The market does not like uncertainty. May has been an ugly month thus far, and fear is back as Europe swindled its way to the forefront of the market's worries. The average investor is having a difficult time deciphering which headlines are fluff, and which ones hold any weight. The majority of them have been negative, so either way you look at it, there is little good news coming across the pond.
Many had hoped the Facebook IPO would provide the uplifting spark we needed to get out of this slump. However, that was a flop by most accounts, and it only went to show how there is no such thing as a "sure thing" in today's market. It seems to me that the market has been efficient in places most people assumed inefficient, and vise-versa. In the case of Facebook, tens of thousands of traders and "home gamers" lined up ready to make a quick buck, as they were positive they could capitalize on the same inefficiencies and opportunities that the IPOs of the past have offered. This was not the case, and almost everyone aside from Facebook went home with their tails in between their legs.
Investors in general possess a strong extrapolation bias, which is the expected continuation of past price changes. It is a flaw deep-seated within our human nature. Furthermore, we are largely overconfident with our decisions and have a strong bias towards optimism. Traders and investors alike need to make sure they are constantly asking themselves, "Why am I making this move? How much of this decision is based on hope, and how much is based on logic?"
With a large amount of uncertainty still remaining, and the increasing probability of a black swan making its way across the Atlantic, there are a few things an investor can do:
- Remain in a Cash position. This is the safest option, however it offers little upside, and over the long run has been trounced by the alternative option of investing in equities. In addition, inflation is working against you, and the buying power of your cash position is decreasing by the day as central banks continue to print into the unforeseeable future (in my humble opinion).
- Fixed Income. At this point fixed income is not much different than cash. The combination of the Fed's promise to keep rates near 0% into 2014 along with their numerous open market activities have pushed bond yields to record lows - into negative real rate territory.
- You can buy stocks.
If you are thinking about #3 as your preferred alternative than you have found yourself in the right place. If you are leaning towards the first two, you can either click the back button on your browser and direct yourself to the nearest "doom and gloom" article and justify your positions, or you can read on and see what you may be missing when you avoid buying (the right) equities in the middle of a market downturn.
I am not here to make recommendations on any specific company, or even industry, for readers to invest their money. All I am looking to do is to highlight the benefits of investing in companies that possess industry leading business models and top-notch brands, and what that means for their long-term earnings potential. I want to open up this discussion in a time of great uncertainty, when there is rampant fear in the market and many of these companies can be purchased "on sale" in the midst of broad market sell-offs. We all know the famous phrase on when we should be greedy and when we should be fearful, but as common sense as the saying goes, it's far too easy to get caught up in the noise and hype and abandon our sense of logic when we most need it.
A strong brand is an extremely powerful thing. A strong brand has the ability to create meaningful, long lasting relationships with its customers, and that in turn creates long-term value to the shareholders. When you are buying spec plays and swinging for the fences, the odds are against your success no matter what the market sentiment is at the time. However no matter how bad the market seems at the time, buying into companies that are industry leaders with formidable business models and strong brands has proven to be a winning strategy.
I also like to see companies with business models that strategically play into certain macro trends that will be growing, not shrinking, as we move forward into the 21st century. I will explain this last point as I provide a brief bio on each of my picks.
Over the last ten years, when the market as a whole has essentially been flat, we see that buying into companies that fit the above description has paid off in a big way. It doesn't take a rocket scientist to figure out who these long-term winners are, and what makes them so great. I will now highlight some of my personal picks for the future, display their performance in regards to the S&P 500 over the last 10 years, and then briefly describe why they are still a buy today, and will be an even better buy when the market experiences periods of broad sell-offs and rampant fear mongering.
Before I begin, let's do a little exercise that tests the reader's brand awareness and the power of brand recognition. I am going to name an industry, and you, as the reader, can mentally fill in the blank.
Fast Food: _______________
Technology Products: ______________
You will most likely find more than a few of your answers highlighted in the following analysis. Below you will find Part 1 that focuses on two select groups of businesses: Consumer Luxuries and Food and Beverage. Part 2 will feature Consumer Services as well as "Miscellaneous Industries".
Best-of-Breed Brands for 2012 and Beyond: Part 1
Some Financial Metrics:
Apple -There are hundreds of articles posted about Apple every month, all claiming one of two things: 1) The stock is on its way to $1,000 in the next twelve months. 2) The stock has peaked and the company is doomed. I am not here to take either of these standpoints. I will only make a few brief points about Apple.
First off, their margins are insane for a hardware company. They depend on carriers to subsidize the "cost" of an iPhone by buying them from Apple for $600 a pop and then taking the immediate loss on the sale to the consumer, only to make it up months later on the profits from the data fees. This is a dangerous proposition, especially with the rise in popularity of Android devices. Long-term, this could be a major problem for Apple, which may find difficulty in convincing carriers they are getting a fair share of the pie.
Yet there is no denying the brand power of Apple, and the value of an "iEcosystem" which allows the consumer to seamlessly integrate all of their favorite technology devices on one operating system. Continued growth in emerging markets is a must for this company. Also, they must continue to innovate - the iPhone series and iPad alone will not be enough to power the next ten years of earnings for them. They need to prove that they can execute in the post-Jobs era, and not go down the same road that GE did post-Welch. If you believe in the bull case, than this stock is ridiculously cheap; it sports a forward P/E of 10 and a PEG of 0.72. Almost 13% off of its highs in early April, now would be a perfect entry point for a prospective Apple bull.
Ralph Lauren - In my mind, Ralph Lauren owns the title of "everyday luxury." It holds a unique pricing point where a wide array of individuals can afford it; from upscale youth to mature professionals, every person who buys Ralph Lauren knows that they are getting a quality product. Their ability to assert themselves as a leader in global luxury items, which means continued growth in emerging markets, is the key to this company's future.
As far as the metrics go, they're price to earnings are a bit richer than others mentioned on the list, but it remains far cheaper than most of its peers (i.e., KORS trading on P/E of 62, Forward P/E of 42). Their 58% gross margin goes to show what kind of pricing power they have with their loyal consumer baser. RL is down almost 20% from its March high of $182 so it's not like you would be being it at the peak of its recent valuation. However, in my opinion there is no reason why this couldn't see $120-$140 on the next big sell-off, in which case it would be a screaming buy.
Nike - Nike owns sports. It's that simple. When you think of sports, you think of Nike. With this year being an Olympic year, billions of eyes from all around the world will see the legendary swoosh nearly everywhere they look. Nike has convinced my generation to pay absurd prices for their products. This helps them maintain their 40%+ gross margins, and return over 20% on their equity. They sign the best athletes in the world, who are admired and adorned by tens of millions of their fans. As the fans - the consumers - grow older, their purchasing power increases. They are able to buy more of the $100+ pair of shoes, the ones that mom and dad used to limit to once a year (at least in my family). Only 5% off of its 52 week high, the uptrend for NKE remains strong. Those who bought in October, when the dividend was close to 2%, have been greatly rewarded. We can only hope to get a similar opportunity in a future sell-off.
Diageo - This is potentially a wild card of the bunch but I wanted to include them because I believe they have an extremely valuable portfolio of brands in the alcoholic beverage industry, and that their long-term success and current metrics support the case that this company is not underserving of a mention in this list. With a market cap just shy of $60 billion, Diageo stock is up almost 80% the last ten years, a feat almost unheard of in the food and beverage industry for a company of that size. What has fueled the growth? Only the best portfolio of strategic alcoholic beverage brands in the world: Crown Royal, Johnnie Walker, Smirnoff, Ketel One, Baileys, Ciroc, Captain Morgan, Jose Cuervo, Tanqueray, and Guinness, just to name a few. They also continue to innovate with new products such as Jeremiah Weed, Captain Morgan 100, and a wide variety of pre-mixed beverages.
Looking at their financials, they are an interesting alternative to Coke - sporting a lower PEG (Price to Earnings Growth Ratio), a higher ROE, the same gross margin, and a higher dividend yield. They are up over 35% from their October lowers, and only 10% off their 52 week high, so they are similar to Nike in the respect to the strong uptrend, but they are definitely one to add to the shopping list if the market starts to head south.
Coke - The uptrend for Coke remains intact, and is still remarkably high off its 2011 floor of $64. What do you get when you are buying shares of Coke? You get one of the strongest brands in the world, with a business model almost untouchable by any single competitor. For a while PepsiCo (PEP) had kept it close, but their move into the snacks business has kept them sidetracked and Coke now owns the #1 (Coke) and #2 (Diet Coke) best selling beverages in the world.
They are heavily investing into emerging markets, and these capital expenditures will surely be realized in the coming decade as they make strong movements into Asia, Latin America, and Africa. It seems fairly priced at these levels, and it may have a bit of yield support with shareholders not entirely motivated to rush to the exits when they own one of the best-run companies in the world that's yielding them almost 40% a year more than the 10 year Treasury currently offers.
McDonald's - Speaking of the best-run companies in the world, McDonald's is to the food business as Coke is to the beverage. Their management is top-class (they have MCD returning almost 40% on their equity), and just like Coke, their business model and market share are unparalleled in their class. Up almost 230% in the last 10 years alone, the uptrend for McDonald's is far from over. We may not see another double in this decade, but I think this company's consistency and dedication to return value to its shareholders will make it a great company to own for not only the next decade but the next ten.
Yielding over 50% more than the 10-year Treasury, when you are buying McDonald's you are getting a stock with significant yield protection to the downside, and emerging market growth and consistent innovation offering significant upside. Sporting a forward P/E of only 14, this stock is cheap and if we see another Euro-induced panic, it could get even cheaper. Even if you think a recession is around the corner, that scenario only bolsters the reason why you should buy MCD, with families electing to forgo eating out at mid- to upscale restaurants and substituting that experience with a high quality, best-bang-for-your-buck meal from McDonald's. Just look at how it performed during the Financial Crisis in 2008: The company (and the stock) were left unscathed.
Starbucks - This is the richest of the bunch, with a current p/e hovering around 30 and a forward p/e of roughly 23, but there is no denying that Starbucks has an extremely powerful brand. It's customer loyalty is rivaled by few companies in the world. Even looking at the list above, perhaps only Apple could claim to have a more dedicated consumer base. Just like McDonald's, this company has a strong and efficient business model, with a market share and brand power that is unrivaled by anyone in its class. Dunkin Donuts is a distant second, and the two companies share very little commonalities in their brand identities and target demographics.
Starbucks has strong pricing power, but its gross margin significantly lags behind the rest of the companies on the list. When Apple has a better margin on a complicated electronic product like an iPad, than Starbucks has on a cup of coffee, that tells me two things: 1) Apple's margin in too high and 2) Starbucks gross margin is too low. Perhaps the absurd run up in the price of coffee beans has contributed to it, with the price of Robusta Coffee beans up fourfold in the last ten years alone. As expensive as their drinks seem, I do not think even Starbucks has been able to counteract that kind of appreciation in their most necessary raw material. This means that if the price of coffee is able to come down to a more reasonable level, Starbucks could see significant margin expansion in the next decade. I expect it to begin creeping towards MCD's gross margin of 40%, which could mean a major organic boost to earnings, on top of their innovation and growth. It also offers a yield (1.25%) which makes it that much more enticing than holding cash in the bank.
When fear and uncertainty are running rampant in the market atmosphere (as they are today), it's important to sit back and look at things with a logical and grounded perspective. Don't buy on hope or sell on fear. Use the broad market sell-offs to build your positions in the best-managed, best-branded companies in the world and let them pay you for waiting while the market finds itself.
A strong brand is a powerful thing, and the charts and numbers back that statement up. Stay tuned for a supplemental article on the same subject, as I do a similar analysis on a different set of companies with equally strong brands and business models as this first set.