The Beautiful Game

The start of the football season has got me thinking about the language that is routinely used in the financial press. How often do we hear about winners and losers, not referring to football teams, but to share price moves over a single day! Quarterly earnings announcements are often reduced down to beats or misses, with much “investment” commentary talking about the ratio between these two numbers. When journalists talk about league tables, they are just as likely to be talking about which fund has outperformed its peers, as whether Chelsea has held its (rightful?) position at the top of the Premier League.

Does this matter? Is this simply the way that journalists make the complex world of business more accessible to the casual observer? Or is it a cynical way of bringing some excitement into the world of investing, which should arguably really be about the benefits of long term compounding of returns with limited trading activity.

I think the language does matter, for two reasons. First, the stock market is complex and fulfils an important function in the capital allocation process. Investors may be charged with looking after significant assets such as savings or pensions. I don’t think that understanding is enhanced by referring to companies’ financial results as a single score, rather than a broader assessment of operational and financial issues. Active investment involves making detailed appraisals of the strength of business franchises, balance sheets, operational performance, environmental, social and governance issues and other matters. Focusing on a single measure such as a “beat vs expectations” is, at best, unhelpful and, at worst, risks undermining confidence in the important role of the stock market.

Second, and perhaps even more importantly, focusing on earnings beats or misses, and daily winners and losers can encourage short term behaviour by company management. It can lead to poor capital allocation decisions if a management team focus on delivering consistent positive earnings surprises, potentially at the cost of longer term investment that could deliver higher growth or improved financial returns. I am in favour of explaining issues as simply as possible, but I don’t think high frequency, simplistic comments encourage a long term perspective. In this vein. I welcome recent moves in the UK to discourage companies from producing detailed quarterly results, putting more emphasis on interim results and audited annual figures.

Perhaps language should not matter, but unfortunately I think it does. If we reduce stocks and shares to the language of football commentary we may all face a penalty by the end of the season.

Simon Gergel

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer and/or its affiliated companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail.

This is a marketing communication issued by Allianz Global Investors GmbH,, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, Germany, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht ( Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch,, which is subject to limited regulation by the Financial Conduct Authority ( Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted.

It’s Skynet for some

There is one word that is overused by investors today – “disruption”. In fact disruption has been with us since the dawn of time. It is just that in today’s world more disruption is technology-led, which is being more readily adopted by populations, and so can go global much more quickly than prior disruptive waves.

But let me warm your palate with a few lines in behavioural investing:

Many years ago a strategist, who still writes great stuff on behavioural investing, posed a question to his clients:

“There are 100 people in a room. They can each select a number between 0 and 100, inclusive. The winner is the person who selects the number that is two-thirds of the average of all the numbers in the room. What number should you select?”

As it happens, when this game is tested in the field the winner will be the person that selects two-thirds of two-thirds of 50 (i.e. goes the second step) i.e. 22.

However, there will be a small but noticeable minority of people who select 0 to 5 – these people worked out that 0 is the correct answer, and everyone is a winner if they all select 0. In fact, once they work that out it is so obvious to them that they can’t see why anyone else would disagree. However, they figure that a few might, so they aim off a bit and select a number a little above 0.

These are the sort of people who are not making long-term investments in auto insurance businesses or auto dealers today. They feel they can see the answer, and fully believe that whilst others may not agree today, they will come round to their thinking in the near term.

And now to link this in with “disruption”:

We live in an age where computing power and digital storage has grown exponentially, whilst its cost has collapsed just as fast. That has allowed computers to crunch through the oceans of data available at lightning-fast speed for super low cost. Hence the days of Machine Learning are upon us.

All of that has allowed autonomous vehicles to come onto the horizon. First step is the advanced driver-assistance system which is already incorporated into many vehicles. Might as well throw Electric Vehicles in there as a side show, but will likely be part of the answer.

So, come the day we are all in autonomous vehicles – what are our insurance payments? I suggest very low. The auto manufacturer/software designer will be paying those, and they will be a lot lower than we all pay today. That begs the question – “if autonomous vehicles were invented first, would the car insurance businesses exist today?” I suspect the answer to that would be “No”. And so those investors that can see that wonder why no one else can, but in the meantime they permanently avoid investing in those insurance businesses.

And what about the Electric Vehicles we all own – and that assumes we own a car by that stage rather than merely rent cars for the journey? They have many fewer moving parts and components, which means that less tends to go wrong. A Tesla vehicle is more a computer than a car.

Auto dealers earn more than half their earnings from aftersales services – that must surely be under pressure at some point in the future. Would the auto dealers exist today if Electric Vehicles were invented first? I suspect the answer would be yes, but they would have a much smaller aftersales business, and we would still be debating the threat from a future where we may not own cars anyway. Again, those investors that see this put them in the “avoid” box and move on.

. . .if we replayed the game, but instead of 100 people we had 100 machines loaded with tensorflow machine learning (that is not complicated, even I have programmed my home computer to learn how to play and win tic-tac-toe – 300,000 games in it does not lose, 1,000,000 games in it wins 85%) then the machines will all give the answer 0. I fear the good strategist at the top of this post will also go the way of the car insurance businesses!

Andrew Neville


Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer and/or its affiliated companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail.

This is a marketing communication issued by Allianz Global Investors GmbH,, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, Germany, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht ( Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch,, which is subject to limited regulation by the Financial Conduct Authority ( Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The duplication, publication, or transmission of the contents, irrespective of the form, is not permitted. 

Golden nuggets

In my previous post, I outlined my framework for investing in gold equities, highlighting the critical importance of ensuring a large margin of safety by only investing in companies with low cost mines at low valuations. In this post, I will take a look at the gold mining industry today in order to assess whether any such investment opportunities might exist.

To kick off the discussion, let’s look at the recent history.

The last bull market in gold started in the mid 2000s and reached its zenith in 2011-12 at the height of the Eurozone financial crisis and Federal Reserve’s (Fed) Quantitative Easing (QE) programme.

I remember this period well. The gold price was encroaching on the $2000 level, having doubled from its pre financial crisis level. Gold bulls were out in force, slamming the Fed for their irresponsible monetary policies that would inevitably lead to hyperinflation. Gold equities were also very much in vogue and widely owned amongst mainstream investment institutions. They also traded on valuations that implied huge premiums to net present value, a situation which made no sense to me, and which was usually justified with the unconvincing retort “that is just how gold equities are valued.”

Once it became apparent that the Eurozone was not going to implode and that QE was not going to lead to hyperinflation, the price of gold collapsed by nearly 50%, bottoming out in late 2015 at just over $1000.

Over this period, the gold mining industry behaved more or less exactly as you would expect. During the bull market, costs inflated as the industry scrambled to increase output as quickly as possible. Numerous expansion projects were sanctioned so that expected future demand could be met. Of course this made the early part of the bear market especially painful as supply was still growing whilst the gold price was falling.

Fast forward to today however and the situation looks very different. After years of hunkering down, cutting costs, reducing capex and repairing balance sheets, the industry is now in a supply constrained situation. As the following two charts from Bernstein show, following a number of years of growing production, the supply side looks set to flat line at best from here. It may even decline considering that much of the pipeline requires higher gold prices to be economically viable.

gold production outlook SCB

This is certainly a helpful backdrop as a potential investor in existing gold mining assets. At the very least it means that a sudden increase in mined supply is highly unlikely to happen. As I argued in my previous post, this is not as powerful for gold as it is for copper due to the fact that mined supply is a small percentage of the existing available stock, but it is clearly a much better starting point than one in which mined supply is expected to grow.

In addition, there are a number of other positives that are shining on gold equities currently.

– Firstly, after the brutal bear market, the gold mining companies that have survived are mostly in pretty good shape now. With costs having come down, profitability is back up to more normalised levels. And cash flows are looking even better since capex is now firmly under control.

– Secondly, there are signs that confidence in the industry is gradually returning. The gold price has been relatively stable for nearly four years now, trading within a range of $1050 and $14001. This has caused sentiment to slowly improve and, more recently, funding for growth projects has started to return. Capital Drilling, a diversified drilling services company, made the following comment in its first quarter update earlier this year:

“Market sentiment is optimistic, with gold and base metal prices remaining strong and major mining companies anticipating budget increases for drilling activities. The industry retains a fundamental need to replace diminishing resources and reserves depleted during the downturn, when exploration drilling was significantly reduced.” 

– Thirdly, despite this improved outlook, my impression is that investor sentiment towards the sector remains firmly in the doldrums, sitting somewhere between apathy and “un-investible.” This is surprising to me. At the very least, gold equities should be largely uncorrelated to financial markets and the economy, a feature that should be appealing against a backdrop of a very richly valued global stock market and an increasingly tired looking economic upswing.

– Finally, valuations do not look stretched. For example, even the typically premium valued Randgold Resources offers a free cash flow yield of around 7%, most of which it has indicated it intends to pay out as dividends. Randgold is one of the lowest cost producers in the world with a production profile that should be free cash flow positive even at $700 gold price2. Amongst the smaller companies, Pan African Resources is valued on 6x earnings, with a 5% dividend yield. Despite this low valuation, the company is set to grow production by 20% by 2019 through a low risk and low cost tailings project that will reduce further its already low overall cost profile3. Capital Drilling is valued on a lowly 16% normalised free cash flow, with a net cash balance sheet, a fleet utilisation level of only 50% and with profit forecasts having recently being upgraded by over 20% at the Q1 update4.

In conclusion, my sense is that the gold mining sector is currently an area where the stock market may not be fully recognising the positive changes that have happened in recent years. It is one of the few areas where absolute valuations are low and the outlook appears to be improving. Investors should consider looking beyond the “un-investible” tag – there may be golden nuggets waiting5.

Matthew Tillett


1. Bloomberg
2. Exane BNP Paribas, May 2017
3. Peel Hunt, company reports, based on a share price of 14.0p.
4. Finncap, company reports, based on a share price of 43.5p.
5. This is not a recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.

Gold – it’s marmite for investors

At one extreme, I know investors who have their entire portfolios invested in a combination of gold, gold equities and cash. Underpinning this view is a deep distrust of central bank money printing, sky high and rising Government debt, alongside dangerously high equity and bond market valuations. The unavoidable endgame is runaway inflation that will cause real interest rates to plummet to negative levels not seen since the 1970s. In this scenario gold – and by extension gold equities – will be one of the few investments that do well.

At the other end of the spectrum, investors such as my colleague Simon Gergel harbour philosophical objections to the very idea of gold as an investment. This line of argument usually runs something like this:

“Gold is an asset that has no practical use other than very minor industrial applications. It costs money to store it and yet it pays no income. Most of the gold ever mined is sitting in vaults somewhere and could come back to the market at any time. This, combined with the lack of practical use, make gold impossible to value and therefore un-investible.”

As someone who thrives on controversy, I cannot avoid being drawn to this debate. Initially I was very much in the un-investible camp, however over the years I have revised my view to what I think is a more practical standpoint.

The metal itself has never held much appeal to me as an investment. And whilst I agree it is difficult to come up with any firm objective measure of value, the plain fact is that the price of gold has tended to go up over time (admittedly with a lot of volatility!) as governments throughout the ages have debased the value of money. Moreover this isn’t just a recent phenomenon. Gold has behaved this way for thousands of years. I may not like it from a philosophical perspective, but this is the reality. Better to accept it and see if there might be ways to profit from it. And here I think gold mining (gold equities) offer more prospects for mispricing than does the metal itself.

In this post I will outline my framework for thinking about gold equities as potential investments. In the next post I will make a few observations on state of the industry today.

In my 2015 blog post “Mining – the big money has already been lost” I explained, with the help of a number of charts, how I think about the broader mining sector. A key conclusion was that from a long term perspective the industry is actually less cyclical than most people think.

When profit margins are very depressed (as they were in 2015), there are powerful forces such as cost deflation, capacity cuts and high grading that tend to bring profitability back to average levels quicker than expected. The reverse is true when margins are elevated. It is at these cyclical extremes when this mean reversion doesn’t get priced into valuations, thereby creating potential buying opportunities at the bottom of the cycle and selling opportunities at the top.

It is possible to put the gold mining industry through the same sort of analysis, however there is one critical difference. Whilst the long term price of, say, copper will ultimately be determined to some degree by the cost of production of copper, the same cannot be said for gold. Indeed there is evidence the relationship actually works the other way around – i.e. that the cost curve adjusts upwards or downwards to whatever the gold price happens to be. This is illustrated in the following chart from Exane BNP Paribas which tracks the gold price back through time versus the cost of production across the cost curve.

Gold cost curve

You can see that cost curve has tended to move up and down with the gold price itself. There are two reasons why this happens.

Firstly, annual gold demand is only a very small percentage of the outstanding gold stock. This means that a supply side response to a fall (or rise) in gold demand won’t necessarily cause a rebalance in the gold price as there may simply be more (or less) of the demand being met from existing stocks.

Secondly, there is a huge variation in profitability across gold mines. Even individual gold mines often have some shafts or pits that are far more profitable than others. This means the gold mining industry is capable at operating to some degree at almost any gold price.

To me, this suggests that any investment in a gold mining equity should demand a very significant margin of safety, certainly greater than for a copper miner for example. Only assets that are low (or have the potential to be low) on the cost curve should be considered because only these assets will be able to stay profitable in lower gold price scenarios. Anything else is speculation. And of course a low valuation is absolutely necessary to compensate for the cyclical downside risk.

Matthew Tillett

How can a value investor buy into technological innovation?

In a world where Google is a verb and Amazon web services has nothing to do with spiders in the rainforest, it is easy to understand why some of the biggest and most highly priced companies in the world are technology firms. However, as the TMT (Technology Media and Technology) bubble of the late nineties showed, investing in technology does not always end successfully.

How can a value investor – someone who likes to invest in a business based on the current (rather than future) value of its assets, profits or cash flow – make money out of this technological revolution? It may seem an impossible task, especially if you look at the valuation of Snap Inc, for example, the owner of Snapchat.  This loss making company recently floated in the USA and now has a value of $24bn1, roughly 59 times its last year’s revenues.

But value investors needn’t give up. Many traditional businesses are now benefitting from technological innovation in quite surprising ways. These companies are using technology to drive efficiency, improve health and safety, or enhance their competitive position.

Here are just a few of the examples I have discussed with the management of companies in the last few weeks2.

Energy giant Royal Dutch Shell, is using drones to inspect large, complex oil refineries. Not only is this far easier and cheaper than sending engineers up tall ladders, it can considerably reduce health and safety risks in the business.

HSBC is introducing voice recognition into its call centres in a bid to remove the need for customers to remember their passwords. The bank is also developing the capability to provide customers with instant bank or credit cards on their smart phones, without the need to manufacture and deliver a physical card.

Construction firm, Balfour Beatty is using fingerprint recognition for its workers and subcontractors when they enter and leave building sites. This technology enables the firm to know where its people are at any time. It should eliminate potential disagreements with subcontractors over hours worked, and should have considerable health and safety advantages too.

The gambling company Ladbrokes Coral is introducing facial recognition into its shops which, along with other digital technology, will allow it to monitor customer behaviour without breaching data protection rules. This can help them identify and support “problem gamblers”, even anonymously.  The same technology should allow Ladbrokes Coral to optimise their product offering for regular customers, with personalized incentives that reflect each gambler’s circumstances. As a result, the business can reduce its regulatory risk on one hand, and help improve player yields and profitability on the other.

A final example is the construction company Kier, which is also using drones. On behalf of water utilities the company will use these machines to spot the slight changes in ground temperature associated with water leakage in pipe networks, without needing to dig up the ground itself. This will help the utility meet its environmental obligations in a more cost effective way.

While none of these examples is going to radically transform the fortunes of the companies concerned, they are all situations in which traditional businesses are exploiting new technologies in relatively low risk and incremental ways. In some cases this may drive a competitive advantage, in others it may increase efficiency, drive productivity and improve profitability. These technologies also bring opportunities to improve the social or environmental impact of businesses, by improving health & safety, helping alleviate reputational and regulatory risks, or reducing environmental damage.

I don’t expect any of these businesses to suddenly re-rate onto technology type valuation multiples. However, they are modestly valued and these minor developments represent genuine progress within the business.  If these – and similar – companies can improve their growth rate or profitability via the selective adoption of technology, that can lead to higher shareholder returns in due course.

Simon Gergel


1 – Source Bloomberg: 05.06.17
2 – This is no recommendation or solicitation to buy or sell any particular security


An interesting company, but is it an interesting investment? The sequel…

In the blog post titled ‘an interesting company, but is it an interesting investment’, I discussed the difficulty in justifying the proposed £1200m initial public offering (IPO) valuation of AO world. This conclusion was reached by analysing the potential market opportunity for AO world. Although the shares performed well initially, the market quickly came to the same conclusion. AO World is currently valued at £620m, which includes another £50m recently raised by shareholders.

In this blog post, the same analysis has been conducted on Purplebricks1, an online estate agent, which like AO world at IPO, is well-loved by the market. Purplebricks provide similar services to a ‘traditional’ estate agent, including a free property valuation and listing on property portals. However they charge a low fixed fee paid on completion and the property owner typically conducts viewings, whilst traditional estate agents charge a commission on completion and conduct the viewings. Purplebricks’ main competitive advantages are a low cost structure, good brand awareness, and a well-invested technology platform.

Since Purplebricks is relatively immature in the UK, it is important to consider what the business could look like (and be worth) in the future. There are five key assumptions to make; 1) number of housing transactions per annum in the UK, 2) the percentage of these conducted through online estate agents, 3) Purplebricks’ online market share, 4) the average fee per transactions, 5) the profit margin that could be achieved.

1. The average number of annual housing transactions over the past 10 years has been 1.1m2. It peaked at 1.67m in 2006 and troughed at 0.85m in 2009. For the purposes of this analysis let’s assume annual housing transactions of 1.2m, slightly above the long-term average, but in-line with the last few years.

2. Online estate agents currently represent c. 5% of total property transactions3, and are likely to continue to gain share given their price advantage vs. traditional estate agents. Let’s assume a figure of 20% in 5 years, but recognise that this could vary by approximately 10%+ either side.

3. Purplebricks currently has a 65% share of the online estate agent market, which has been creeping up over time. There are quite a few small competitors, such as Emoov and House Simple, which although they are losing share, continue to grow rapidly. To be conservative, let’s assume a stable market share of 65%, although this could be higher.

4. Purplebricks charges a fee of £849 per instruction as well as optional extras like conveyancing, viewings and energy performance certificates. The blended fee per instruction is currently c. £900. Management have recently increased prices, and stated that they don’t plan on increasing them again in the near-term. If prices increase in-line with inflation over the next 5 years, this would reach c. £1000.

5. As the business is sub-scale, and only just turned profitable, the profit margin assumption is difficult to make. However margins should be expected to increase as the business grows, and benefits to accrue from economies of scale. Looking at similar businesses, a margin of 30% might be achievable.

The above are clearly just assumptions, but as things stand today they are a useful starting point. Based on these assumptions, Purplebricks UK business would hypothetically be earning profits of around £40m. Given the company is a market leading business delivering attractive growth rates, it is likely the market would value this profit stream at premium to the market, perhaps somewhere in the region of £700-900m.

This compares to a market valuation today of £830m, within the theoretical range of £700-900m. However, most people would not pay £1 today for a hypothetical £1 of value at some point in the future about which there are considerably uncertainties. Any rational investor would apply a discount rate in order to compensate them for the investment of time and risk.

With this in mind, it could well be argued that it is difficult to justify Purplebricks market valuation by the UK business alone. Indeed, a significantly higher valuation would need the nascent Australian and West-Coast US businesses to perform to plan. This is certainly possible, however it is also very early days for these businesses, so it is somewhat surprising that investors appear so confident that they will be successful.

Purplebricks has an attractive business model because the company has the potential to grow into markets that are more immature and where they are the market leader. It is perfectly possible that the company will succeed, eventually becoming a much larger business. But unfortunately the valuation suggests that much of this success is already factored into the share price today. And with senior management and non-executive directors having recently sold nearly £30m in shares this year alone, one has to wonder if they agree.

Matthew Hall


1. This is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.
3. 1.2m annual housing transactions, assuming Purplebricks has 40k listings, and a 65% share.

Shut up shop

Research findings out today show that 896 stores disappeared from Britain’s town centres in 20161. On average, between 14 and 15 stores were closed every day, while only 12 stores were opened. It also showed that Britain’s town centres are shifting towards ‘leisure and experience’ destinations, like coffee shops and gyms, and away from ‘traditional retailers’, like clothes and general merchandise.

I wasn’t surprised by these research findings, and don’t think many others will be either. Most of us will have seen the changing landscape of our own local town centres, and seen the high profile failure of household names like BHS. In fact, only a couple of weeks ago Jaeger – another well-known retailer, which can trace its roots back to 1884 – entered administration, putting its 46 stores at risk.

In my opinion, the prognosis for many of these ‘traditional retailers’ is bleak, and in some cases terminal. We will continue to see shrinking town centres, and more ‘traditional retailers’ entering administration. The ailment that afflicts them is online shopping and, sadly, there is no cure. Online retailers can provide a superior consumer experience in many respects, and there is little traditional retailers can do about it.

For example, online retailers can not only offer a far greater range of products, but they can also shift them more quickly in order to meet consumer tastes. This is because online retailers operate from large distribution centres, which can hold a huge range of products, and where it is easy to replace one product with another if consumer preferences change.

Online retailers can also offer superior prices. This is partially because their business models are less labour intensive and they don’t have to pay rent on a network of stores. But, it is also because they are willing to invest significantly in prices and generate very low margins, enabling them to grow quickly and gain market share. This is understood and often encouraged by their shareholders who prefer sales growth and market share gains over profits.

More consideration is needed when examining who provides a superior service. With a traditional retailer, going in-store means a consumer can get advice, will receive the good immediately and, if necessary, return the product easily. If the store has an online presence, customers can also use ‘click and collect’ services. However, these are all areas in which online retailers are constantly improving, and any advantages traditional retailers have is being eroded. Many online retailers already allow shoppers to read reviews and get advice, and from a customer service perspective, delivery times and costs are decreasing while free-returns are becoming the norm.

Unfortunately for traditional retailers the online retailers are getting more aggressive. They see themselves in an ‘online arms race’, reinvesting all the benefits from their growth back into the business to provide even more superior products, prices and service to their customers. This then drives further growth, the benefits of which are also reinvested. This is a continuous process which extends the position of online retailers compared to traditional retailers.

Most traditional retailers are acutely aware of the challenges above. However the solutions are hard to find as they reflect a structural difference in business models. They are not to blame for the situation they are in. In many cases they are trying to find solutions, but just like the typewriter vs. the computer, or the horse vs. the automobile, there is little you can do when you are faced with a significantly superior replacement.

The stock market is aware of these trends and as result online retailers trade at a significant valuation premium. As a growth investor I am attracted to the high growth and structural advantages that online retailers offer, but I recognise that expectations are high, and these businesses need to continue to grow strongly to justify the valuation. In contrast a value investor might look at a ‘traditional retailer’ on its low valuation with strong cash flow, and argue that the market is being overly pessimistic on its outlook. Both can be successful investments, but over the long-term it seems clear to me which business model will win2.

Matthew Hall


1. Source: Independent newspaper, 12/04/2017
2. This is an opinion. It is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.

Mr Market is smiling on consumer staples. For now.

Warren Buffet famously described companies that “buy commodities and sell brands” as the sort of business model in which he likes to invest. The consumer staple companies certainly fit this description. Their products – basic personal or household items such as shavers, toothpaste or washing-up liquid – are cheap to produce, but sell at a relative premium, packaged in ubiquitous brand names that completely dominate supermarket shelf space.

In the jittery macroeconomic environment of recent years, these companies have become safe haven investments. As investors bid up the price of their seemingly reliable cash flow and dividend streams, consumer staples have significantly outperformed the stock market. Some commentators even refer to them as “the expensive defensives”.

However the outlook for these companies as investments may be far less rosy than the experience of recent years would suggest. I see two headwinds:

First, powerful long-term structural changes in consumer behaviour are slowly undermining the dominant position currently occupied by many consumer staple brands. The vast majority of basic household products are still purchased on the high street, but e-commerce is growing rapidly in this space. Experience from other industries suggests that scale is the critical factor here. The manufacturers of products where usage is regular and predictable, and shipping costs are low, have shown themselves to be particularly vulnerable to disruption. Witness the recent success of Dollar Shave Club in the US as a model of things to come.

These changes won’t destroy the consumer staple business model in the way they have for many high street retail brands. The problem is growth – or lack of it. As e-commerce penetration increases, I think it will be harder for consumer staples to sustain their already fairly pedestrian growth rates.

Again, experience from other industries suggests it is not the incumbents who capture this new online growth, but the more innovative and recent entrants to the market. One solution is to acquire this growth, as Unilever has with its recent purchase of Dollar Shave Club. Yet this comes at the cost of diluting the firm’s overall return on capital, since these acquisitions will only be possible at very high valuations.

Another solution is to buy each other. In the last few weeks, Reckitt Benckiser has agreed to acquire Mead Johnson and Kraft Heinz has attempted – but failed – to buy Unilever. These deals are about cutting costs and leveraging balance sheets in order to create a more attractive earnings growth trajectory. Investors are cheering this today, but these deals are also being done at high valuations. It remains to be seen how much genuine value can be created when five or more years of perfectly executed synergies are required to justify deal financial metrics.

The second major headwind is valuation. Within the UK stock market, the household products sector trades on a price to earnings ratio of over 20 times, with a free cash flow yield of barely 4%1. This is a rich valuation in absolute terms and a significant premium to the wider UK market.

Bulls will point out that the sector has always commanded a premium valuation by virtue of its “quality” business model characteristics. This has certainly been the case in recent years, during which time these companies have mostly performed pretty well operationally. Such high valuations reflect a perception of stability and predictability, against a backdrop of a cyclically and structurally uncertain world.  But these valuations are unlikely to be sustained if investors seriously start questioning the long-term growth profile of these companies.

An additional factor to consider when reflecting on these companies’ high valuations is the role of monetary policy. Since the financial crisis began in 2008, interest rates around the world have headed ever lower. As a result, investors have been forced up the risk curve to find income-producing financial assets. With many of the traditional yield paying sectors such as banks and energy disappointing, it is easy to why the consumer staples sector has attracted a scarcity premium. This effect is impossible to quantify, but is certainly something to keep it in mind, particularly as US interest rates look set to head higher over the near term.

One of Benjamin Graham’s great contributions to investing was ‘Mr Market’ – the concept of a psychopathic individual with a tendency to swing from delusional optimism to unreasonable pessimism. Today, Mr Market is singing the praises of consumer staples far and wide. With the ingredients all in place for a very different view down the line, some investors may feel they wish to take advantage of Mr Market’s current mood while it lasts.

Matthew Tillett


1. Source: Morgan Stanley estimates, March 2017

A sign of the times…

Would you pay a premium for financial leverage? For most of my career – barring a short period before the financial crisis – investors would have answered an emphatic no to this question. It is not difficult to see why. Financial leverage acts like an amplifier for shareholder returns. It can enhance returns in the good times, but significantly increases the risk profile by making shareholders more exposed to unexpected negative events. With a generally weak and politically uncertain global economy, it is entirely understandable why highly leveraged companies would warrant a lower valuation.

But today strange things are happening in the consumer sector.

In my previous post, which discussed the recent 3G Capital backed Kraft Heinz bid for Unilever, I questioned the business and financial logic of ripping out cost and leveraging the balance sheet at a company like Unilever. What does the stock market think of this approach to business? Take a look at the following table.

3g cap

The table shows a comparison of two companies across three subsectors in the consumer sector. In the blue rows are the companies that are backed by 3G capital. You can see that they all have significantly higher financial leverage than the more conservatively financed comparison company. Despite this, in all cases the equity valuations are actually higher for the more leveraged companies. The market is paying a premium for financial leverage.

The obvious justification for this premium is superior financial performance. The 3G backed companies have delivered and are forecasted to deliver higher earnings growth. Rather than paying a premium for financial leverage, perhaps the market is paying a premium for superior management. This is possible, but as I argued in the previous post, I think more time is needed to properly judge the long term impact that radical cost cutting strategies may have on branded consumer goods companies.

Also note that this phenomenon does not only apply to 3G backed companies. For example, in the tobacco sector, British American Tobacco (BATS) has recently bought Reynolds American and in the process has leveraged its balance sheet to 4.6x net debt / EBITDA1. It’s share trades on 18x p/e. Japan Tobacco, the least leveraged of the global peers at 0.1x net debt / EBITDA, trades on 16x p/e, an 11% discount to BATS2.  Arguably the less financially leveraged companies should actually be valued at a premium since they have option of using their balance sheet capacity to increase equity earnings but they do not currently have the same level of downside risk were an unexpected negative to hit them.

Remember that much of the superior earnings growth of these companies is a consequence of the acquisitions themselves. It is not difficult to create earnings growth when the cost of debt is so low, since the earnings yield of the asset purchased is almost certain to be higher than the cost of the debt used to fund it.

But don’t confuse this “earnings accretion” with genuine value creation. The latter is much more challenging to achieve because it requires the overall return on investment to be higher than the hurdle rate or “cost of capital”, which for most businesses would be a high single digit rate. Because recent deals in the consumer sector have been done at such high valuations, even on the managements’ own forecasts most of them will need 5-10 years before the overall return exceeds the cost of capital. As a generalist, I find this surprising and somewhat concerning. In any other sector, investors would not applaud this sort of capital allocation behaviour.

I have no fundamental problem with any of these companies and nor do I think that financial leverage is necessarily a negative. Rather it is a question of risk and reward. And here I think that investors are seriously mis-judging the risk profile. A valuation premium for financial leverage is a sign of the times. It suggests the market is already discounting the positives whilst potentially ignoring the negatives. Against such a backdrop, investors would be wise to stick with more conservatively financed and lower valued companies3.

Matthew Tillett


1. Source: Moody’s estimates, January 2017< 2. Source: Bloomberg estimates, 01/03/2017
3. This is an opinion. It is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.

Re-lever Unilever?

Hats off to the Unilever Board for rejecting out of hand the recent takeover approach from Kraft-Heinz. Aside from the socio-political obstacles, there are compelling financial and business reasons why Unilever is better off on its own, and it is encouraging to see the Board taking such a strong stance on this.

The private-equity group 3G Capital no doubt saw the potential to increase Unilever’s profitability significantly, as they have done at Kraft-Heinz and Anheuser-Busch before that. The 3G model is one of radical cost cutting. Combining strong brands that are protected by pricing power with a ruthless focus on removing layers of management can result in huge increases in profitability. Slap on a healthy dose of financial leverage and the returns to equity holders can be enormous.

Indeed, both Anheuser-Busch and Kraft Heinz shareholders have been well rewarded in recent years with strong absolute and relative total returns. And, now with the backing of the mighty Warren Buffett, how could anyone argue against the 3G model?

Yet the jury is still out on this approach. A recent McKinsey report showed that market shares for some of Heinz’s key categories had fallen following the 3G takeover1. Of course, financially this was more than offset by the increase in profits from the massive reduction in costs. But is this really a sustainable long-term approach to managing a business so dependent on the strength and health of its brands?

The attachment of consumers to these brands is the main strength of the consumer staple business model. Radically cutting costs risks damaging these customer relationships, or leaving a gap in the market for newer, more innovative entrants. Whilst cost cutting provides an immediate boost to profits, such changes can take several years to become apparent.

There are plenty of companies in which the 3G model would make sense; but Unilever is not one of these. This is a company with a heritage and culture stretching back decades and an investment horizon that looks equally far into the future. Culturally it is hard to think of a worse fit for the 3G approach. Unilever has also delivered impressive shareholder returns over almost any time period, suggesting it is already pretty well managed. Ripping costs out and leveraging its balance sheet might enhance shareholder returns even further but this would also significantly increase the risk profile.

With the deal scrapped, commentators are asking what Unilever should do now. How can it protect itself from future approaches? Some have suggested that Unilever should leverage its “inefficient” balance sheet in order to buy back shares and boost earnings, whilst others have suggested using the money to finance a big deal. This is classic bull market talk, reminiscent of the mid 2000s when every consumer company was supposedly underleveraged and on the verge of being acquired by private equity. We all know how that ended.

Here is some alternative advice for Unilever: Don’t rock the boat. Continue to run the business for the long-term. And as for the balance sheet, low leverage is as much a strength as a weakness. As Mr Buffett himself is fond of saying: “It is only when the tide goes out that you discover who’s been swimming naked.” The current era of cheap money and high valuations is unlikely to last forever. It would be far better to deploy the balance sheet counter-cyclically from a position of strength and when valuations are lower, than be peer-pressured into doing something rash today2.

Matthew Tillett


1. Source: Bloomberg news –
2. This is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.