The book Capital Returns is too good to summarize. The book itself is a summary of Marathon Asset Management’s investor letters from 2002-2015. The intellectual flexibility that firm demonstrates is inspiring.
One key takeaway is analyzing industries through a capital cycle theory lens. The capital cycle can be described as follows:
- High returns on capital lead to competition entering an industry.
- The new competition increases the amount of assets chasing the same dollars of profit.
- More assets fighting over the same profit dollars reduces margins.
- Reduced margins decentivize entrants, drive out competition, and enable the surviving companies to begin increasing margins.
Accordingly, firms and sectors with the lowest asset growth tend to outperform. The phenomenon is called the asset-growth anomaly. See https://www.aqr.com/Insights/Research/Journal-Article/Investing-in-the-Asset-Growth-Anomaly-Across-the-Globe for a solid paper on the topic. That theory is a major reason I like the beer industry so much despite the rise of craft entrants. Globally, I still perceive the industry to be very rational and I view brewpubs more as restaurant competition rather than brewer competition. That said, it’s impossible to view more assets chasing beer sales dollars as bullish for Big Beer. But I digress…
A lot of traditional consumer brands discuss disruption. Why? Historically, traditional large brands leaned on retail distribution channels, dominated shelf space everywhere, scaled production and distribution to enhance margins, and pushed their messages out via advertising. See https://www.forbes.com/sites/antoinegara/2018/04/30/jorge-paulo-lemann-says-era-of-disruption-in-consumer-brands-caught-3g-capital-by-surprise/#2607284d1f9b. Today, the internet eliminated traditional advertising and distribution barriers. Therefore, it is easier to have launch a new brand.
Moreover, consumers are willing to trust brands quickly. Therefore, the brand equity that used to serve as a consumer short cut has eroded. That said, social media influencers and internet marketing are not very discerning. Time will tell whether brand equity makes a comeback. Watch the documentaries on the Fyre Festival on Netflix or Hulu to determine whether you think its plausible that consumers begin to crave the certainty of Big Brands again.
Regardless, barriers to entry are clearly lower than they used to be.
The perception of viability attracts assets to the industry. When new assets chase returns faster than industry profit pools grow, total profit declines. Importantly, Mr. Market knows that. So it’s worth looking to see how entities are priced given the facts. Kraft Heinz is a traditional CPG company impacted by these trends; though mostly because of consumer’s willingness to trust private label brands. Its valuation relative to history looks like:
I’m not extremely excited about those multiples because a 16x EV/EBIT equates to less than a 5% unlevered (EV/NOPAT assuming no interest expense) cash flow yield on a firm that isn’t growing. Moreover, competition remains strong and private label attacking market share is likely to continue. Personally, I’d like to see Kraft Heinz offer a return on equity north of 12% (PE of ~8.3x) before I got excited given the facts as I understand them.
But, I will continue to watch “melting ice cubes” because when facts and/or results change they can offer very attractive risk/rewards. More importantly, no one else likes to own them. Historically speaking, out of favor companies outperform the most loved companies. Though this last “bull run” makes me wonder whether that rule changed. Time will tell.