This week the FTSE-100 hit record territory, cruising towards 8,000. But some sectors in the UK market are faring better than others…
Early summer sunshine – at last
In the January edition of Master Investor Magazine, I predicted that the Dow Jones Index would continue rising over the course of this year and that it could possibly hit 30,000 by the end of 2018. I also predicted that the FTSE-100 would exceed 8,000. As I write the Dow is nudging 25,000 after another volatile week and the FTSE-100 is down a bit from its recently achieved all-time-high of 7,820. Despite the torrent of negative news from the Bank of England, the BBC – and even the usually self-effacing HMRC – the Footsie is on a roll.
There are a number of reasons for this. As the economist Filipe R Costa wrote in this month’s edition of the MI magazine, British equities, traumatised by uncertainty, look cheap even though extreme scenarios rarely materialise.
But canny equity investors need to dig deeper. Looking out to the second half of 2018 I am expecting this bull run to continue – but I am obliged to add a note of caution. Quite clearly, some sectors are motoring ahead while others are in the doldrums. This week, I want to flag two sectors whose fortunes are sobering.
Stock market investment is about what to buy and what not to buy. Diversified equity portfolios should have minimal exposures to these sectors and some individual stocks are candidates for short positions.
Why consumer staples are on the wane
They are fund manager favourites but here are three stocks which depress me.
Unilever (LON:ULVR) is planning to move its headquarters from London to Rotterdam. The company said its decision in March was “nothing to do with Brexit”. It fought off a £115 billion hostile takeover bid last year from Kraft Heinz (NASDAQ:KHC) and is believed to be seeking a safer haven – takeover rules in the Netherlands are tougher. The company is a brand master – it makes iconic British consumer staples such as PG Tips tea bags, Marmite, Knorr stock cubes, Dove soap and Persil washing powder. The Anglo-Dutch company dates from the merger of Dutch Margarine Unie and British soap maker Lever Brothers in 1929. The reason that Kraft Heinz cited for its bid was Unilever’s declining performance.
Reckitt Benckiser’s shares (LON:RB.) fell precipitously in February after having missed brokers’ profits estimates. The owner of such diverse household brands as Dettol, Mr Sheen, Nurofen, Scholl, Veet, Clearasil, Gaviscon, Durex and Harpic once looked like a sure-fire bet and was highly cash generative, paying steady dividends.
Nestlé (VTX:NESN), the Swiss food giant whose multiplicity of food and beverage brands such as Nescafe, Milkybar, Kitkat, San Pellegrino, Purina, Shreddies and many more is also looking vulnerable. The activist hedge fund manager, Daniel Loeb recently took a $3.5 billion stake in the company while calling for radical changes in strategy.
The consumer goods industry, one of the world’s largest, is now facing massive disruption due to deep and subtle changes in consumer behaviour. Revenues are falling and margins are under pressure. What is going on?
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A report by the consulting firm Bain & Co. published in March showed that after years of consistent growth the consumer goods industry started to stall in 2012. Over the period 2012-2016, according to Bain, 29 out of 34 consumer goods companies analysed suffered a fall in sales or profits or both. Like–for-like sales growth fell from an average of 7.7 percent year-on-year over the period 2006-2011 to just 0.7 percent over 2012-2016. Operating profit growth fell from 6.1 percent to 1.3 percent. Bain thinks there are four main reasons for this.
First, the period of rapid growth in previously booming emerging-market economies is over. Large countries such as Russia, India, Mexico and Brazil – which were hoovering up popular Western brands ten years ago – have seen their growth rates decline by 20-25 percent, while China has experienced a more brutal deceleration. That slowdown, combined with the strong devaluation of their local currencies, accounts for more than half the problem in top-line growth for many multinational consumer goods companies.
Second, the consumer goods industry experienced high levels of M&A activity in recent years. In the past, M&A spurred growth but now it is having a negative net effect as divestitures have been greater than acquisitions among the largest players.
Third, many product categories have disappeared due to unprecedented levels of disruption. Two examples that Bain gives are the transition from ground coffee to coffee capsules or from standard to craft beer. This is part of the rise of small artisanal producers who have arisen in local niche markets. One exemplar is the rise of so-called micro-breweries supplying a small number of bars in a local community. This is very common in the USA; while in the UK there has been a sudden upsurge of micro-distilleries making gin such as the East London Liquor Company. All of these are micro businesses in their own right; but, collectively, they are taking business away from the multinationals.
As a result of this disruption, only 40 percent of all so-called fast-moving consumer goods (FMCG) categories have experienced volume growth in excess of population growth over the past 10 years. In the US, small brands are 65 percent more likely than large brands to outgrow their category, according to Bain. In fact, less than 5 percent of the growth in US consumer goods between 2011 and 2015 came from the 25 largest companies.
Along with bricks-and-mortar retailers
Moreover, large retailers (the major customers of the brand masters) are in long-term decline (on which more below). As a result, they are cutting back on physical space. Witness Marks & Spencer’s (LON:MKS) decision to close 100 stores this week. In the food sector the only supermarkets that are growing are the discounters. Aldi and Lidl offer much less choice than traditional supermarkets. Famously, these don’t stock branded goods at all but rather sell generic goods. You won’t find Kingsmill bread, Mazola cooking oil or Twining’s tea in Aldi: these are all top-selling brands of Associated British Foods (LON:ABF).
The rise of online shopping has increased price transparency and thus competition. Amazon (NASDAQ:AMZN) is now moving into groceries and consumer staples with its Prime Pantry unit selling its own range of goods. The supermarket giants flourished in the age of the big weekly supermarket shop – but that’s not how people shop anymore.
In the past, mass market brands were sustained by mass media advertising. People of my generation can still hum the tune to the Fairy (a dishwashing liquid made by Procter & Gamble (NYSE:PG)) TV commercial. But that is not generally how young people tend to consume advertising these days. It is probably more important for P&G today that Amazon’s Alexa or Google Home recommends their product than that they run a successful TV commercial campaign. In any case, numerous studies have shown that brand loyalty is weakening as consumers focus on the bottom line – price.
Finally, Bain argues, activist investors such as 3G Capital now strongly influence the boardroom agenda, completely redefining the notion of the lean enterprise. The pressure to engage in major cost-cutting programmes aimed at short-term profit improvement has restrained new product development for some companies.
If anything, these trends are likely to intensify, such that it will become very difficult for traditional big players to make money in branded consumer products at all. Amazon’s current valuation may seem astronomical – as I write it is trading on a P/E ratio of 248! But if it could come to dominate the consumer products market with its own label products, that could generate huge additional sales and profits.
Doom and gloom in the retail sector
In the April edition of Master Investor Magazine, I discussed The Death of the High Street. I enumerated a litany of bankruptcies and so-called company voluntary arrangements (CVAs) in the bricks-and-mortar retail sector on both sides of the Atlantic. Since then, the outlook for retailers has, if anything, got worse.
I cited four main reasons why even much-loved retail brands like M&S were standing on the edge of a precipice. First and foremost, and most obviously, bricks and mortar retailers are losing business to their online rivals. Nothing seems to be able to slow the rise and rise of internet shopping. In the USA e-commerce is growing at about 15 percent per annum while sales for bricks and mortar retailers are growing at between one and two percent. The UK figures are of a similar order.
Second, bricks-and-mortar retailers have been highly leveraged, especially since the financial crisis. For a time they have been able to carry a heavy burden of debt given near-zero interest rates. This has been accentuated by a number of high profile leveraged buyouts in the sector. As interest rates trend back up again such highly leveraged companies will find it more challenging to service their debt. Refinancing of outstanding debt will also become more difficult. Retailers – and indeed restaurants – have to maintain high levels of working capital which means that their cost of capital is higher than that of service providers.
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Third, bricks-and-mortar retailers have not been able to trim their costs sufficiently. This is partly the fault of government – particularly in the UK, where large surface retailers pay exorbitant business rates. (Their customers also usually have to pay to park – another deterrent to physical shopping). Bricks-and-mortar retailing is also labour-intensive, so employee costs are a significant factor. As well as wages, retailers have to pay social charges (NICs in the UK) on those wages as well as pension contributions.
A fourth factor specific to the UK is that a weak pound further to the Brexit referendum has increased the prices of imported products, especially food. This has put pressure on margins.
For all this there are some niche retailers which are still expanding. One such is Mountain Warehouse (private), which started out as a stock clearance business selling branded goods but which now sells mainly own-brand outdoor clothing and footwear.
The short side
This month Greencore (LON:GNC), Debenhams (LON:DEB) and Pets at Home (LON:PETS) have followed in the path of the ill-fated Carillion to become Britain’s most shorted stocks according to wealth manager Cannacord Genuity.
Investors are currently punishing Greencore, the world’s largest sandwich maker by volume, further to a March profit warning and the announcement of the J Sainsbury (LON:SBRY)-ASDA merger. More than 15 percent of the company’s stock was on loan in the first week of March. Asset managers such as BlackRock, GLG PartnersandJP Morgan held short positions in the stock. Shares in Greencore over the last 12 months have fallen from 244 pence to 164 pence as I write – substantially up from their 13 March low of 127 pence.
Debenhams, the troubled chain of department stores, revealed an 85 percent fall in half-year profits on 19 April. This was partly attributed to the weather (the Beast from the East in early March). But there are clearly deep, systemic issues unfolding here. Institutional investors shorting Debenhams include UBS and Odey Asset Management.
Pets at Home suffered a double-digit fall in profits recently as well as the departure of its chief executive. Its share price has almost halved since last October.
Supermarkets also loom large in the list of shorted stocks including J Sainsbury, Marks & Spencer and WM Morrison (LON:MRW). The news from Marks and Spencer this week is sobering. On Tuesday (22 May) the company announced a massive restructuring involving the closure of about one third of its bricks-and-mortar retail space – but allied to the roll-out of new online sales capacity. On Wednesday (23 May) the company reported that pre-tax profits for the year to 31 March fell by 62 percent to £66.8 million, largely due to costs related to the group’s restructuring and store closures. When those costs are excluded, profits before tax were down by 5.4 percent because of weaker margins within the food division (as reported in Wednesday’s MI newsletter). Its shares actually jumped by five percent on the day.
The princess and the frog
Regarding the J Sainsbury-ASDA merger, it seems to me that the Walton family and their suits have got a much better deal than the venerable Sainsbury family and theirs. Both UK grocery giants have an essentially family-dominated management culture which has both great strengths and weaknesses. But the Sainsbury brand (I never said that brands don’t matter) is so much more potent than ASDA’s. Sainsbury’s is stylish, customer-focused and not cheap; while ASDA is no-nonsense, customer-friendly and inexpensive.
Many analysts have commented that there are few obvious synergies in this deal – except the oligopolistic opportunity to squeeze suppliers tighter. I predict that one strategy the new entity will pursue is to ditch consumer brands – just like Aldi and Lidl. No more Kellogg’s (NYSE:K) cornflakes, then.
The march of the artisans
The up-and-coming artisan producers are harder to invest in but many – such as the East London Liquor Company mentioned above – are raising money on crowdfunding platforms. (That is not an endorsement on my part – just an example of the current phenomenon).
But if gin and tonic is your thing – check out Fever-Tree Drinks (LON:FEVR). You could have bought their shares for around 210 pence two years ago but since then they have fizzled up to £29.05 as I write. Out of nowhere, they have a created a unique feel-good artisanal brand which people want (nay, need) even more than Harpicor Nurofen…
Headwinds
The FTSE-100 may be ignited by animal spirits this week but down on the ground confidence is not that great. There are two great clouds of uncertainty in the UK right now: Brexit, and the prospect of a Corbyn government.
Regular readers may have observed that – I contrast to last year – I have not written much about Brexit this year. That is because I believe that I set out in a series of articles last year precisely what I regard as the facts of the matter. Unless the government disentangles the UK from the existing EU customs union and agrees a comprehensive free trade agreement with the EU (which would be in both sides’ interests) the entire enterprise will be a waste of effort.
In terms of the ghastly Brexit negotiations, however, an irresistible force has collided with an immovable object. I shall explain shortly why I still think that a “no-deal” outcome is quite probable – and why it may even offer opportunities. I shall also explain why the HMRC estimates of administrative costs to business post-Brexit (which have sent the Remainer BBC wild as I write this) are based on facile and highly questionable assumptions.
And then there is (what I call) New Old Labour. This week Mr McDonnell, a putative Labour Chancellor of the Exchequer, told us that his real task was to overthrow capitalism. Increasingly, the Corbyn-McDonnell-Abbott agenda resembles that of Chavez-Maduro which has beggared one of the wealthiest countries in South America. Mr McDonnell is an admirer of Chairman Mao and carries his Little Red Book on his person. And yet university-educated children of respected friends are still planning to vote Corbyn…
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These two factors explain why the UK market has lagged of late. In mid-May the UK stock market was trading at a cyclically adjusted price earnings ratio (CAPE) of just over 15 compared with ratios of 20 in Germany, 27 in Japan and 30 in the USA. The average for emerging markets was 17. The UK dividend payout ratio relative to returns on government bonds also looks favourable compared to other leading markets.
Yet UK retail investors have withdrawn £5.5 billion from UK unit trusts since the Brexit referendum in June 2016 according to the Investment Association. It is evident that a number of major overseas institutional investors have also pulled out of the UK market as a result of the two great uncertainties outlined above.
One day – possibly sooner than we might think – those two great clouds of unknowing will dissipate. In the meantime, forget passive equity investment (heads I win, tails you lose for fund managers) and get sector specific.
You deserve to enjoy this party – and it could get a whole lot more raucous yet.