GAM Investments’ Swetha Ramachandran believes premium brands with strong pricing power and a loyal customer base are likely to be among the top performers in an inflationary environment.
Inflation is currently top of the mind for many investors, corporates and consumers. As a result, pricing power is the ‘thème du jour’ for the market and specifically the branded consumer goods sector, with corporates seeking to pass on rising inflationary pressures through pricing to mitigate their own margin pressures. In October, during a Q3 2021 earnings call, Charles Bergh, CEO of Levi Strauss, highlighted the huge difference that can be made by a brand’s strength. “In 2011, we didn’t have pricing power. The very different situation today is that we’ve been able to take pricing over the last 12 months and it’s sticking.” In November, Ferrari CEO Benedetto Vigna made a similar observation; Ferrari is a premium brand for which customers are prepared both to wait and to pay up. “There is a way to manage [the waiting list] properly by adjusting prices and in fact we already started to increase prices so that we can manage this situation properly. Usually customers are also willing to wait a little bit, because when you drive a Ferrari, you don’t just drive a car, you drive a Ferrari car.”
Many companies in the luxury space remain confident in their pricing power due to the strong underlying demand for their respective brands. How do we evidence pricing power? Quantitatively, we look to gross margins as well as stability of gross margins. In this respect, the luxury sector scores favourably on both counts. We note that forecast gross margins for most of the companies in the sector are similar to their historic averages, despite higher cost inflation than at any point in the last three years, suggesting what has been anecdotally confirmed, namely, the ability of strong brands to pass on inflationary pressures through pricing.
Chart 1: Gross margins in the luxury sector – forecast and historic
With the expected return of inflation increasingly dominating investment approaches, we take the view that pricing power in the luxury goods sector can likely offer a reliable hedge against inflation, as has been demonstrated over time. Forbes, which has been tracking a Cost of Living Extremely Well Index – comprising a basket of goods typically purchased by luxury consumers including watches and handbags but also opera tickets, cosmetic surgery, and thoroughbred horses – noted 2021 inflation of 10.1% in its basket. This compares to a cumulative average of 5% since it started tracking it in 1982 till the end of 2021 – two times US CPI over both periods. The 10.1% jump is the biggest in its custom index since 2008, with fashion inflation particularly noted at +10.8% (versus +1.1% in 2019).
Chart 2: 40-year history of Forbes’ Cost of Living Extremely Well Index versus US CPI
Federica Levato, an industry expert at Bain, has commented that customers are becoming more accepting of higher prices as younger consumers are more motivated by ‘price relevance’ than by the actual price – with price relevance referring to the ‘perceived value’ of an item. While the expectation is that customers will continue to polarise, in terms of spending and attitude towards luxury, Levato says: “Brands will need to develop a credible offer at different price points, to increase their relevance with different customer audiences, but staying true to their core DNA and positioning”.
The thriving resale market is also playing an important role in underpinning the sector’s pricing power credentials. The appeal of ‘pre-owned’ is increasing significantly with younger, more sustainability-minded shoppers looking to increase the circularity of their fashion consumption. The investment appeal of luxury products further reinforces these consumption habits. Rebag, a luxury resale platform launched ‘Clair’ – Comprehensive Luxury Appraisal Index for Resale – two years ago, built on six years of constantly updated data. As expected, the data shows the triumvirate of Hermès, Chanel, and Louis Vuitton holding their place in 2021 as the top three labels in terms of brand value despite a global pandemic – in large part attributable to the brands’ control over pricing and inventory (see Chart 3). While Hermès handbags are top of the list, retaining an average of 90% of their retail value, Louis Vuitton followed with 80%, gaining 17 percentage points over 2020 in terms of value retention. Interestingly, the strongest and most consistent climber since 2019 has been Kering-owned brand Bottega Veneta.
Chart 3: The value of brands
Similarly, in the watches and jewellery category, three brands – Van Cleef and Arpels, Rolex and Cartier stand above the rest with Van Cleef pieces noted to retain an average of 95% of their retail value, followed by Rolex and Cartier at 82% and 74% respectively.
What does this mean for luxury and premium brands?
We note that not all companies will benefit equally from pricing power, particularly in wake of the ‘hyperpolarisation’ in consumer tastes that has persisted since the start of the pandemic. For leading brands, the role of price rises against the backdrop of fairly inelastic demand, combined with rising inflation, could act as a powerful motor for margin expansion, considering the 25% - 30%+ margins the sector earns on average. We believe the market is underestimating the role of price rises on margin expansion in the current and coming years and investors continue to search the market for brands with strong pricing power not currently reflected in valuation. Hermès and, as mentioned above, Ferrari are examples of two companies whose above-average valuations reflect not only a relative supply scarcity but also strong pricing power (itself a function of scarcity), in our view. We believe brands as wide-ranging such as Cartier (owned by Richemont), Levi’s and L’Oréal are moving to elevate their product mix to benefit from the pricing halo that used to be the preserve of fashion and leather brands alone. The resale value of stronger brands propels both confidence in the first-hand market as well as an opportunity for younger, sustainability-minded shoppers to enter the luxury category and adopt a ‘buy less, buy better’ mindset.
If we do enter an inflationary environment, we believe luxury companies able to pass on price rises to a loyal customer base are likely to be among the top performers.
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 not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented and are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. There is no guarantee that forecasts will be realised.