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Investing In Sensory Indulgence: International Flavors & Fragrances

|Includes: International Flavors & Fragrances Inc. (IFF)


Fitness apps and boot camps, Paleo diets, sustainable this and sustainable that. Yeah it's all good. But aren't we allowed to just enjoy anything any more? International Flavors & Fragrances ($IFF) exists in order to help give an affirmative answer to that question, and is even working to do so when you consume good-for-you things. If that doesn't make for steady business prospects and a low-volatility investment case, then I don't know what does.

Setting the Table

While I'm all in all the time on sensory indulgence, the reason I'm writing about $IFF today is because it's a new addition, the only new addition, to the once-every-three-months rebalancing of the Smart Aphla Low-Volatility Select - S&P 500 portfolio, which was introduced here, recently reviewed here and which can be followed for free on Portfolio123.

The stock's Beta is 0.90. But that famous widely-used statistic is over-rated. It's a report card showing how bouncy a stock just happened to have been relative to the market in a specific past period. Depending on lucky or unlucky breaks, some frighteningly speculative stocks can at times wind up with very low betas and vice versa. What's really is important is how volatile we expect the stock to be in the unknown future. That depends on how volatile or stable we expect the company's earnings stream to be, and in that regard, $IFF looks like a terrific prospect.

The Sensory Arms Race: A Stable Foundation

As its corporate name suggests, $IFF has two lines of business; flavors and fragrances. It produces ingredients that help food and beverages taste the way the do and that help household products such as fabric care products, hair care products, toiletries, home care products and personal washing products smell at least tolerable and at times, good or even downright wonderful.

What $IFF produces are add-on ingredients. Why are these added in? It's because consumers want them. They want things that taste and smell good, and prefer things that taste and smell better than other things. In other words, $IFF is a supplier for a sensory arms race.

Is this a prescription for business stability? Yes. This can be envisioned by imagining how life would be if taste and small of products we consume and use was less than it is now. (There's a reason why eons ago spices were prominent among Silk Road traders and sought after my Medieval mariners who sought new routes to the East.)

And Then Some

Growth prospects are also present. These relate, simply, to the potential to do better.

For example, there's much talk today about natural products. Actually, younger readers may not realize this but natural products were glorified decades ago. The reason why they've taken so long to catch on is because they used to taste and smell like $%@*#. The reason why they're finally starting to make some headway is because they' are becoming increasingly tolerable and progressing toward good and better and, eventually, great.

$IFF's R&D efforts play an important role in making that happen. Over the trailing-12-month period, it's R&D spending amounted to 8.1% of sales. It averaged 8% over the past five trailing-12-month periods, versus a Chemical industry median of 2%.

Let's consider two protein sources; beef and tofu. Imagine cooking and eating both with absolutely no seasonings, spices, etc. Reactions to beef may vary depending on the cut and personal taste. Reactions to the tofu will likely be invariable, something along the lines of "When do I start eating?" Now you have a sense of the sorts of challenges $IFF deals with when it's 10-K refers to R&D efforts to develop "a comprehensive understanding of flavor interaction with protein and texture and develop taste solutions for new or alternative protein sources."

Another example is the Laborotoire Monique Remy operation $IFF recently purchased to give it a push in the growing cosmetics area (too, it's representative of the small purchases that are likely to be part of the company's future). Here, too, natural ingredients are increasingly favored. LMR enhances $IFF's ability to, according to the 10-K, transform "naturals, such as narcissus, jasmine and blackcurrant bud, into pure absolutes that retain the unique fragrance of their origin."

And by the way, its not enough nowadays to have ingredients that function well. Consumers want more transparency into what, exactly, those ingredients are. So $IFF needs naturals and proprietary compounds it can comfortably disclose (as if the typical user actually understands what any of it is, but perhaps that's just me; I almost failed high-school chemistry).

Just as in pharmaceuticals, there are innovation opportunities in delivery systems. $IFF is talking much about its "encapsulation" efforts, which enhance the ability of fragrances to remain active throughout a product's expected life cycle and which even allow fragrance to be added to functional or molded plastic.

Clearly, there's a lot more on $IFF's plate than just sitting around tracking GDP, or more particularly, consumer spending while hoping for the best.

And Then Some More

Lately, I've been irritating some pros (quants) who think I'm nuts to be questioning their willingness to plow client money into non U.S. stock and bond markets without actually thinking about the risk and reward characteristics of the countries in which they are investing. They argue against my "home country bias" by pointing out that geographically diversified portfolios reduce risk. That, to me, is one of those countless adages that sound great if you say them fast enough (thanks to Brooklyn Law School Professor Richard Farrell, from who I stole that phrase, which he often used on us knuckle-headed students).

Imagine a two-asset portfolio: Apple ($AAPL) and something else. I suppose you would cut correlations by pairing it with something like iShares MSCI China Small-Cap ($ECNS). But would that really be less risky than, say a portfolio consisting of $AAPL and $IFF. We know $IFF has a stable-plus business. And about the prospect of benefitting from long-term improved living standards in developing nations, $IFF is no slouch, not at all.

About half its revenue base comes from emerging markets. But here, the geographically diverse exposure is managed through business people with on-the-ground knowledge and experience (seriously; while $IFF is a global company, it has a strong regional orientation when it comes to nuts and bolts in order to address local tastes and preferences), as opposed to passive managers whose understanding of global markets may not go much if at all beyond the Excel Correl function and possibly vacations in tourist destinations.

The difference is interesting in terms of where $IFF competes. The passive ETF crowd gives you cookie-cutter exposure to Asia, Russia, Eastern Europe, and Latin America. $IFF, on the pother hand, focuses on business opportunity, not ETF fads. It is in China but also aims at Africa and the Middle East (and, of course, Canada). So it provides genuine, not scripted, geographic diversity (actually, $AAPL would do likewise in our hypothetical two stock portfolio; there really is a lot more to diversification than boilerplate guru-speak).

$IFF Numbers

Earnings comparisons now aren't as hot as the action crowd might want. To some extent, that's part of the price of stability And given a strong dollar, there has been a drag when foreign based numbers are converted to dollars (and yes, this is also present in the much else the geographically-diverse crowd peddles). But this is not an earnings momentum play.

Here is what we're looking for in a low volatility play:

Table 1





S&P 500

Ret. On Assets % - 12 mo.




Ret. On Assets % - 5 Yr




Ret. On Equity % - 12 mo.




Ret. On Equity % - 5 Yr




Interest Coverage 12M




Returns on capital are among the most persistent metrics out there and so high returns suggest stable business tendencies. $IFF is OK but a bit above the median in terms of its use of debt, but in an interest rate environment such as we've had, that's fine. Notice it's way-above-par interest coverage ratio. This, too, is vital for stability; the less interest coverage there is, the more volatile the earnings stream is likely to be since interest doesn't vary with sales.

Now . . . valuation is high.

Table 2





S&P 500

PE using Est CurYr EPS




PE using Est Next Y EPS












But I could care less.

This isn't the time or place for a full-scale explanation of the theory of stock valuation. But for now, suffice it to say that an ideal P/E ratio is 1/(Return-Growth) with Return being an expectation that moves up or down based on interest rates and, drum roll, risk. Since Return is a positive number in the denominator of our grand fraction, as Return falls (based on reduction in business risk), ideal P/E rises (this is analogous to the way 1/5 = .20, but when you divide by a lower number, say 1/4, you wind up with a higher result, .25.) Based on similar formulations, ideal Price-to-Sales and Price-to-Book also rise when margin and return on equity respectively rise. ($IFF's margins are well above average and those are what cause this company's returns on assets and equity to be as high as they are).

This is incredibly important. Many nowadays want potentially less volatile stocks. But time and again, I'm seeing bloggers and talking heads whining about high valuations and suggesting investors avoid them (not just $IFF but lots of lower-risk equities). That's flat-out wrong!

Overvaluation is not based on high ratios per se but on ratios that are higher than should be given the characteristics of what you're buying. The PEG ratio is one manifestation of this. And in terms of a stock like $IFF, you are supposed to pay up for risk protection. You know that. You do it when you insure your car. You do it when you insure your home. You do it when you buy health (aw heck, I'm not in the mood for a political brouhaha). You do it when you buy derivatives to hedge the risk of stocks. And you have to do it even if you want to simply buy less risky stocks.

If $IFF or other stocks of this nature aren't your cup of tea, that's fine. But for goodness sake, if you want to own it, don't let someone who doesn't understand how stocks are supposed to be valued talk you out of it.

Disclosure: I am/we are long IFF.