, which in turn is helping drive the growth of digital advertising and e-commerce as a key route to market, and the rise of Emerging Market competitors, life has become more complex in Staples-land. The days when a Staples company just had to flood TV channels with advertising, and the seemingly homogenous Emerging Markets with product, are gone.

In this more complex world it is crucial to be selective. Some segments, such as beauty, consumer health, spirits and tobacco, are more attractive than others, such as food and beer, given either better volume growth (beauty and consumer health), more opportunities for premiumisation (spirits) or stronger pricing power (tobacco). Managements have also become more important. It is crucial that businesses are ‘fully invested’, not skimping on innovation and the associated advertising and promotion to inflate short-term profits at the expense of the franchises. In addition, companies need to be more decentralized and entrepreneurial in the new era. They need to battle the improving competitors in the Emerging Markets and upstarts in Developed Markets whilst navigating the more complex media environment. This cannot be done in command and control mode from the Group Head Office. Our view is that with the right segments and good management, Staples companies can grow their top-line at 2%+ in Developed Markets and 6%+ in Emerging Markets, while steadily improving margin.

Companies need to be more decentralized and entrepreneurial in the new era.

The valuation for Consumer Staples does not look demanding, particularly in relative terms, with a premium of only 20%1 versus the MSCI World Index on the next 12 months forward earnings, and around half that in free cash flow terms. Valuation has certainly not deterred M&A activity. Most famously there was the ‘clash of civilisations’ when Kraft Heinz made a short-lived bid for Unilever.2  The 3G/Kraft Heinz philosophy is to slash costs, boosting margins massively, even if this comes at the expense of top-line growth. Unilever's approach of steady sales growth along with some margin improvement may deliver steady compounding, as opposed to a one-off step-up in margins. That said, Kraft Heinz's bid may prove to have been helpful in accelerating Unilever's existing margin improvement plans and perhaps triggering some welcome asset disposals.

Valuation has certainly not deterred M&A activity.

Reckitt Benckiser is taking over Mead Johnson, the baby food company. Baby food is an attractive segment, perhaps close to its bottom in the key Chinese market. While new to Reckitt Benckiser, the category plays into its traditional core competence of exploiting neuroses, be they about spots (on faces or clothes), insufficiently shiny drinking glasses at dinner parties, germs in the house, or now marketing high quality infant nutrition to parents for their little ones. The company has a proven track record of improving what it acquires, taking out cost and working capital, and accelerating sales growth. This is helped, as in this case, where it is effectively replacing a scientist-orientated management with seasoned marketers.

Finally, British American Tobacco is buying the 57% of Reynolds American it does not already own.3 Here we see revenue opportunities around “Heat not Burn” cigarettes, the next generation of reduced-harm smoking, where British American Tobacco and Philip Morris International are leading the way. The U.S. tobacco market is attractive in general, given the increased concentration and the relatively low cost of smoking, but it is also a natural market for this new technology. Owning the whole of Reynolds American will help spread its reduced-harm product “glo” across the United States. Any progress that President Trump makes in reducing corporate tax rates may also help the economics of the deal.

High quality Consumer Staples companies, in the right segments and with the right management, are a useful source of that predictability in our opinion.

We would argue that predictability has value in a deeply uncertain world where the MSCI World Index trades on an historically high 16.6 4 times next 12 months earnings, earnings which themselves include an assumption of double-digit earnings growth. High quality Consumer Staples companies, in the right segments and with the right management, are a useful source of that predictability in our opinion, which along with high returns on capital and decent growth can help them compound steadily over time. As such they are likely to remain a core part of the portfolio.

Head of International Equity Team
Managing Director

1 Source: FactSet; as of 31 March 2017.

2  On Friday, 17th February 2017, Kraft Heinz disclosed its unsolicited bid for Unilever. Unilever rejected the bid. On Sunday, 19th February 2017, Kraft Heinz withdrew their offer.

Source: British American Tobacco Press Release, 17 January 2017.

FactSet; as of 31 March 2017.

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