14 May 2021 | Paul Dixey
Investing in Luxury and the Consumer - Part 2
In Episode 6 Part 2, Tim and Alastair join Paul again to discuss the difficult political balancing act the Luxury sector faces...
Read the transcript below:
0:43 Paul Dixey:
Welcome to the Art of Investment. I'm your host Paul Dixey, and I'm delighted to have Alastair and Tim back on the podcast. We're going to be talking about the headwinds that the luxury goods companies faces as we move forward and as the economy reopens. So Tim, let's start with you. What are the risks that something like LVMH or Nike face as life goes back to normal and the economy reopens?
01:17 Tim Gregory:
Well, I think the concern is actually, and it just highlights the conundrums of the market, how we're going to see demand shaping up as things hopefully, get back to normal. Luxury goods demand has held up incredibly well, people have continued to have discretionary spend available, despite some of the problems in global economies. And actually, because they haven't been able to spend money on flying, or they haven't been able to spend money on expensive hotels because they've been stuck at home, the simple fact of the matter is they've found other ways to spend their money. And obviously, we've seen that in some of the speculation in the broader stock market, the way that multiple valuations have expanded there. But obviously, it's also created an environment where there has been an opportunity to spend on relatively expensive or very expensive products in the case of the higher end luxury goods. And what we simply just do not know at this point in time, and it’s a discussion Alastair and I've have had a number of times, and have with my own colleagues within the Vermeer Global Fund, about when things normalize. And when people return to flying, and they return to going to expensive hotels to spend their money, will they stop spending on products like luxury goods? Or will they still continue to spend because they're actually now in airports. So you know, every time I look at the results of various travel related luxury goods businesses, or whatever it might be, the one thing that sticks out of course, is the total collapse of travel spending, and spending at airports. And we had results earlier this week from Davide Campari - now that doesn't actually sell specifically high end luxury goods products, but there's no doubt its businesses are materially affected by weakness in travel, that there is no one going through airports, no one picking up duty free. And those shops that have done so well, within airports have all been closed for over a year. So it's very difficult to work that out. But it does definitely create a little bit of cause for concern that when money is available to be spent on other products, that may have an impact on demand going forward.
03:38 Paul Dixey:
And I guess one of the other risks that these companies face, particularly those operating, whether that's sourcing goods or selling goods, in China. And the difficulties from a political standpoint, there. Alastair, I know you've been looking at the political dynamics between the US and China, I wonder whether you could give the listeners your most recent thoughts on firstly - what are the issues, and secondly, do we think the companies that we spoke about in the first part of this podcast, be able to overcome them?
04:17 Alastair McRobert:
I guess it's worth backtracking a little bit there. A few of the things we spoke about in the last episode being that: China is the greatest opportunity for these firms with really high growth; the Chinese consumer; and some of the statistics we've seen is that China will represent half of the luxury market as soon as 2025. So as a global luxury player, you have to be in China. But a few of the things Tim and I have said over recent weeks is that it also presents one of the greatest risks of these companies. Everyone saw tensions rise between the US and China when Trump was in power. We probably thought that President Biden would be a little bit more benign, but it's the forced labour issues in Xinjiang, and the persecution of the Uighur Muslims that have sparked off tensions again with President Biden, and he's now been stronger on China than we might have expected. And you might think this is an easy problem for Western brands to deal with, 1) you've got to denounce what's happening in Xinjiang, and 2) you've got to prove that your goods are not sourced from Xinjiang and being a product of forced labour. Doing those two things will clearly appease the western consumer, but if you denounce the goings on too strongly, you're at risk of upsetting the Chinese states. Both with the soft power that the Chinese state has, for example, social media influencers won’t support those brands anymore, going right up to the hard power that the Chinese state has. And we even look at things like boycotting of certain brands in China, because we're in a bit of a status quo at the moment, the risk from here is that there are two pieces of legislation making their way through Congress at the moment, which would formalize the banning of goods being produced in Xinjiang and arriving on US shores, whether those do pass through Congress, which looks like they will. And we see some sort of retaliation from China, and a bit of a tit for tat, as we saw when Trump was in power which would make it very difficult for these Western brands. They’re managing to tread that line between keeping the West and China happy at the moment, but that may get a little bit more difficult in the future.
06:52 Tim Gregory:
If I could just sort of jump in there, with a couple of points to add. Obviously on the one hand, what we've already seen, in context of what Alastair's has said, is very strong results in China from non-US athletic wear retailers for a start. So Intersports and Li-Ning have both had tremendous results. Now, it just may be that they are performing well in a sector that is doing so well, that it is just natural growth that they're seeing. But it may be, and there have been plenty of analysts who've wanted to pick this out, suggesting that it actually could be them taking share from brands like Nike and Adidas in the short term, and how to Alastair's point if they are losing share this is a very big question going forward. And there's no doubt that Nike shares have been struggling ever since this issue came about. And the second point I just wanted to just touch on very quickly, it is very important for investors to understand the interdependence now of the relationship between China, the US and the global stock market in general. We have benefited so much as the global economy from the levels of growth that have been created by China. If you do get a serious situation here, where there is, as there was, or as was hinted at, in 2018, where you have the risk of a trade war, if that spills over into other issues, that is very negative for the economy. So something we have to watch out for very carefully going forward.
08:42 Paul Dixey:
So Alastair, if we put the political issues between the US and China aside, is there a way that we can invest in the Chinese consumer from a domestic perspective, rather than rely on these international European and American companies?
09:02 Alastair McRobert:
As you highlight there, it's investing in the domestic Chinese opportunity that is potentially a good way to hedge against that political risk between the US and China. At Vermeer Partners, we've been looking at a number of Chinese funds, we’ve been buying some of the Bin Yuan Chinese fund. Clearly the Chinese domestic market is a difficult one for us to get a deep understanding of, so having fund managers on the ground - local ones - is a fantastic way to really get exposure to that Chinese domestic opportunity. And it's important to note, I think that the Chinese for whatever reason, probably an accident of history, have a real taste for Western brands at the moment. As they've come into the middle classes and the upper classes, the existing luxury brands have been Western, and it's going to be certainly interesting over the next few decades, and whether anytime Chinese brands emerge to take the place of Chinese consumers, tastes and desires. And actually, while we're on it, I did a piece of work a couple of years ago on Baijiu, which is the Chinese spirit and actually the most consumed spirit in the world, even though most people haven't heard of it - a colourless liquor that's made from fermented grains. The foremost Baijiu brand is one called Moutai, and it happens to be the drink of choice for the CCP, which always helps. They aim themselves at the super premium end of the market, so that plays in well to the luxury opportunity that we've been talking about in China, and actually has one of the best economic moats are barriers to entry that I've seen in that, while it's fermented in these pits, which give it the flavour. And these pits are centuries old now, so it is completely impossible to replicate what these guys are doing, as well as having a fantastic brand to draw on as well. So it's those kind of things that we're looking at to really try and tap into the Chinese consumer. And as I said, diversify away from that political risk that we've seen between the US and China.
11:29 Paul Dixey:
And the other thing I think we need to keep an eye on is also the price that we're paying for these companies that we’ve spoken about. If we use LVMH for example, historically the shares have traded on a price earnings multiple of around 24 times. Looking at estimates for earnings this year, the shares trade on 30 odd times earnings. Now, I guess the two things we've got to think about when we're making investment is how good the underlying business is, but then also how much are we willing to pay for those businesses? So with something like LVMH on 33/34 times next year's earnings Is that too rich or multiple to be paying for these quality businesses that we've spoken about?
12:20 Alastair McRobert:
No, we didn't think so Paul. It's important to note that LVMH, when it was trading on 25 times was at a discount to certain peers. In the past, because of its diversified portfolio that has, at times been seen as a disadvantage in comparison to some of the purer plays like the Pradas and Burberrys and Montclers of this world. But there's absolutely no reason why diversification can't be seen as a good thing. I spoke last episode about how Gucci's fortunes have changed over the years, and having that diversified approach can certainly be a good thing. We've also got to remember why the company is trading over 30 times now: the Chinese consumer, as we've spoken about a lot now; and also things like the fantastic acquisition strategy that they should continue to employ going forward. So despite a strong share price rise over the past year or so, we remain comfortable with the stock.
13:24 Paul Dixey:
And Tim, are you happy with the valuation these companies still?
13:30 Tim Gregory:
We live in a world of very expensive shares, don't we. If you want to buy quality, you can't buy on 10 times yielding five. Sadly, we'd all love to do that. But as our CIO has said, so repeatedly, 30 is the new 20. So LVMH fully deserves to achieve the premium it has done, for all the reasons that we've said already. So put it into the context of a world of very expensive shares generally, with interest rates low and set to remain low for a long time yet, these valuations can be justified. It’s a whole different debate about valuations in the market and what they should be at. In the context of the market and in the context of where LVMHs sits, it can justify its current rating. And I think the point that Alastair made about the fact that the stock has performed so well, because it was an unjustified conglomerate discount which has been removed, this does explain a lot of the share price performance. And it has been an element of catch up to the valuations of of other luxury goods stocks, so I don't think people should be put off by the fact that the stock has done really well. It's really just been moving to a rating commensurate with its performance and that of other luxury goods companies in the sector.
14:48 Paul Dixey:
So guys, I think we should wrap it up there. Thank you very much for your expert views again in the second part. It's been really interesting to hear I think, despite obviously the near term risks that these companies face in terms of the reopening of the economy, and whether consumers continue to spend on luxury goods. I think the long term investment thesis clearly remains in place, with these companies demonstrating great pricing power and barriers to entry and scale etc. We will clearly be watching how the consumer spends as the economy opens up. But on that note, thank you all for listening, and we look forward to seeing you soon.
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