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OPINION

The great can be good

The great can be good
December 17, 2014
The great can be good

It's a dangerous sentiment, but you can see from where it gets its currency. Hindsight shows that, for shares in a comparatively small number of great companies, there rarely has been a price that turned out to be too high. True, sometimes an investor needed more patience than at others. But, given resilience, the outcome was almost always good.

Takes shares in Nestlé (SWX:NESN), the Nescafé-to-Perrier foods group. Buy the shares today at Swf72.45 (£47.60) and you pay 24.4 times the company's latest 12-month earnings. That multiple is even fatter than the fat content of Nestlé's 'chunky' Kit Kat bars to which Bearbull may be addicted and it's above the average multiple for the past 20 years, which is an ample 23 times. Yet history shows that paying 24.4 times earnings usually brings good rewards. From 1993 to 2010 there were seven occasions when an investor could have paid that multiple while Nestlé's shares were on a rising trend (rather than buying as the rating dropped through that multiple). On four of the seven occasions, that would have generated gains one year on (average gain for the seven - 12 per cent); five out of seven times there would have been gains over two years (average gain - 15 per cent); and six out of seven times there would have been profits over three years (average - 29 per cent).

It rather makes you think you can't go wrong. Of course, you can - of which, more in a moment. However, if an investor is to do what I suggested two weeks ago - The Carlsberg Way, 28 November - and invest in the world's developing economies via shares in world-class multi-nationals, there is little option but to pay high earnings multiples.

Yet for the likes of Nestlé, Procter & Gamble (NYSE:PG), Unilever (ULVR) and Diageo (DGE), it has not always been so. In the past 30 years there have been times when those producers of fast-moving, low-ticket branded consumer goods were perceived as over-bureaucratised, low-growth, capital-hungry beasts whose best days were behind them.

That was before there was widespread appreciation of the power of brands in low-ticket yet essential - or near essential - products. In those categories it is not enough for shoppers to stock up on washing powder, remember to buy toothpaste and shampoo and not to forget the snack bars. The washing powder - which is really a gel - has to be Ariel (Procter & Gamble); the toothpaste must be Colgate Stripe (Colgate-Palmolive (NYSE:CL)); the shampoo must be TRESemmé (Unilever) and the snack bars Snickers (Mars Corporation). Or maybe the must-buy products will be Persil (Unilever), Crest (Procter & Gamble), Aussie (P&G again) and Boost (Mondelez International (NasdaqGL:MDLZ)).

It does not really matter which. What's important is that consumers think in terms of brand names as much as they think of generic products and often have an irrational loyalty to the brands they favour. For producers, that's a fair return on the heavy marketing costs and expensive plant that keeps an established product in its market-leading position. For investors, it's great to know that their company has products that generate regular amounts of repeat sales; this keeps cash washing through the operation almost come what may.

Onto these merits has been added the approbation of the new middle classes in emerging markets, who love the seal of quality implied by established brand names. Hence the shares ratings of the companies in the table. This is a speedily assembled list of 29 developed-world companies whose characteristics meet the criteria we're discussing. Many of those included are blindingly obvious - not just Unilever, Nestlé and P&G, but also British American Tobacco (BATS), SABMiller (SAB) and Reckitt Benckiser (RB.). Others are less so, or less well-known to UK investors - Beckton Dickinson (NYSE:BDX) and CR Bard (NYSE:BCR), both of which distribute small-ticket medical devices and diagnostic kits; Church & Dwight (NYSE:CHD), which is a sort of US-based equivalent of Reckitt; Experian (EXPN), which seeks to piggyback on the consumer activity via its credit-rating and checking services.

On average, shares in the 29 trade on 23 times their latest 12-month earnings. The most lowly rated, at 15 times earnings, is London-based PZ Cussons (PZC), best known in the UK for its Imperial Leather and Charles Worthington brands; while the highest rated, at 56 times, is Michigan-based Stryker Corporation (NYSE:SYK), which makes surgical equipment and is a perennial takeover target. In addition, the group of 29 is perilously close to its all-time high - on average the ratio is 94 per cent. Nine of the 29 are at their all-time high and only three are less than 80 per cent - PZ Cussons, as investors fret about the group's heavy exposure to the ebola-threatened countries of west Africa; GlaxoSmithKline (GSK), weakened by its trials in China; and Denmark's Carlsberg (CPSE:CARL B), depressed by its exposure to Russia.

And why shouldn't the group be highly rated? They are a successful bunch. On average, they run operating profit margins of almost 22 per cent and generate a return on capital of close to 28 per cent. Simultaneously, they do this without carrying much debt. On average, net debt is 12 per cent of the market value of their equity.

Yet sustaining growth via expansion into developing markets is tough. It's all very well for a fast-moving consumer goods company to have a repeatable model in theory, where it tweaks proven products and distribution systems from one market to another. In practice, says Dunigan O'Keeffe, from the Mumbai office of management consultant Bain & Company, multinationals encounter two big barriers.

First, they find themselves operating at the far edge of their supply chain and of their ability to hire top-class managers. Second, they have to compete with a new type of competitor - "nimble, focused entrepreneurial enterprises, deeply embedded in their home markets, with ready access to local talent and often a hard-driving founder," according to Mr O'Keeffe. Indeed, research by Mr O'Keeffe and a colleague, James Allen, show that multinationals often end up producing "satisfactory underperformance". They do alright, but they struggle against local competition. In the period 2005-10, the developing-market subsidiaries of 92 multinationals grew their revenues and profits by 15 per cent a year on average. In contrast, local competitors grew their revenues by 26 per cent a year and their profits by 23 per cent.

That said, for UK-based private investors, taking the emerging-market route via multinationals may still be a better option than going via exchange-traded funds or actively-managed ones. However, there is an obvious snag. These investments also come with a big exposure to the developed world. After all, only 29 per cent of the revenue of companies in the table derives from emerging markets (and that estimate is made with some rather brave assumptions). That might be acceptable, but it must influence the other equity choices that an investor makes. Selecting from this list of 29 may bring sufficient geographical diversification, but it's less likely to bring enough diversification by activity - too much emphasis on non-cyclical consumer goods. Some investors might not care about this - diversification being an overrated notion, they may say. Others will.

 

CompanyShare price ($)Price % of all-time highMkt Cap ($m)Turnover in emerging mkts (%)Profit margin (%)RoCE (%)Debt/mkt cap (%)*Price/salesPE ratioCash flow multiple
The Coca-Cola Company (NYSE:KO)  44.54 99195,0902924.121.59.34.224.318.0
Nestlé (SWX:NESN)  74.99 99239,3093115.516.48.42.624.416.2
Unilever (LSE:ULVR)  42.56 94120,8713814.915.99.42.020.215.5
Pepsico (NYSE:PEP)  100.39 100150,2442215.523.313.22.222.015.5
The Procter & Gamble Company (NYSE:PG)  91.07 100246,082na19.317.29.13.023.915.8
Stryker Corporation (NYSE:SYK)  94.66 10035,8121914.516.6-2.03.856.020.1
Becton, Dickinson and Company (NYSE:BDX)  141.02 10027,0732019.526.24.53.223.015.5
Johnson & Johnson (NYSE:JNJ)  108.51 100303,7322928.437.6-5.84.117.716.6
The Estée Lauder Companies (NYSE:EL)  74.26 9628,1902615.845.1-0.22.625.317.3
CR Bard (NYSE:BCR)  170.99 10012,8071323.630.23.44.016.010.3
Baxter International (NYSE:BAX)  73.69 9539,9382119.020.318.02.421.412.7
Brown-Forman Corporation (NYSE:BF.B)  96.0 9620,3731532.537.82.76.830.830.5
Church & Dwight. (NYSE:CHD)  75.74 9810,1322519.321.06.73.125.819.1
Colgate-Palmolive (NYSE:CL)  69.86 9963,6703624.958.27.23.730.419.7
GlaxoSmithKline (LSE:GSK)  23.49 73114,2172023.023.520.23.117.314.2
3M Company (NYSE:MMM)  160.6 100102,9161622.331.14.53.221.616.0
British American Tobacco (LSE:BATS)  58.68 99108,8713937.829.915.94.819.616.2
Diageo (LSE:DGE)  30.89 9177,4103530.318.017.94.822.127.7
Heineken (ENXTAM:HEIA)  78.29 9945,0152613.710.830.21.926.811.0
Kone Oyj (HLSE:KNEBV)  46.4 10023,8101713.9122.7-4.92.726.419.0
Mondelez International (NasdaqGS:MDLZ)  38.89 8865,3322612.28.724.61.919.310.3
Anheuser-Busch InBev (ENXTBR:ABI)  114.79 98184,4444132.414.925.33.920.4na
SABMiller (LSE:SAB)  53.68 9186,2367027.311.015.75.123.622.7
Reckitt Benckiser (LSE:RB.)  82.09 9458,9883925.829.45.83.920.019.3
PZ Cussons (LSE:PZC)  5.23 772,2044313.318.62.11.615.419.3
Asahi Group (TSE:2502)  31.96 10014,786na7.09.922.51.025.4na
Carlsberg (CPSE:CARL B)  88.25 6713,5802713.98.444.01.215.09.1
Philip Morris International (NYSE:PM)  87.39 91135,7793843.459.919.74.517.615.6
Experian (LSE:EXPN)  16.4 8216,2402024.317.123.53.319.510.4
Averagena9487,6952921.627.612.13.323.116.8

This issue is beyond the scope of this week's exercise, interesting though it is. Nor is there space to whittle down the 29 to a list of, say, 15 chosen ones (a number still enough to bring decent diversification). Suffice to say, however, that my core would probably comprise GlaxoSmithKline, PZ Cussons, SABMiller, Nestlé, CR Bard, Philip Morris International (NYSE:PM) and either Unilever or Procter & Gamble. That brings diversification by product and geography, plus - in the case of Glaxo and PZ Cussons - share ratings depressed by short-term factors. And it's likely that onto these would go holdings in either Brown-Forman (NYSE:BF.B) or Diageo (DGE), Coca-Cola (NYSE:KO) or Pepsico (NYSE:PEP) and Heineken (ENXTAM:HEIA) or Carlsberg (CPSE:CARL B). And, before you know it, we're into the nitty gritty of stock selection and asking that perennial question: what is too high a price to pay for shares in a great company?

■ Meanwhile, the Bearbull Income Portfolio is having a lousy end to the year; though it would not surprise me if much of the ground the equity market has lost this month will be recouped by the year's end. Certainly, there seems to be something perverse about a market reaction that was determined to extract bad implications from what must be good news for the developed world (I am talking about its response to the drop in the oil price). The income fund has not been clobbered as much as it might have been chiefly because I sold its holding in BP (BP.) on 2 December at just over 429p per share. I have been muttering for some time about wanting to cut the fund's holding in FTSE 100 stocks and - as the oil-price decline gathered momentum - BP seemed the obvious candidate, even though - at that point - the share price had not dropped through the stop-loss level. Simultaneously, I bought 2,500 shares in Latchways (LTC) at 745p each. True, as I discussed last month (Bearbull, 21 November), the Latchways share price lacks momentum. Then again, I've never been much of a momentum investor. As for the longer-term merits, on a three-to-five-year view, I am confident Latchways can bring the fund a return comfortably above its target of 8.5 per cent a year.