AI #15: The hottest investment story of 2011

I'm sure you've watched it happen many times. You find an investment story that you hope will deliver healthy returns for a few years. You settle on the best way to invest. And then suddenly the stock catches the public imagination.

Within months, a stampede of investors has sent the stock far beyond any reasonable valuation. And you fret about getting burned.

I'm sure that most of you were investing during the dotcom bubble, so you know that anxious feeling well. Those overheated years probably had a permanent effect on you. They certainly did for me.

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Right now, there's no doubt what the hottest story around is: the emerging market consumer. No one seems to have any doubts about the potential of billions of new consumers joining the global economy in the decades ahead. And that should make us ask some careful questions.

I don't have much doubt about what's going on on the ground. Not every emerging market has got its act together, but many are making rapid progress. Incomes are rising, living standards are changing and the consumer boom is very real and will run for a long time.

But the internet boom was also founded on real breakthroughs that are delivering benefits even now. The problem the bubble came because people believed the hype and paid too much to be involved in the action.

Could the same happen again this time? Yes. Has it? I don't believe so.

In this week's issue, I'm going to look at why history suggests that we should be willing to pay more for some top consumer companies than we would for most stocks. We shouldn't get carried away but there is some evidence to suggest that they can deliver much stronger long-term returns than we might expect.

At the end of the letter, I'll also be giving you the key information from my meeting with Petra Foods, one of the Asia Investor consumer plays, and updating my buy limit to reflect the latest results.

But first let's have a look at why consumer stocks might warrant a higher valuation than most other stocks.

The power of a great brand

A top consumer brand can be a very powerful thing. Makers of snacks like Mars Bars, drinks like Coca Cola, household goods like Domestos, medications like Nurofen and personal care products like Crest, as well as those old standbys of cigarettes and alcohol, have done extremely well over the long run.

Why? First, they're bought, used and replaced on relatively short cycles (that's why they're often called Fast Moving Consumer Goods). Shoppers display brand loyalty, buying the same type each time. People continue to purchase these goods even during recessions. All this results in stable demand.

Second, competition isn't too ferocious. These industries tend towards oligopoly, with a small number of firms controlling many brands and not fighting aggressively with each other on price. Each firm is the sole producer of its brand and it's tough for potential new entrants to build a brand that shoppers instinctively reach for. Technological developments don't often make existing products and brands obsolete. So solid margins can be sustained and investment requirements are not onerous.

Third, higher incomes mean increased consumption of many of these goods, including the tendency to trade up to higher-value products once consumers can afford them. And the way that most of these goods seem like necessities once a consumer begins using them plus the relatively low absolute price each time they go to buy makes it easier to raise selling prices. So producers are able to pass on higher costs and benefit from greater wealth, ensuring steadily rising real earnings over the long term.

Contrast this with durable goods, like refrigerators, music players or cars. Each consumer only buys one occasionally and demand falls during recessions. There is typically little brand loyalty (except perhaps for the occasional firm like Apple). Competition is tough: because the price point is higher, consumers shop around for discounts. Life cycles are short: new research and development is needed to keep up the competitor's new model, meaning high investment requirements. Yes, people will certainly buy more of these goods as they become wealthier but that may not translate into strong profit growth over the long run.

So it seems likely that staid-looking makers of ice cream and tissues might deliver better returns than much more exciting looking industries over the long run. Of course, we can't just assume this we need to look at the evidence.

Unfortunately, long-term sector studies are pretty thin on the ground. But Jeremy Siegel of Wharton has done some work based on the fate of the original members of the S&P500 when it was created in 1957. The following table comes from a study by him and Jeremy Schwartz published in 2004, and summarises the average annual performance by sector between 1957 and 2003. (Where firms were taken over, the study assumes the proceeds were invested in the buyer if it was listed, or in the overall index if it was taken private.)

The results are in line with what we expect. The type of firms we're looking for are typically classed as Consumer Staples or Healthcare there's a lot of overlap between and we can see they're the two top sectors. The outperformance between these and less strongly performing sectors adds up substantially over time: in this data set, the average gain over 10 years is about twice as large for Healthcare as for Utilities.

Not only were these sectors the top long-run performers, they also seem to have been fairly reliable, as we speculated they should be. I don't have a decade-by-decade breakdown for the entire period, but the data below from David Rosenberg of Gluskin Sheff shows sector performance in the S&P500 over the last three decades. Consumer Staples and Healthcare weren't always number one, but they were consistently decent, even producing positive returns over the last decade.

But we're interested in something a bit more specific than the overall sector. We're really looking for dominant consumer companies the market leaders and top brands rather than any old producer of sandwich bread or bottled milk.

This is a slightly harder thing to measure, but if you go back to Siegel's work and look at the very top performers in the S&P500 from his study, you'll notice something interesting. Of the top 20 performing stocks that survive from the original 100, 18 out of 20 of them are Consumer Staples or Healthcare companies that own strong brand names - the exceptions being oil firm Shell and engineering group Crane.

What should you pay for this growth?

Valuing stocks is a very inexact business. There are lots of tools that we can use, but ultimately, all of them come down to trying to estimate what will happen to a business in the future something we can't do with any degree of certainty.

When I'm looking at a stock I try to recognise that I can't predict the future and avoid the temptation to be misleadingly exact. Instead, I aim to satisfy myself that this is a good business. Then I think about different possibilities for how it might change more conservative ones and more optimistic ones. Then I come up with a range of future valuations based on that and I set my buy limit which needs to be a concrete number in line with the more conservative end of that.

Usually, these businesses will be established, stable and profitable, if often small. They're non-cyclical, secure in their markets and have some protection from a new low-cost competitor moving in. They should have reasonably low capital requirements and not be threatened by improvements in technology. Management should be capable and committed to the company (I like family businesses for this reason). The balance sheet should be solid, and the firm should be generating cash and paying dividends. Earnings growth should be sustainable for several years at a high single-digit to mid double-digit pace.

If a business like this is on a p/e of under 15, I'm probably interested in looking further. If it's under 10, I'm likely to be very interested. And if it's over 20, I'd probably consider it too pricey unless it operates in a handful of very specific areas.

Consumer staples are one area I am prepared to pay over 20. And another fascinating study by Jeremy Siegel implies I am right to do so. In this study Siegel examined the fate of the Nifty Fifty a group of high-growth companies that investors were extremely excited about in the late 1960s and early 1970s, bidding them up to p/es of 40-50 or more in many cases.

In the study, Siegel calculates the return on each between 1972 and 1995 and also calculates both the original p/e at the time and what the warranted p/e' would have been (ie the p/e that would have produced long-term returns in line with the market average).

You can see the results below. It's clear that Consumer Staples and Healthcare firms commonly justified the high valuations placed on them and managed to deliver above-average returns from strong earnings growth, while other firms typically didn't. And if you're questioning whether the overall market was expensive at this time ie the Nifty Fifty were less expensive relative to the market than they seem the market p/e in 1972 was 19.3, against an average of over 40 for the Nifty Fifty.

Now, obviously we need to be careful with our conclusions from this. First, this is solely based on the experience in the US (that's where the data is best and most consistent, and it's where researchers tend to study the most). Although it seems reasonable to suspect that what happened in the great American consumer boom has a fair chance of being repeated in an even bigger Asian consumer boom, we can't be certain of that.

Second, although the consumer stocks outperformed in the long run, they had ups and downs. The Nifty Fifty had a tough time in the mid 1970s and underperformed the overall market. Those steep valuations may have been justified for some in the long run, but that was no consolation to those who'd bought in near the top and didn't have a couple of decades to wait.

Third, all that this suggests is that top consumer brands may outperform the market in the long run. It doesn't mean that any old consumer firm will do so and it doesn't guarantee that we will pick the winners.

That said, I don't think it's insane that we should be willing to pay more for the best consumer companies in emerging markets than we would for most other kinds of stocks. Obviously, the 50, 60, 70 times earnings that some of the Nifty Fifty subsequently justified would be a huge gamble on everything going right. But should we be willing to pay in the 20s or even 30s?

That doesn't seem to be too much of a stretch. It is difficult to be completely confident in the analysis, especially since long-run data in most emerging markets is pretty sketchy but most of what I see points in the same direction. For example, according to one fund that holds Nestl's and Colgate Palmolive's Indian subsidiaries - which are independently listed in the country, due to historical regulations there - these two stocks have traded on a forward p/e of around 30 for three decades and have still returned an average of 28% and 27% per year respectively over that period, excluding dividends.

It's because of this potential that consumer staples firms are a key part of the Asia Investor portfolio. While I don't restrict the kinds of stocks I cover too much because I want to have the scope to recommend anything that I think is attractive, there are two types of investment that are going to be more common than others.

The first is good quality small and mid caps, because these are typically under-researched and often cheap - I'll be writing about this separately in MoneyWeek Asia on Thursday. And the other is these stocks that are or could become some of the top consumer brands in Asia.

What are these potential future heavyweights? Well, we have a few in the portfolio already, such as Vitasoy and Hsu Fu Chi. And we'll adding more in due course. I've compiled a list of about 50 or 60 names that are worth knowing.

I'll look at the list in detail in a future issue. But now, let's move on to a quick update on Petra Foods.

Why I'm raising my buy limit on Petra

Petra is an interesting business that has elements of both a high-priced consumer firm and a cheaper, less glamorous one. As you may remember from my original note, this Singapore-listed firm is a specialist in cocoa and chocolate, with a dominant position in the Indonesian market.

I was able to get a meeting with Petra's finance director on my latest visit to Singapore, which was extremely helpful in clearing up some points about how the company operates. So I'd like to update you on that and alter my current recommendation to reflect the latest results and outlook.

To recap briefly, Petra has two main divisions, cocoa ingredients and branded consumer. Although these both spring from the same raw material, they are very different, to the point where Petra is effectively two separate business, as we'll see below. In the first nine months of 2010, the two sides contributed roughly equally to Ebitda (earnings before interest, tax, depreciation and amortisation) as the chart below shows.

Petra doesn't break down earnings at a lower level than this, but based on the respective assets of each division and some assumptions when allocating debt, I would estimate that cocoa ingredients accounted for around 30% of overall net income and branded consumer for 70%. That's because the cocoa ingredients division is more capital intensive and has higher depreciation and finance expenses.

The cocoa ingredients business produces intermediate products cocoa liquor, cocoa butter and cocoa powder that are sold on to manufacturers such as Nestl and Mars, who are increasingly outsourcing these operations.

This wasn't the side of the business that originally attracted me to Petra: it seemed a fairly generic processing business. But I'd satisfied myself that it didn't have the faults of many processing business: while it's fairly capital intensive, it doesn't have the enormous cyclicality and exposure to price swings that makes industries such as steelmaking so unattractive. Petra produces ingredients to order, on committed contracts with creditworthy leading multinationals, and hedges its cocoa bean price risk using futures when orders come in.

It seemed a respectable, if unexciting business. But I was interested to know why Petra thought it worthwhile. So what did I learn? First, there's obviously increasing long-run demand for cocoa ingredients as sales of chocolate-based products grow in emerging markets. As Nestl sells more Milo - a chocolate drink very popular in many Asian markets it needs more cocoa powder to make it.

And it doesn't just need any cocoa powder, but a specific grade so that taste remains constant. A global firm like Petra which has processing plants in Asia, Europe and Latin America that can deliver consistent-quality ingredients is the supplier that the multinationals need.

So why are the big vertically integrated manufacturers like Nestl outsourcing this part of the chain, rather than adding production in house? The answer apparently is down to product balance: getting the right combinations of each ingredient according to your needs. If a manufacturer that requires more cocoa powder as sales of one product increase, but has no increased demand for anything that uses cocoa butter, increasing processing to produce more powder will leave it with excess cocoa butter.

Outsourcers like Petra are better placed to balance the mix of products and also seasonality of demand and asset utilisation because it has many different customers with different needs. And because its own chocolate division takes only a small part of the output ingredients, it doesn't run into the same problem that a firm producing mainly for itself would.

I also wanted to know more about potential problems with excess grinding capacity and plant shutdowns this has happened before, especially in West Africa (where many cocoa growers are) in 2002 and 2006. But apparently this hasn't been a problem for Petra in the past. Its plants are located close to customers rather than suppliers, putting it in a stronger position when demand is slacker. So far, it has never had to shut down plants and has always run at high capacity. Margins have come off slightly sometimes, but grinding has still made money.

In terms of the outlook for this division, as mentioned in my first report, the newly upgraded European plant is undergoing quality assurance tests with customers. As these are completed and Petra can increase production of premium ingredients, margins will increase to be in line with the Asia and Latin America facilities that's likely to take a couple of years. There are no plans for another major project of this scale, but it's possible to add some extra capacity to existing plants, which could allow capacity growth of 10% a year over the next two-three years.

Overall, my view on the cocoa ingredients division is a bit more enthusiastic than it was beforehand. It's not capable of the same kind of long-term capital-light growth that the consumer division is, and it doesn't offer the same ability to earn excess returns from a powerful brand. It is a commodity business and will always have lower margins than the consumer segment. But I can definitely see the appeal of this to a specialist firm and understand why Petra thinks it's worth being involved - and once the European plant is fully optimised, its contribution to the bottom line should start to look much more respectable.

Turning to the branded consumer division, Petra's number one in Indonesia, with around 58% of the market, thanks to famous brands like its Dairy Queen chocolate and cashew combination, which is where the whole business began in the 1950s. Mars, Nestl and Cadbury's combined have less than 10% of the market.

I thought I had a fairly good idea of Petra's potential here but in fact it may be greater than I assumed. As mentioned in my original report, chocolate consumption in Indonesia is estimated at around 0.3kg per person per year, compared with 0.9kg in developed Singapore. That seems to offer plenty of potential for growth.

Interestingly though, Petra estimates that only a small portion of the population currently eat chocolate maybe 15-20 million out of a population of around 235 million. But among those that do, there is a very strong chocolate culture, which comes from the former Dutch colonial influence. So existing chocolate consumers eat a great deal much more than the headline statistics suggest. And as incomes rise, that consumer base is likely to spread.

So Petra's core market may have even more growth potential than I expected. And its current growth rate of 15-20% might be sustainable for a very long time.

The other very promising market is the Philippines, where it bought some long-standing brands in 2006 that had a market share of around 5% and has since doubled that. In contrast to Indonesia, where it covers the whole market, in the Philippines it focuses mainly on the low end. In the same way that it extends its brands into every niche in Indonesia, it may well be able to go upmarket by adding higher-end products to existing brands in time. For now, sales are apparently growing at over 30% a year here.

To my mind, it's clear that Petra's consumer business merits a fairly high valuation the kind of dominant consumer brand that we discussed in the first section. The ingredients business seems a decent business but doesn't have quite the same potential and should trade at a lower valuation. With two separate businesses that other than top management have completely separate teams, this is perhaps best viewed as a sum of the parts' stock.

My updated estimates for Petra are in the table below. Although we don't have the results for FY2010 yet, they relate to the year just finished, so it makes more sense to base the valuation on my FY2011 estimate. (Note that Petra reports in US dollars my calculations below are based on a current exchange rate of US$1= S$1.285.)

My updated buy limit for Petra is S$2. This corresponds to an overall p/e of 20, or approximately 10 times my estimated earnings for the cocoa ingredients division and 25 times my estimate for the branded consumer one, in line with my rules of thumb in the first section. Thus Petra, which has been on hold pending review thanks to recent strong price gains, moves back to a BUY.

That's all for this week. I'll be back in a fortnight with a new recommendation. In the meantime please keep your eyes open for the reader survey which I'll be sending out in the next few days. I'd be really grateful if you could complete this. Your feedback will help me improve Asia Investor.