12 April 2016
Capitalism is often said to have a growth imperative. On a macro level, politicians have made promises that can only be paid going forward if economies grow, whilst at the micro level businesses which do not grow are expected to fall prey to creative destruction. Whilst the macro topic is interesting, and the likes of Kenneth Rogoff make some compelling challenges to it, my business is companies, so that’s what I’m going to focus on.
Let me start by stating plainly that we like growth, provided the business is riding the tailwinds of rising demand, be that online fashion or consumer goods in emerging markets. However, focusing on growth in mature industries, where demand is stable, is a recipe for disaster. Neither statement is really ground-breaking stuff, but my next assertion is more controversial: in developed markets, most industries are mature, with growth only eked out thanks to inflation and meagre population and productivity growth.
To put it simply, we are not going to consume more baked beans; a pay rise will not translate into an increased number of laundry washes; and we’ve seen all too recently what happens when banks chase growth in new markets such as subprime. Even sectors like automobiles, where you might expect some long term growth, have in fact been static, as can be seen on the chart below.
And this despite a 50% growth in the population of the USA since 1976.
Source: Bloomberg, Ward’s Automotive Group, 28 June 2016
Yet most companies’ annual reports will have, within the first five pages, some comments from the CEO about the growth in sales. The growth imperative is entrenched. The result is the cyclicality we see in so many industries: as the market expands, CEOs get busy investing to grow capacity only to find that the much anticipated demand from consumers wanting to concrete over their garden doesn’t materialise. They all suddenly realise the industry is in over-capacity, leading to price competition and the weakest players going under. At which point capacity gets more balanced, prices start to rise and the whole cycle starts again.
So are CEOs complete idiots? Well, let’s just say they’re caught in classic game theory. Investments tend to lower the cost of production, thanks to technological advancements which improve plant productivity. Therefore, if they do not invest whilst their competitors do, when the downturn comes they will end up being the high cost producer and be taken out. This can even happen in growing industries, as we’ve recently witnessed in the iron ore mining industry. Even the most bullish CEO did not realistically believe that the demand from China would match the entire production coming online. However, faced with the option of being a higher cost producer or investing to lower cost of production further, they all decided to invest.
China is big, but… Want to guess the direction of spot prices in the last two years? And the share prices have followed.
Source: Bloomberg, The World Steel Association, 28 June 2016
So where am I going with all this? I believe there is a better way. And, somewhat counter-intuitively, it is emerging from one of the least cyclical, best performing sector of all: the consumer staples industry. The new model’s best known pioneers are probably 3G Capital and Reckitt Benckiser. But before we go and look at what it is they are doing that is so revolutionary, let’s have a quick look at the industry they operate in.
The consumer staple industry also suffers from the growth imperative
Now, those are just excerpts – what you can’t quite see there is that in every single one of these cases growth was reported ahead of profits.
And who can blame them? If we look where value has come from in the Western consumer stocks, we find the largest chunk of returns since 2005 has been topline growth, followed by dividends, which together account for almost two-third of the value generated for shareholders.
But… what happens if we look at the top half in the sector? We find that margin has been a slightly larger factor than growth.
So what about the bottom half – have they really underperformed because of margin destruction? The answer is yes.
So what do we find if we go further up the value scale – does the margin story still hold? And the answer is again yes, in fact increasingly so.
And the answer is still yes when we wonder if this still holds true for the top decile.
Source for all the above: Bloomberg, 28 June 2016. Calculations by THS Partners
So, what does one make of all this? Yes, of course growth does matter to an industry’s return, the charts above are pretty clear on this. But if you want to invest in the winners, invest in those who focus on the margin, not those who focus on growth. This is good news as margin improvement is also easier for a company to achieve than growth; costs, the largest part of margins, are largely under their control. Note that the growth seems to follow – the top quartile stocks have also experienced significantly higher growth than their pedestrian peers. Why should that be? There are many reasons, but M&A is one of the top ones; those with materially improved cash flows have been able to buy out weaker companies, or part of their product lines.
And this is exactly what the Reckitt Benckiser and 3G Capital of this world have done – they have first and foremost focused on operational efficiency. They then used the cash flow generated from their improved operations to buy other companies or product lines in areas where they could see interesting things happening – be that another opportunity to improve margins or higher growth.
Reckitt Benckiser embarked on this path after their merger in 1999, and look at the margins:
Margins expanded from 11% to 25% over 17 years has made shareholders 13.5x their money, or 17% IRR (including re-invested dividends). The EM exposure has been modest (~25%). Source: Bloomberg 6 July 2016
Then observe the invested capital discipline, which has only risen due to acquisitions:
Source: Bloomberg, THS Partners commentary, 6 July 2016
Naturally, there will be pushback against this assertion from many parties who will say margins improved thanks to growth, not the other way round. Though my charts above pretty much disprove this, the best way to comprehensively debunk this idea is to look at volume growth. That’s obviously harder to do – product mixes change the whole time, volume numbers aren’t consistently reported, etc. But we can look at single companies in more commoditised product areas – e.g. the beer volumes of AB Inbev in North America.
ABI has managed to grow earnings every year since the Inbev takeover (and cash flows even more), despite falling volume. The fall in 2015 was due to a revision to cost assumptions in the post-retirement healthcare benefits as well as a modest increase in brand investments – brands still matter.
To summarise, we argue that:
- Growth is a good thing at industry level
- But the winners within an industry are those that focus on operational efficiency (margins)
- The cash flow generated by efficient operators will enable them to have their pick of growth-focused less efficient operators. They will therefore outgrow the industry via M&A
This new model to prioritise efficiency over sales growth has been pioneered by Reckitt Benckiser and 3G capital. Margins do not however grow to the sky, as eventually competitive pressure will put a lid on them. Until then, significant shareholder value will be created by those who prioritise operational efficiency over growth.
 Rethinking the Growth Imperative, Kenneth Rogoff, 2 Jan 2012 https://www.project-syndicate.org/commentary/rethinking-the-growth-imperative
This report was prepared exclusively for the benefit and use of the recipient and does not carry any right of publication or disclosure. Neither this report nor any of its contents may be used for any other purpose without the prior written consent of Taube Hodson Stonex Partners LLP. Circulation is restricted to professional and institutional investors only and is being furnished on a confidential basis. This report may include forward-looking statements which are inherently uncertain and based on assumptions that could change as a result of company operating performance, capital markets risks and general economic conditions. Please note that the content above is not intended to provide advice of any kind and should not be used as the basis of any investment decision, nor should it be treated as a recommendation for any investment. This report is provided for information purposes only and is subject to change. Reference to specific securities should not be construed as a recommendation to buy or sell these securities but is included for illustration purposes only. The report may contain projections, estimates or forecasts about specific securities but it should also be noted that the views expressed may no longer be current and may already have been acted upon by Taube Hodson Stonex Partners LLP. Unless otherwise stated, the information and views in this report are the result of our own research and in preparing this report, we may have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by related parties. No warranty or representation is given to this effect and no responsibility can be accepted by Taube Hodson Stonex Partners LLP, to any intermediaries or end users for any action taken on the basis of the information. Past performance is not a guide to the future and the figures and returns in this report are purely to illustrate the author’s points. The value of investments can go down as well as up and an investor may get back less than invested. For investments in overseas markets, changes in currency exchange rates may affect the value of an investment. Investments in a currency other than an investor’s own currency will be subject to movements in foreign exchange rates. Issued by Taube Hodson Stonex Partners LLP, authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered address: Cassini House, 1st Floor, 57-59 St. James’s Street, London, SW1A 1LD.
Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
Reference to a specific security is not a recommendation to buy or sell that security.