European Equities

European Equities - why we sold Unilever

Quality is (and has always been) our mantra, the crux of our investment philosophy.
February 2018

Sacha El Khoury

Director, Portfolio Manager, Global Equities

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Risk Disclaimer

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

As always investment values may fall as well as rise and capital is at risk.

 

 

Quality is (and has always been) our mantra, the crux of our investment philosophy. Whether a company makes excellent returns today or has the potential to do so in the future, we believe it is the factors that allow a business to defend these returns that makes or breaks its ‘quality’.

Why?

Because of mean reversion. Most companies will see their profits and returns revert to the mean, except those companies that have ‘moats’ wide enough to defend themselves against the competition.
 
Warren Buffett talked at length about the importance of economic moats. To him the dynamics of capitalism simply guarantee that competitors will repeatedly assault any business “castle” that is earning supra-normal returns. So a truly great business must have an enduring moat that protects its excellent returns – enduring being the operative word here – as mean reversion asserts that moats will tend to erode as they cede to competitive pressures.
 

The power of compounding

As the first port of call when assessing an investment, the moat (i.e. a company’s competitive advantage) is what we spend most of our time testing. Companies with wide moats will likely compound growing returns for a very long time, and that compounding effect can be very powerful indeed.
 
But what happens when that moat starts to erode? More importantly, what happens to a highly-rated, well-owned stock when that starts to happen? As Mauboussin’s1 findings clearly show, this does not bode well for long-term investors, and this is what, with our margin-of-safety hat on, we are trying to avoid at all costs.
 

Unilever, a household giant…

And so to Unilever, the stock that for many investors, epitomises quality. Unilever, for years, has been able to deliver returns well above its cost of capital, consistently and predictably. Its portfolio of ubiquitous brands, comprising household staples like Hellmann’s, Ben & Jerry’s, Dove and Comfort, are present in 98% of households across the UK and are used by 2.5 billion people every day across the globe2 . This enormous scale advantage has given it leverage to negotiate shelf space with traditional retailers, which means the brands have been front and centre in consumers’ minds at the most critical moment of the purchasing decision.
 
The business’ sheer marketing budget size has also allowed it to monopolise prime advertising time on television to build brand equity and loyalty. With around 60% exposure to emerging markets where the premiumisation trend is in its infancy, and a healthy mix of food to non-food categories, Unilever looked every bit the classic one decision buy-and-hold quality compounder. No wonder the Warren Buffett-backed Kraft Heinz tried to acquire it last year!
 

…too big to ignore?

So if we say we invest in ‘quality’, why did we sell Unilever, when every quality investor under the sun holds the stock? And plus, isn’t the stock too big to ignore? It is, but not in the way you might necessarily think.
 
The speed of change in industry practices, including the shift from off to online, we are witnessing today makes it necessary to challenge perceived wisdom. That applies to the market’s definition of ‘quality’ and the assumed absolute strength of brands. Our process allows us to invest dispassionately by ridding ourselves of classic behavioural pitfalls like emotional attachment to a stock, confirmatory bias, and anchoring.
 
Unilever has been a fantastic investment for the last decade, and we have been happy long-term shareholders since July 2006.

Risk Disclaimer

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

As always investment values may fall as well as rise and capital is at risk.

 

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European Equities 

But as we have previously said, when facts change, we should change our minds…
 

Power shift

While we might be tempted to make like ostriches and bury our heads in the sand, the reality is that there is an undeniable shift in power from brands to consumer, a structural shift in how consumers communicate with brands and how they relate to them. Our research suggests Unilever’s stronghold is weakening, and its moat eroding. There are a number of reasons why this is the case.
 
The advertising landscape is changing – let’s face it, mega brand owners like Unilever have had a bit of an easy ride. But linear TV, the technology which has for years driven brand loyalty, is being replaced at warp speed. The prime real estate of evening TV advertising is losing eyeballs, despite TV still accounting for around 40% of the advertising market. Incremental advertising dollars are being spent on ‘new world’ platforms: YouTube in fact is now a more watched format than US TV, with more than 1 billion hours of content consumed per day. A quarter of the planet’s population is now on Facebook. The reach of platforms like Instagram with its 800m active users, is just breath-taking, and frankly unprecedented. The barriers to reach, target and influence consumers are a lot lower than what they used to be, and the productivity of one advertising dollar on these platforms is in general higher than on traditional channels. Challenger brands are therefore accessing huge audiences at low cost, and their growth is gathering pace.
 
The following is a powerful illustration of how low barriers to entry have sunk: 20-year old Kylie Jenner had 98.7 million followers on Instagram at the time she decided to launch her own beauty product (she has 103 million followers today). She decided to test a single product under the brand Kylie Cosmetics, with a single landing page and relying solely on her own channel to reach her audience. The Kylie Cosmetics page quickly gathered 14.6 million followers and achieved $420 million in retail sales in just 18 months. It took Tom Ford cosmetics (owned by Estee Lauder) six years to achieve this sales number. If this isn’t an eye opener, I don’t know what is.
 
The customer’s voice is king! Not only is this allowing smaller brands to proliferate and take share from big brands, but it is also giving consumers a powerful voice, robbing brands of control over the message. For instance, only 6% of the interactions on social media are generated by accounts that are officially associated with Chanel, the luxury brand. Chanel simply doesn’t control its own brand message on the most influential social media platforms. When you no longer control the conversation, things can go wrong fast, as illustrated by the Dove advert mishap3. The shift in power is palpable.
 

Shifts in the retail landscape

Distribution is another component of the moat that is changing dramatically, and undermining the power companies like Unilever used to wield. Traditional physical distribution channels, like retailers and shopping malls, are themselves going through a traumatic period of mass closures and reinvention. In the face of the inexorable rise of online shopping, power is again shifting to the consumer as price transparency increases and choices are narrowed down to a small screen, with the help of filters and sorting options. And with the rise of private label champions Aldi/Lidl, the disrupters have completely changed the landscape and reframed the customers’ decision to have some radical implications on how purchasing decisions are made, to the detriment of incumbent brands.
 

Being nimble is key

We know from our holding in specialist ingredients company Kerry Group that local brands are gaining market share at the expense of big multinationals. Craft almost everywhere is growing faster than the market. In fact, according to Euromonitor, small branded goods companies with less than $1 billion in sales have been growing at approximately 4x faster rate than larger manufacturers with sales over $3 billion.
 
Why? Simple, innovation. They are small, smart, and nimble. They have data in spades, and although unsettling at times, are able to predict consumption patterns. Big brands in contrast often don’t even have a CRM because of cumbersome legacy systems.
 

Acquiring growth

So how are they reacting? By acquiring concepts they were unable to develop organically. Think about Dollar Shave Club, the start-up founded barely seven years ago in a garage, which Unilever bought for $1 billion. Unilever’s spending spree has just begun, and it is having to pay eyewatering multiples to acquire growth.
 

Underinvestment

If that wasn’t enough, the last couple of years have seen shareholder activism gathering pace. Financial orientated management teams are succumbing to margin fanaticism at the behest of shareholders. And why not? After all, Warren Buffett and 3G paid a super-premium price for Heinz in 2013 and have made a handsome profit while aggressively ripping costs out of the business. While we see the merits of approaches such as the Zero Based Budgeting (ZBB), the Buffet/3G approach is not always the best, as it can lead to chronic under-investment at a time when brands need the most support. Heinz sales were down -16% in the UK last year.
 
Post the Kraft Heinz bid on Unilever earlier last year, CEO Paul Polman has vowed to redouble efforts to improve the margins by rolling ZBB across the entire organisation.

Use our handy glossary to look up any technical jargon you are unfamiliar with.

Source: Unilever, 24 February 2017

Red flags

Unilever’s latest set of results revealed the company is losing share in half its markets/categories vs. historically gaining share in 60% of markets and categories. Growth is becoming harder and harder to come by, innovating is difficult, scale is not as limiting to smaller brands as it used to be, pricing power is waning… so what are the investment implications?

  • Unilever has been potentially over-earning and these pockets of supra-normal profit will come under attack, as the moat surrounding them is slowly eroding.
  • Their ubiquitous brands are struggling to stay relevant, innovate and grow.
  • Faced with these challenges, Unilever are turning into forced buyers of disrupter brands: they’ve made 21 deals since January 2015, adding around $2.5 billion of sales for a grand total of around $10 billion. Individually, the deals might not look significant compared to Unilever’s size and balance sheet. Collectively, however, we see the deals to be dilutive and value destructive longer term.

 

Paying more for lower quality

At the time of sale, Unilever was trading at 22 times earnings, 4% free cash flow yield, and struggling to grow organically.

With the longevity of cash flows generated by this business called into question, and a deteriorating quality, the valuation was offering less and less margin of safety. And in the context of a concentrated high conviction portfolio, this certainly doesn’t make the cut.

Here at BMO Global Asset Management, we follow a disciplined approach that aims to make sure we don’t overpay for quality. Importantly, we constantly monitor and question the preconceived notions of quality and our process is designed to create an environment in which we assess businesses in a systematic and dispassionate manner. In our view, such an approach is entirely consistent with delivering outperformance over the long term.

Our process allows us to continuously question preconceived notions of quality, and test and re-test economic ‘moats’.

Competitive advantage is a key driver of long-term returns.

Signs of weakening in Unilever’s stronghold prompted reassessment of a long-term investment.

Valuation is as important as Quality in the pursuit of superior long-term returns. 

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