As we toured the different segments of the plantation it occurred to me that there are many lessons to be learned about risk management and resilience from farmers.  With factors such as the weather and volatile commodities markets out of their control, farmers must strike a balance between maximizing short-term returns from their cash crops while still ensuring as much as possible the long-term sustainability of the plantation by doing such things as preserving the soil and diversifying their produce.

A simple example of this balance is how Carlos and his sons protect the rich soil of their plantation from the effects of the sun, wind, and rain.  A less far-sighted farmer might think it wise to dedicate all of his plantation to growing coffee if that is the most financially rewarding crop, but that risks overtaxing the soil and reducing its health going forward.  Carlos and his sons do quite the opposite, dedicating a patch of the plantation to growing simple grasses that have no immediate financial value, but which when cut provide a kind of protective layer for the soil so that its richness can be preserved for future growth, as seen in the photo below:

From an investment perspective, it occurred to me this is similar to maintaining cash in a portfolio even when it yields close to nothing.  It has no immediate benefit in terms of increasing the portfolio returns, and the drag may cause underperformance against a fully invested benchmark, but in volatile times, holding cash can prove to be a lifesaver as it covers short-term expenses while your longer-term holdings recover and grow.  In reality, the only performance benchmark that matters is whether you can still pay your bills or not.

Unpredictable and unforgiving weather is a fact of life for farmers, and I asked Carlos about the infamous frost of 1975, which ruined more than half of all the coffee crop in Parana.  Many coffee farmers were ruined, and sadly suicides rose as desperation set in.  Those fortunate farmers who survived the ruinous frost were certainly lucky, but they also benefited from not having had all their exposure to coffee, and so were able to ride out the storm.  In fact, opportunistic coffee farmers who held on just long enough were able to acquire additional land on the cheap, and so benefited from the eventual rebound in ensuing seasons.  The lesson is pretty obvious:  one invests or farms for the long-term, but long-term goals are achieved only by surviving the short-term, which can bring even unthinkable disruptions to one’s operations.

A long-term goal of any family farm is to generate economic profit, but mainly it is to provide income and security for generations yet to come.  One way Carlos and his sons ensure this is by periodically reducing production by cutting down older plants so younger plants, which should yield more in the future, can take their place.  It requires patience and discipline to sacrifice income in the short-term, but it is necessary for to sustain the health of the plantation.

This kind of rebalancing discipline is no less important to a diversified investment portfolio, which periodically requires the selling off of overweight, winning positions to reduce concentration and seed future growth.

Most importantly, what I learned from my discussion with Carlos and his sons is the importance of resilience.  The plantation has provided income for the family over multiple generations certainly through a lot of good fortune, but also because they have run the farm with resilience in mind.  Resilience is something that we as investors have been conditioned to overlook with our fascination with daily stock price movements, quarterly reporting, and benchmarked performance.  I did not ask him, but I am sure Carlos would say he has never worried about how well his neighbors were doing as he has always been sufficiently occupied worrying about the maintenance of his own plantation.  Resilience requires the discernment to determine what is important and the ability to ignore what is not.

Writing on the topic of resilience in the Edelweiss Journal in 2021, Michael Weeks summed it up rather well:

“Resilience is an unseen aspect of economic life.  We cannot count it or touch it.  It doesn’t appear on financial statements, while its absence drives men and women to the unemployment office, machinery to the scrap heap, and businesses into bankruptcy.  Even unseen, it is a factor in nearly every decision a business owner makes…We may think we are prepared for what may come, but this is only a guess.  The only real test for hard times is to survive hard times…

Resilience only comes from owners.  Resilience is not a fluke that one stumbles into.  It is a deliberate and purposeful objective which some aim for and others don’t…[Owners] must build up reserves and competencies in the good years to give them options in the bad.  They are motivated by a sense of responsibility — to themselves, their families, those they work with, and those who will come after them.”

These are useful lessons to keep in mind as we enter what promises to be a rather tumultuous period in the economy and financial markets, buffeted by the winds of inflation and armed conflict.

The post Lessons In Resilience From A Coffee Farmer appeared first on Fortune Financial Advisors.

Here is why I favor sector-neutral positioning:  I would argue that if you are deviating from the index by making active bets with your portfolio, and if you are subject to benchmarking, it makes sense to limit the number of things you have to “get right” in order to perform favorably relative to the benchmark.  With that in mind, if I am going to craft a relatively concentrated but diverse portfolio with 30 positions I would rather take my active bets both intra-sector and intra-industry than by trying to pick which sectors will do best overall.

You can see from this performance quilt from Novel Investor that a sector’s performance can often go from worst to first and vice versa from one year to the next:

For example, financials were the bottom performers in 2007, 2008, and 2011, but they were in the top half of performers in 2016, 2017, and 2019, and second so far in 2021, and so on.  You might think that is does not matter if you are skilled at security selection, but a recent paper from Standard & Poor’s suggests that around half of daily price movements for S&P 500 constituents could be explained by price movements within their respective sectors (graphic via S&P):

In other words, despite whatever fundamental qualities you might like about a given stock, if its sector is out of favor, there is a good chance that the stock you have selected will be as well, vice versa.  It is difficult to quantify with certainty how much of a role the sector plays over the very long term, but in the short-term it does seem to make a difference.

So now that we have argued for a sector-neutral portfolio posture, what is the best way to structure and allocate the portfolio?

The first step is to decide how many positions you want to hold in the portfolio.  There is a balance between diversifying and spreading positions too thinly, and so a number around 30 makes sense to me.  As my friends at Ensemble Capital have demonstrated, the benefits of diversification start to diminish, and perhaps the quality of the portfolio starts to decay, as positions number more than 20-30 names (graphic via Ensemble):

The next step is to determine how to structure the portfolio in a sector- or market-neutral fashion.  Of course this will depend on the market benchmark one uses, so for these purposes we will use the MSCI USA index.  Here are the sector weightings of that index as of June 30th:

The second step is to re-base the portfolio according to how you want your positions to interact.  For example, I do not see much purpose in distinguishing between information technology and communication services since the largest communications services stocks are no longer telecommunications names but platform companies such as Alphabet and Facebook, which were once part of the information technology sector, so I have combined those weightings in the re-based portfolio.  Similarly, I have combined consumer staples and consumer discretionary because one can argue that a stock like Amazon, which is now the largest consumer discretionary stock by market value, has now taken on some staple-like characteristics, especially during the pandemic.  The same can be said for a stock like O’Reilly Auto Parts, which is technically classified as discretionary, but has acted more defensively in the past as tough times economically mean people keep their cars longer and spend more on them.  That being said, here is how I re-based the portfolio according to my personal criteria:

With the sector weightings decided, it is time to decide how to allocate within the sectors.  In this case, I favor equal-weighting within sectors because it has been demonstrated that equal-weighting within sectors yields superior results, with the possible exceptions of energy and some other smaller industries.

A second consideration is whether you want to make your portfolio global in nature.  I have written before that home bias may not necessarily be a bad thing for American investors; in fact, there is a reason why most global portfolios that focus on “quality” stocks have a heavy bias to American firms.  But in some cases foreign stocks are just as high quality as their American peers, and in some cases they are superior, so I think it makes sense to consider including them when you see those opportunities.

Finally, we have the finished product, which is a globally diversified, 30-position portfolio that is both sector-neutral, and equal-weighted within each sector:

Or in pie-chart format:

The obvious caveats are that the end product will be determined by each person’s decisions as to how to classify and consider the 30 or stocks to be included in the portfolio – is Amazon a technology, consumer discretionary, or consumer staple company? – and so the end weightings will deviate a bit from the index weights, but in this way I feel an investor is balancing the desire to be diversified globally and across sectors,  maintaining an agnostic view as to which sectors will do best, all while focusing most of the active security selection to the industry and firm levels, and not watering down the portfolio in the process.

The post How To Craft A 30-Stock, Sector-Neutral Portfolio appeared first on Fortune Financial Advisors.

In addition to this unique combination, tobacco and defense have historically been reliable inflation shelters, rewarding investors with positive real returns during periods of higher inflation that more negatively impacted both their respective sectors and the broad market.  This should be of interest to investors given the latest uptick in consumer prices, which was the largest increase since 2008.

In the case of tobacco, there has been only brief 120-month period since 1947 in which real returns briefly turned negative:  the late 1990s when shares fell at the height of government-led lawsuits against the industry.  In fact, during the 1970s (highlighted in the chart below), when inflation averaged more than 7% annually, and both consumer staples and the broad market generated significantly negative real returns, tobacco stocks performed extremely well, with real returns averaging more than 6.5% annually, versus roughly -1.8% for both staples and the broad market.

This is no fluke, of course:  the increase in the costs of tobacco-related products has far outpaced broad consumer costs over time; for example, since 1986, tobacco CPI has averaged close to 7% annually versus just 2.5% for all items:

It is true that a great deal of this cost increase is due to regular tax increases, but it is also true that the excise tax structure affords tobacco product manufacturers an advantage when it comes to pricing power.  As my friend Jon Fell of Ash Park wrote last December:

Tobacco is the only Staples industry in which prices can consistently rise higher than inflation, and excise structures create a further advantage for manufacturers in disguising the level of price increase they themselves take.  To the extent that some of the tax burden is specific (based on the number of cigarettes per pack) rather than ad valorem (based on the selling price), manufacturers can obtain a bigger price increase of their own relative to any given level of retail price increase.  That excise multiplier effect is very important when tax accounts for 60-80% of the retail price.

This pricing advantage is crucial in an inflationary regime in which more commoditized staples industries, which are also more exposed to commodity cost increases, – think petroleum for disposable diapers, for example, – can pass along costs only very slowly.

A less obvious advantage for tobacco stocks in an inflationary regime is their typically depressed valuation multiples.  In the 1970s, for example, broad staples earnings in real terms were actually quite robust, but inflationary pressures pushed multiples into contraction.  This effect is typically less pronounced when starting valuations are much less demanding.

Like tobacco, defense stands out among its peer group for proving to be resilient in the face of inflationary pressures, with only the immediate aftermath of the end of the Vietnam War the sole period of negative real returns for the industry since 1963:

Like tobacco, defense stocks have almost always found themselves to be in the cheapest quintiles of the market, which helped during periods such as the inflation of the 1970s when the group suffered far less multiple contraction than the broader market.  Yet the industry has other advantages over its industrial peers when it comes to inflation.  Military machinery has become increasingly complex and expensive, and new projects require years to design, test, and produce.  Given the critical nature of these weapons programs, special materials for these projects must be obtained without much concern for costs, so demand is price inelastic.  Contracts are written with cost inflators that allow defense companies to pass along these costs to the government very easily.  All of these factors, along with the cyclical and episodic nature of large military spending programs, combine to create a structure that benefits military contractors in terms of pricing power.  This is obviously quite unlike most other industrial peers who feel the pressures of inflation much more sharply.

In sum, if inflationary pressures in the wake of the COVID pandemic prove to be more than transitory, investors might find safe havens in tobacco and defense.

*MSFT = Microsoft, AAPL = Apple, XLK = S&P Tech ETF, CL = Colgate Palmolive, XLV = S&P 500 Healthcare ETF, SPY = S&P 500 ETF, NSRGY = Nestle, XLU = S&P 500 Utilities ETF, XLB = S&P 500 Materials ETF, XLE = S&P 500 Energy ETF, XLF = S&P 500 Financials ETF, XLI = S&P 500 Industrials ETF, XLY = S&P 500 Cons Discretionary ETF, PG = Procter & Gamble, XLP = S&P 500 Consumer Staples ETF, BTI = Brit. Am. Tobacco, MO = Altria, GD = General Dynamics, NOC = Northrop Grumman, LMT = Lockheed Martin

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When times get lean, it is tempting for corporations to hunker down and wait for the storm to pass, but often enough boldness is rewarded in the longer term.  This is the lesson Ms. Cadbury teaches us about Nestle, which, being a Swiss company, spent much of the early 20th century surrounded by warring neighbors.  When World War I came along, Nestle faced a crisis as they were cut off from Britain, a very profitable market for them, by the German submarine blockade, and their continental operations were obviously disrupted by the British blockade of German ports, not to mention the conflagration across the continent.  Rather than sit idly by and watch their fortunes deteriorate due to circumstances quite beyond their control, Ms. Cadbury writes that Nestle’s directors embarked on a bold plan:

“The Nestle directors borrowed on a large scale to invest in setting up companies overseas or buying a controlling stake in foreign companies.  Through their American branch in Fulton, New York, they acquired interests in firms in North and South America.  Their shares in milk-processing companies in Ohio and Philadelphia alone brought them control of twenty-seven factories.  Nestle’s production in America rapidly became fives times greater than its entire Swiss production before the war.”

While this large bets on global empire building eventually came at a cost, – the company recorded its first loss in 1921, the result of the cessation of war-related orders and economic turmoil, – the aggressive long-term strategy continued to pay off; during the Second World War, Nestle’s presence in America once again proved to be life-saving as innovations like Nescafe proved immensely popular in one of the few major markets largely untouched by the destruction.

Conversely, Hershey, which had long been a dominant brand in America, felt no need to expand beyond its borders.  As Ms. Cadbury notes, American soldiers brought Hershey bars with them around the world, but after the war, Hershey executives failed to capitalize on this free marketing, and they made the decision to focus on where the disposable income then was, which was in the United States.  This shortsightedness cost Hershey as they ceded market share in globally to Mars, Cadbury, and others.

Perhaps the most interesting takeaway for me from Ms. Cadbury’s history is the extreme durability of familiar confectionery brands.  It might be surprising to many that, for example, Hershey bars are a product that have been sold more or less unchanged since 1900, or that Snickers, introduced in 1930, helped Mars navigate the Depression as its peanut core offered a more satisfying snack to consumers who were short on cash:

In sum, for those who are interested in the history of the confectionery industry, Chocolate Wars is an indispensable resource.  Readers will come away with a deeper appreciation for the struggles of the early chocolatiers who had to solve very complex chemical and logistics problems to bring chocolate to consumers.  I, for one, now find it difficult to pass through the candy aisle at the grocery store without stopping to think of the long histories of these familiar candies and the rich legacies they still represent.

The post Lessons from The Chocolate Wars appeared first on Fortune Financial Advisors.

Mr. Levinson artfully describes the impacts of major innovations on the industry, such as refrigeration,  which transformed the ways in which grocers were able to stock and store perishable items, and the automobile, which liberated shoppers from the limitations of purely local shopping choices.

However, I must confess that my favorite example is the lowly cardboard box, which, Mr. Levinson notes, was ‘discovered’ by accident – the employee of a paper bag manufacturer set the blades incorrectly on a batch of paper bag cuts – and allowed for a “cheap, convenient form of packaging…that could be decorated with pictures, logos, and brand names.”  It was a seminal moment that helped give rise to the branded goods that are still widely known even today.

One of the major themes of Mr. Levinson’s book, of course, is the conflict that arises when major retail chains such as A&P, which through their superior efficiency and scale offered consumers low prices that that small proprietorships could never hope to equal, begin to be targeted by ambitious politicians such as Texas Congressman Wright Patman, who portrayed himself as a guardian of small business, and the retail chains as a menace to prosperity.

The Great A&P is, at its core, an economic history book, but it is also an excellent business book as well.  Readers will learn a great deal about how the Hartford brothers were revolutionary in their vision for A&P, guiding it to become the world’s largest retailer, a position it would not relinquish for several decades.  Mr. Levinson, notes, however, that the two brothers failed to inculcate sufficient resilience within the firm to guide it once they passed on; indeed, the story of A&P after the deaths of the two brothers is one of failure to adapt and subsequent decline.

Mr. Levinson ends his story with analogies to Walmart and Amazon, and a provocative discussion of what really constitutes a monopolistic advantage in industry.  As Mr. Levinson notes, in the digital age, when consumers surrender personal information to vendors even while enjoying their low prices, the concept of monopolistic market power and how it is exercised should be expanded beyond the prices consumers pay for goods and services.

I reached out to Mr. Levinson to answer a few questions about A&P, the grocery business, and the current feeling toward big business in America.  He was kind enough to answer in detail:

During the golden years of A&P, the close control with which the Hartford brothers managed the firm seems like a distinct advantage as they kept a focus on the long-term health of the company, whereas a more widely owned firm might have been tempted to take a more lucrative approach in the short-term.  However, once they passed on and the firm fell into the hands of less skilled operators, the firm began its long decline.  Do you think there is a lesson there?  In other words, should the brothers have anticipated that they could not run the firm forever, and inculcated a better culture for those who would ultimately be running it long after them? 

ML:   One of the lessons of the A&P saga is that it can be dangerous to choose your own successor, as the Hartfords did. Another is that while it’s important to have managers who understand the firm and its culture, a firm can become too ingrown. At the time of the Hartfords’ deaths, all of A&P’s top managers had worked for the company for several decades, and they had a poor understanding of how the world was changing. Some fresh blood would have better prepared the company for the post-Hartford era.

Kroger is an example of a major grocery chain that was a contemporary of A&P’s, but which is still thriving today, behind only Walmart in terms of annual retail sales.  You detail at length the missteps A&P suffered after the deaths of the Hartford brothers.  Have you studied at all how Kroger managed to avoid those same mistakes and how it has managed to adapt and survive even in the digital age?

ML:   I have not studied Kroger in detail. One important difference between the two companies, though, is that A&P very rarely acquired a store, much less an entire company. Kroger, in contrast, has expanded over the years mainly through acquisitions. Those acquisitions potentially bring fresh blood into corporate management, and that’s likely to Kroger’s benefit.

Given the rise of the various megacap technology firms, and how much of our everyday lives with which they are involved, why do you think there is so much less pushback against them then there was, for example, against A&P?  Is it because Americans are more comfortable with big business now than 100 years ago, or are we, as your final chapter seems to suggest, perhaps blind to what constitutes real monopolistic power?

ML:  We seem to be in the early stages of a discussion of corporate power in the United States. Certainly, Americans are more comfortable with big business than they were a hundred years ago, but they have also been fed an ideology that there’s nothing wrong with big businesses unless they are blatantly fixing prices. There is a move back to a broader understanding of how corporate power can affect society, and that may have consequences for tech firms as well as firms in other industries.

The post Book Review: The Great A&P and the Struggle for Small Business in America by Marc Levinson appeared first on Fortune Financial Advisors.

In the first blog we featured the chart showing the multiple one could have paid for some great Consumer Staples companies in 1973, and still made a 7% annual return (excluding dividends) – slightly better than the market – over the next 46 years. A common push-back is that the chart illustrates survivor bias, and that overvalued losers are missing. Is that fair?

JF:  We wondered about that as well, so we checked it. A few years ago we dug out the stats for all the US and European branded Consumer Staples stocks which had a market cap of $173m or more in January 1973 (equivalent to $1bn in today’s money). Outside the 25 surviving companies we featured in the original work, we found a further 41 which met the market cap threshold and have since disappeared because they’ve been acquired or merged.

Of those 41, 27 (66%) outperformed the US market up to the point at which they were bought. If you add those figures to the 21 surviving companies which had market caps over $173m in 1973, of which only Avon hasn’t outperformed, that’s outperformance from 76% of the 1973 universe.[1]

Figure 1: Performance relative to the US market up to the point of acquisition

Performance annualised in US$, calculated from 1st January 1973 up to the point of acquisition; includes gross dividends.
Numbers above bars indicate numbers of years of trading history from Jan 73

Source: Ash Park / Refinitiv Datastream

Going into the detail of the underperformers is interesting too. There are four where the underperformance was pretty marginal and the absolute returns OK: Beatrice Companies (a 9.2% annualised absolute return for 13 years), Revlon (7.3% annualised for 13 years), Borden (9.6% for 22 years) and United Biscuits (10.8% annually over 27 years).

And there are four real disasters, all of them brewers. Two (Brau und Brunnen and Actris) were from Germany, where brewing is a famously-tough business (lots of small family brewers who don’t consolidate).

Then there are two US brewers, Schlitz and Pabst. The Schlitz tale is a bit of a classic: in 1976 they were only just smaller than Anheuser-Busch, with a US market share of around 16%. The Uihlein family which wanted to overtake A-B again needed increased capacity, but decided to cut corners: rather than investing in capex they chose to reduce the brewing cycle (to 14 days, v A-B on nearly 40), having already reduced the beer’s malt content. But with lager, if you reduce the ageing time you also require more stabilizers to stop solids being formed when proteins blend with the tannins in the beer; those solids look like mucus and float around in the bottle. In 1976 they changed the stabilizer they were using, and unfortunately that accelerated the production of solids. Schlitz waited a long time before doing a product recall, and sales tanked because people didn’t want beer with mucus floating around in it. They followed that up with one of the worst advertising campaigns of all time, which became known as “Drink Schlitz or I’ll kill you”.

Schlitz’s decline continued, and eventually they were sold to Stroh in 1982 as a shadow of their former selves. Pabst’s downfall was largely due to sins of omission rather than commission: they lacked the marketing dollars to compete effectively in the mainstream, and failed to launch a light beer in time to compete with Miller Lite and Bud Light.

Carter Wallace, which was a personal and healthcare company broken up in 2001 by Church & Dwight and a private equity firm, looks very bad on the relative performance but in fact did an OK-if-pedestrian 6% absolute return for 28 years (a positive real return of 0.8%). It was hit mostly by problems it had with its pharmaceutical operations in the early / mid 90s – the FDA started investigating its cough medicines in March 1992, suspecting they could be carcinogenic, and then in 1994 it had to withdraw a new epilepsy drug, Felbatol, after several patients died.

Of course we’re not saying that you should pay any multiple you like for one of these companies and just hold forever; we know that’s not realistic. The point we’re trying to make with our original chart is that the market is generally very poor at recognizing the longevity of cash flows from successful Staples companies. And the fact that over three quarters of the 1973 universe has outperformed the market over getting on for 50 years I think does say something important about the fundamental strength and resilience of this industry.

How do Staples perform in inflationary regimes?

JF:  It’s been a while since we’ve seen inflationary times, but if we look back several decades we’ve got data for two 10-year periods when inflation was high or relatively high: the decades to December 1982 (when US CPI averaged 8.7%), and December 1992 (CPI average 3.8%).

I think the most important message is that earnings from the Global Staples[2] companies beat the market quite handily over both of those periods: annual growth in real terms of 4.2% in the first decade, compared to just 0.5% for the market, and 7.8% annually in real terms over the second decade, versus the market’s 2.6%. If anything, the advantage of high-ROIC, low capital-intensity businesses should become even more important in inflationary periods.

But a lot depends on the starting multiple, too. In December 1972 Staples started with a trailing P/E of 31.5 which went to 10.8 over the next 10 years, whereas the market only went from 21.8 to 11.7: that’s why Staples underperformed the market in the 1970s. Whereas over the subsequent decade both Staples and the market benefited to a similar degree from re-rating (Staples back up to a trailing P/E of 19.6; the market to 21.0).

Figure 2: Decomposition of annualised total returns

Figures show real and nominal returns in US$. Global Staples refers to an Ash Park Index calculated for the World Food, Beverages, Tobacco and Household & Personal Care sectors.

Source: Ash Park / Refinitiv Datastream

As things stand today, Global Staples and the market are both once again on a similar forward P/E, which puts Staples’ P/E Relative near a 20-year low and should mean the chances of de-rating driving underperformance are quite limited. Meanwhile it’s important to remember that on the measure which really drives long-term performance – the combined effects of earnings growth plus dividends – Staples has almost always beaten the broader market. That comes back to the consistency of delivery we talked about in the first post.

Figure 3: Combined returns from earnings growth and dividends, 10-year rolling

Nominal returns in US$. Global Staples refers to an Ash Park Index calculated for the World Food, Beverages, Tobacco and Household & Personal Care sectors.

Source: Ash Park / Refinitiv Datastream

What do you see as the biggest, most likely threats to a global staples portfolio.

JF:  On the macroeconomic side of things, weak global growth isn’t good – although we know that Staples does better than many other things in that scenario – and dollar strength also holds back returns because a lot of the large Staples companies are truly global, with big businesses in Europe, Japan, and emerging markets. A strong dollar (up nearly 30% on a trade-weighted basis in the last 10 years), along with very low inflation, help explain why Staples’ nominal returns over the last decade have been squeezed as shown in Figure 3.

There’s always the danger of self-inflicted harm if management chases short-term profit. That’s what drove the Schlitz example, and more recently you’ve seen something similar from the 3G businesses: an obsession with margins, and underinvestment in brands and growth, and that behaviour spread to other companies who got scared that if they didn’t boost their own margins they’d be at risk of 3G buying them. It was probably US Food – which we haven’t owned – that felt that effect most severely, and the good thing now is that most Staples companies are back in reinvestment mode, which should bode well for future growth.

The short-term approach is a bad idea anyway, but it’s even worse when smaller, innovative companies are trying to grab market share. And ‘disruption’ continues to be the threat that we find ourselves talking about most. Howard Marks had an interesting line in one of his recent letters: “the onslaught of startups with readily available capital and minimal barriers to scaling means that the durability of legacy businesses has never been more vulnerable or uncertain”.

That might well be true, but it’s something every sector is exposed to, and in the case of Staples brands it’s typically not like as a startup you’re creating a completely different technology: there might be things that are slightly different; maybe you can get the product sent straight to your door rather than having to schlep to the grocery store, but you’re really offering novelty. And if you’re not really offering something that revolutionary, what makes your new food or personal care brand any less disruptable than the legacy business whose lunch you’re trying to eat? You’re going to have to adapt, change, or be disrupted in future as well.

Ben Schott wrote a great Bloomberg Opinion piece a few months ago, gently sending up what he calls Blands: startup brands with slightly cutesy names and logos, like quip, Harry’s, GLEEM, Yumi and Bimble. They claim to be unique and groundbreaking but follow very similar formulas in terms of business model, look and feel, and tone, and they’re funded by large and successful VC and PE firms yet make themselves out to be the underdog.

The advantage incumbents have is that they have massive resource in terms of people, connections, distribution, marketing budgets, which they can put into adapting their own businesses. Some of them might be a bit slow, but they tend to get there in the end. Who’s going to deal with ongoing disruption better in the end: large, profitable companies or businesses which never made much margin in the first place?

Are we getting near ‘peak bland’? It’s almost exactly 10 years since Mike Dubin founded Dollar Shave Club, but allocators still tell us there’s a massive wave of capital making its way to new direct-to-consumer (DTC) brands. You’ve got more and more money chasing small consumer disruptors at higher and higher valuations. We want to stay clear of that. For the large companies this is sort of an outsourced R&D. They can watch the disruptors battle it out, see who emerges in this survival of the fittest contest, and then buy them and scale them up. This is something we watch carefully, and for the last couple of years we have been shifting our portfolio weightings out of megacaps and into some of the slightly smaller – but still sizeable – Staples companies which we can see have the right strategies and assets to thrive in this environment.

[1] Our first chart had 25 companies in it, but Carlsberg, Lindt, Pernod-Ricard and Smucker had market caps under $173m in January 1973.

[2] ‘Global Staples’ in this section refers to an index created by Ash Park using Refiniv Datastream data for the World Food, Beverages, Tobacco and Household and Personal Goods sectors.

Disclaimer:

Kingsway Capital Partners Limited (“Kingsway”) is authorised and regulated by the Financial Conduct Authority in the United Kingdom (the “FCA”). Ash Park is a division of Kingsway. Kingsway does not offer investment advice or make any recommendations regarding the suitability of its products.  This communication does not constitute an offer to buy or sell shares or interest in an Ash Park Fund. Nothing in these materials should be construed as a recommendation to invest in an Ash Park Fund or as legal, regulatory, tax, accounting, investment or other advice. Potential investors in an Ash Park Fund should seek their own independent financial advice. The offering materials may only be distributed in accordance with the laws and regulations of each appropriate jurisdiction in which any potential investor resides.

Past performance is not necessarily a guide to future performance. Kingsway has taken all reasonable care to ensure that the information contained in this document is accurate at the time of publication, however it does not make any guarantee as to the accuracy of the information provided. While many of the thoughts expressed in this document are presented in a factual manner, the discussion reflects only Kingsway’s beliefs and opinions about the financial markets in which it invests portfolio assets following its investment strategies, and these beliefs and opinions are subject to change at any time.

The post Further Exploring the Resilience of Consumer Staples with Ash Park’s Jon Fell appeared first on Fortune Financial Advisors.

We noted that these few industries with stellar performance records shared a few things in common such as wide economic moats and earnings stability.  At first glance, the defense industry (labeled as “Guns” as that is how it is listed in Professor Ken French’s data library) would seem like it would not fit along with the other industries like tobacco, pharmaceuticals, and food, which are staples of everyday life.  However, a deeper look at the dynamics of the industry and its history reveals that the major defense companies (often referred to as “primes”) have performed very much like the more obvious high quality, low volatility industries.

For example, it is remarkable that since mid-1963, the furthest back data go, the defense industry has not suffered a negative ten-year result over any period, while the broader market has suffered two (although one was essentially flat):

This is all the more remarkable given that the defense industry suffered in the 1990s an economic shock that was proportionately worse for it than the Depression was for the economy as a whole in the 1930s.  It is not as though the stocks of these companies were not affected by the huge decline in government defense spending that resulted from the end of the Cold War; in fact, the collapse in defense stock prices culminated in a greater than 60% drop, which was greater than what the market suffered after both the tech bubble burst and during the financial crisis:

Certainly the industry benefited from the surge in defense spending that coincided with the conflicts in Afghanistan, Iraq, and elsewhere, but it was also by this time extremely lean and efficiently run after years of consolidation, prudent divestments, and cautious management which had resulted from the severe reduction in government defense spending.  With fewer opportunities to grow, a decline in capital expenditures ensued, and the focus became returning cash to shareholders, mostly from cash earnings.

To illustrate this change in management focus, I asked my friend, Jesse Livermore (@jesse_livermore on Twitter), the author of the Philosophical Economics blog, to crunch the numbers for me using data from O’Shaughnessy Asset Management (with whom Jesse is a frequent research partner).  The major shift from investment to consolidation and cash returns on the part of defense companies can be seen in this great chart that Jesse created:

Two great examples of this focus on returning cash to shareholders are Lockheed Martin and Northrop Grumman.  Since 2003, Northrop’s management has repurchased more than 50% of shares outstanding.  Lockheed’s management has been almost as active.  Yet it would be incorrect to assume these repurchases were done indiscriminately, as has perhaps been the case in other industries; for example, as this chart demonstrates, several of Lockheed’s repurchase programs were initiated at extremely opportune times:

The success of defense stocks can be explained from a factor perspective, as well.  Jesse prepared another chart, which shows that defense stocks have rarely been among the most expensive stocks in the market, and, more recently, they have been among the least volatile, traits they share with consumer staples to which they are sometimes compared (chart via Jesse Livermore & OSAM):

Now once again the defense industry is faced with skepticism about its future and budget allocations, and valuations have compressed.  Yet the world is not any safer, and potential enemies the world over continue to invest in modernizing their militaries in an attempt to keep America at bay.  It seems to me that the industry is well positioned to continue to deliver for shareholders for years to come.

Disclosure:  both the author and clients of Fortune Financial Advisors, LLC, own Lockheed Martin and Northrop Grumman.

The post Exploring the Surprising Resilience of the Defense Industry appeared first on Fortune Financial Advisors.

Consider, for example, the weighting of the top stock, Apple, which currently represents close to 7% of the S&P 500’s market capitalization:

Similarly, the top ten stocks make up more than 27% of the index, surpassing both the tech bubble and 1980 oil bubble peaks:

Another data point is that, like 1980 when a majority of the top ten S&P 500 components came from the energy sector and related industries, today a majority are technology or technology-related (as CNBC’s Michael Santoli pointed out on Twitter, if you account for the two Alphabet / Google share classes, that boosts Visa to the 10th spot, which is also arguably tech-related):

Another illustration of how the top of the market is distorting things is to compare the respective capitalization shares and earnings shares of each S&P 500 sector.  Unlike 2017 when we last visited the topic, there are material disconnects between certain sectors’ capitalization shares and their earnings shares, with technology and consumer discretionary, for example, currently being over-represented relative to their earnings contributions, while financials and healthcare are under-represented (data via Yardeni):

In their most recent Guide to the Markets, J.P. Morgan pointed out a similar disparity in the megacaps’ capitalization share and earnings share, as well as the huge valuation gap between the megacaps and the remaining index components:

Of course, none of this is to suggest that these popular growth stocks cannot continue to grow and become an even larger chunk of the market.  Yet it seems beyond dispute that the index is now extremely concentrated, and material disconnects are surfacing between the fundamentals (e.g. earnings contributions) of certain segments of the market and their market values.  Given all this, one is tempted to wonder if the next decade will be a little kinder to small, mid-, and equal-weight strategies, which have languished, relatively speaking, for years.

The post The Most Concentrated Market in 40 Years appeared first on Fortune Financial Advisors.

Given intense investor interest in the space, I invited Matthew Dolgin, who covers the cell tower operators for Morningstar, to share his views regarding what makes these attractive businesses, future growth opportunities for the space, and much else.  Our interview is below:

There is a lot to like about the cell phone tower business:  high barriers to entry; strong recurring cash flows; a strong tenant base.  These are all well-known positives and widely discussed.  What do you think are some downsides to the business model?

There’s really little to dislike about the tower business model, which is why any hesitation I have about the stocks at any given point in time is typically based on valuation rather than concerns about the businesses of the pure tower companies. Despite how good the model is, there’s more of a ceiling to the level of sales growth they can produce, so even more so than some other companies, it’s hard to justify paying higher and higher multiples.

The limitations to growth are the limited pool of potential customers (primarily mobile phone carriers) and the finite space that the tower providers can lease. Few organizations have substantial need for tower space, and for those that do, there is only so much physical space on a tower in which to put equipment. It’s difficult to envision any of the providers falling below low-to-mid-single-digit annual sales growth on their towers in the foreseeable future, but it’s likewise difficult to envision organic (same-tower) sales growth ever achieving double digits.

The customer concentration is another potential pressure point. Carrier consolidation has certainly been a threat traditionally, and the concentration also gives carriers power. The tower industry has thrived with roughly 3% annual rent escalators on U.S. towers (escalators are often tied to inflation internationally). Switching costs and the historical decision by carriers to use third-party tower providers prevents realistic concern that they would leave towers, but the concentration also limits tower pricing power. If tower companies wanted to be much more aggressive with pricing, the carriers could come up with alternative options.

What is your view of future growth prospects for the industry internationally?  I understand from your work that emerging economies in Asia and Latin America, for example, represent great growth opportunities given the rise in the middle class there, and attendant demand for smart phones and mobile data, etc.

I am bullish on the prospects for emerging market growth, which is a big factor in why American Tower is my favorite among the tower firms I cover. Almost half of its revenue comes from outside the U.S., predominantly in Latin America, India, and Africa. SBA gets about 20% of its sales from outside the U.S., predominantly in Latin America (mostly Brazil), and Crown Castle is exclusively in the U.S.

Source:  American Tower Investor Relations

Three main reasons underlie my international bullishness: lack of 4G saturation in many markets; use of mobile devices as primary broadband connections; and very high populations. Regarding 4G, emerging markets tend to be years behind the U.S., which has had ubiquitous 4G for about a decade. 4G brought a lot more data use and much higher need for bandwidth, which translates to more spectrum needed and therefore more equipment going on towers. As each of the countries in Africa and all parts of India get up to 4G, there will need to be more tower spending. Further enhancing data use is that in many of these countries, there is not broad coverage of wireline connections, meaning all internet usage will rely on those tower connections, unlike in the U.S. Finally, the sheer number of people in places like India is just a further tailwind to potential data usage and therefore need for wireless spectrum and tower deployment.

With all that said, India has been a huge anchor on American Tower the last few years due to major carrier consolidation. They have been slowly getting past that, and I still believe they will be well-served in that market long term.

Finally, I like the geographic diversification the international presence brings. The U.S. has been a great market the last few years, but it is also a mature market that tends to ebb and flow. If and when we get more into an ebb, the international exposure should allow American Tower to outperform.

I have heard it argued that self-driving cars are another important growth opportunity for cell tower operators.  How do you view this?

Self-driving cars are just a huge unknown, but I am not expecting them to ever be major catalysts to tower growth, and I’m certainly not forecasting it in the near term.

There are several things we don’t know: How much wireless spectrum do they need? How much will they rely on sensors that are independent of towers? Who will be the customer on towers? The car manufacturers? Will they be part of carrier plans?

While we don’t know the answers, we do know that things like sensors really don’t require much bandwidth, and current deployments have been negligible. While some tower presence may be critical, it doesn’t seem to me that autonomous vehicles will be a major source of traffic…data traffic that is; please excuse the pun. If it’s not causing a lot of data traffic, it’s not going to lead to a major growth driver for tower companies.

More broadly, I think you can look at many IoT uses through the same lens, and maybe in ten years we’ll see it differently, but we’re not expecting it to cause any major movement on towers in the near to intermediate term.

What do you think are the greatest potential disruptors of the cell tower business?

Apart from the threat of consolidation, which no longer really exists in the U.S., small cells has long been on our radar, but we really don’t think they will ever cannibalize the need for towers.

With small cells, a firm deploys spectrum on structures like light poles within cities rather than on the big macro towers. Ultimately, however, deploying spectrum on small cells is really expensive because of the very limited distance signals can cover from them, not to mention the inferior signal one might get from them due to the nature of the spectrum that is typically deployed on them (mid-to-high band).

Small cells will be integral to the fastest 5G signals, but a) we see them as complementary to macro towers rather than a replacement, and b) we see them as being widely used much more so in densely-populated cities rather than rural and more ex-urban areas. (With dense populations, the cost for coverage of such small distance can be worthwhile, whereas that’s not the case in sparsely populated areas).

With small cells not being a huge concern as a tower disruptor, I guess my biggest concern is therefore the unknown. Technology moves really fast and seems to always be able to do things that were previously inconceivable. Years down the line, it would not surprise me if more narrow bands of spectrum could accommodate more bandwidth and propagate farther, and with that, the use for an extensive presence on towers could be reduced. Innovations like dynamic spectrum sharing, carrier aggregation, and massive MIMO are things we’ve analyzed recently that allow carriers to more efficiently use spectrum (and therefore deploy less equipment on towers). Our view with those technologies now is that they simply counter some of the further tower deployments that are happening and will not disrupt the industry, but I’m sure there will be yet another technology coming soon. Fast-moving technology is a main reason why we put narrow, rather than wide, moats on tower businesses. I can’t even try to predict what will be technologically possible in twenty years.

How do you view Crown Castle’s decision to invest heavily in small cells, especially given the potential competition from AT&T and Verizon?

Crown Castle’s small cell strategy is the reason we favor its peers. Towers, which we think are fantastic, account for 70% of Crown Castle’s revenue and about one quarter of its capital spending, and the segment generates 65% operating margins. The company’s remaining revenue comes from its fiber segment, which includes small cells. Fiber accounts for over 70% of capital spending and has operating margins around 55%.

Ultimately, our view is that it is really expensive to build out fiber, and we are very skeptical the company will ever generate a worthy return on the massive spending it has been doing. You mentioned the primary reason. Crown Castle has acknowledged that having only a single tenant on a fiber run does not produce returns that justify the costs. To Crown Castle, the attraction of small cells is the ability to colocate multiple tenants on the fiber. But unlike towers, where each carrier is meeting its tower needs exclusively with third-party tower providers, two of the three major U.S. carriers can meet at least some of their need internally, and they have expressed a desire to do so. What’s more, there are many fiber owners out there. Unlike towers, where the tower itself is the scarce resource, with small cells, the fiber is the scarce resource. If you have fiber, anyone can pursue the permits to put up a small cell on the nearest street pole. With AT&T and Verizon willing to pursue fiber alternatives besides Crown Castle, we don’t think Crown will garner sufficient colocation.

To be sure, AT&T and Verizon will use Crown Castle’s small cells to a certain extent, as no single firm blankets enough of the landscape with fiber to meet all of a carrier’s small cell needs. Nonetheless, there is much more competition in small cells than in fiber, and we don’t think Crown will gain enough scale to make the business economically profitable.

Do you think the REIT structure makes sense for these businesses?

With the cash they generate and the tax benefits the REIT structure brings, it makes a lot of sense. The REIT structure may contribute to the firms being more highly levered with debt than companies in many other industries–as they often use debt to fund expansion–but with the steady, contractually guaranteed cash flows from financially stable customers, we don’t see that as a problem.

None of the firms is forced to pay especially high dividends, and SBA’s strategy is actually to return cash to shareholders well in excess of what it’s required to pay in distributions, which it does through its aggressive share repurchase strategy. That’s a whole separate issue for SBA, as it takes on more debt to fund the buyback, but the bottom line is that the REIT structure doesn’t put the firms in a cash crunch and doesn’t affect the businesses they’d be in anyway, so it seems to be a smart strategy to lower their tax burdens.

How can readers get in touch with you and your research?

Readers can sign up for a subscription to our analysis at www.morningstar.com/products/research.

Thanks, Matthew!

Clients of Fortune Financial Advisors, LLC, own shares of AMT, SBAC, and CCI.  

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It seems like most financial writers focus on the stellar returns of their favorite market sector over time, but Ash Park takes a slightly different approach: each of your quarterly letters starts with a graph that shows that global Staples have not suffered a negative 5-year period starting from December 1972.  Why do you think this is significant and what characteristics unique to global staples have contributed to such a favorable result?

JF:  We’re aiming for long-term growth with our strategy – and the sector’s returns have been excellent – but wealth preservation’s an important goal too, hence the significance of the sector not having lost money in any five-year period in getting on for 50 years.

What we love about the Staples companies is that they can sustain super-normal profits over the very long-run, supported by the strength of their brands and franchises. And we think that’s something the market consistently underappreciates. Of course these products tend to be defensive too: when times are tough people still need to eat, drink and wash, and they typically turn to products and brands that they love and trust.

Ash Park clearly views the various staples industries differently in terms of attractiveness, and that is evidenced by a significant allocation to tobacco and beauty, while having smaller positions in the food and beer industries.  How do you differentiate among the various consumer staple industries in terms of attractiveness?  In other words, what is attractive about tobacco, for example, and what is less attractive about food?

JF:  We actually have a strongly-held view that it’s the quality of a company’s management, culture and people that really matters most, more than the category it’s exposed to. A good company will always find a way to delight its consumers and grow – even with things as apparently mundane as air fresheners or trash bags – and there are brilliant brands across each of the Staples industries.

But we do think Beauty and Personal Care has a good tailwind: there’s a limit to the quantity of food, drink or tobacco you can consume, but fewer constraints on how much you can spend looking after your body or your appearance. It’s the one Staples sector where consumer spending has consistently out-stripped GDP growth. And gross margins are high – typically 70-80%, so the companies have massive firepower to invest behind their brands.

A good packaged foods company might have 35-40% gross margins, so that’s a tougher starting point. And outside a few areas – chocolate and confectionery would be an important exception – creating strong brands can be tougher, not least because it’s a very diverse category, tastes are quite local, and lots of people like to cook their own food.

Tobacco’s a special case. It has challenges which are well known, but in recent times the valuations have been pushed to what we think are absurdly cheap levels when you consider how resilient the consumption base actually is, the pricing power these companies have, and the longer-term opportunity to shift consumers into much less harmful ‘next-generation’ products like vapes or nicotine pouches. So we’re very excited about the Tobacco portion of our portfolio.

A common argument among consumer staples bears is fear of disruption by lower cost competitors who will sap away market share from major brands. How does Ash Park think about the possibility of disruption and the threat it poses to core holdings?

JF:  Well we fight very hard to make sure we’re not complacent about this, but the risk to well-managed Staples businesses from smaller or direct-to-consumer brands seems over-hyped. Large branded consumer companies have been buying and bringing to scale smaller brands for decades. The best way to put this in context is perhaps to think about what’s happened to and is still going on in, for instance, the Retail, Finance, Autos or Airlines industries. Almost everything seems more disruptable than Staples. In a way, what more disruptive an event could you have had than Covid-19? Big, well-managed Staples brands seem to be coming out of this stronger than ever because they have the resources, know-how and consistency of delivery to manage through turbulent times.

How does Ash Park view the opportunity set in emerging market consumer staples companies? Do you think any of the major EM staples will ever come to rival those from Europe and North America for global supremacy?

JF:  Over the longer run there should be a strong per-capita growth-driven story in emerging markets, but the question is how to play it. To access that growth opportunity you’ve got a fairly limited choice of quality businesses which are directly listed in the EMs themselves, and they’re often on really expensive multiples. But embedded in the global businesses are some of the best EM consumer companies out there, with many decades of experience operating in these markets, high governance standards and of course diversification. For our strategy around 40-50% of look-through, underlying sales typically come from EMs, and we think that we get exposure to these markets which is both better quality, and cheaper, than we would if we tried to invest in them directly.

You could argue that in Beer, what is effectively a Brazilian company – AB InBev – has already risen to global dominance. So it can happen, though it’s not easy because so many assets are already in the hands of the large US and European businesses.

In your third quarter 2019 letter, “The Perfect Investment,” you list several qualities of what would make the perfect investment: a growth mindset, skillful capital allocation, attractive valuation, and so on.  Can you expand on this a little bit?  How realistic is it to think many companies exhibit several of these characteristics at once?

JF:  I think it’s really important to have a clear view of what you’re looking for in your investments: the right behaviours, attitudes and set-ups that should be able to sustain long-term growth and a great return on capital. Having that well-defined framework simplifies the process of looking for new stocks and reduces the time you spend chasing down blind alleys. We’re not looking for the best-performing stocks in any one year, we’re looking for companies that can win year after year after year.

We know that no company is perfect, and we wouldn’t be doing our job properly if we didn’t identify potential red flags. We started that letter with a quote from Vince Lombardi which sums things up well: “we are going to relentlessly chase perfection, knowing full well we will not catch it, because nothing is perfect. But we are going to relentlessly chase it, because in the process we will catch excellence.”

“The Perfect Investment” features one of my favorite charts that shows the multiple one could have paid in 1973 and still realize a 7% CAGR (price only) through September of 2019:

Alongside the chart you write, “the market is generally very poor at recognizing the longevity of cash flows from successful consumer staples companies.”  Why do you think this has been the case historically?  You read of tech bubbles and even utilities bubbles in the 1920s, but staples always seem to be overlooked.

JF:  Yes, lots of people seem to like this chart, including a certain well-known fund manager who’s grabbed it for the introduction to his new book! Cheeky, but you could say flattering too. I suppose the ‘Nifty Fifty’ episode of the early ‘70s was the closest we’ve come to a Staples bubble, which is slightly ironic: the time people thought valuations on these stocks were crazy might be the nearest some of them have been to being valued properly.

It’s easy to dismiss high-quality consumer companies as boring. There’s nearly always something more eye-catching in the market, something apparently growing more quickly, with a better ‘story’. But the thing about Staples companies is that if they look after their brands properly, if they keep investing and innovating, they can carry on growing pretty much indefinitely – whereas many of the supposed hotter stories fade at some point and then new winners emerge in those sectors. Owning Staples is a time-efficient strategy because you don’t have to worry about finding the ‘new new’ every couple of years, with the reinvestment risk that entails. It’s a patience arbitrage that works through delayed gratification while excitement trades at a premium.

Kingsway Capital Partners Limited (“Kingsway”) is authorised and regulated by the Financial Conduct Authority in the United Kingdom (the “FCA”). Ash Park is a division of Kingsway. Kingsway does not offer investment advice or make any recommendations regarding the suitability of its products.  This communication does not constitute an offer to buy or sell shares or interest in an Ash Park Fund. Nothing in these materials should be construed as a recommendation to invest in an Ash Park Fund or as legal, regulatory, tax, accounting, investment or other advice. Potential investors in an Ash Park Fund should seek their own independent financial advice. The offering materials may only be distributed in accordance with the laws and regulations of each appropriate jurisdiction in which any potential investor resides.

Past performance is not necessarily a guide to future performance. Kingsway has taken all reasonable care to ensure that the information contained in this document is accurate at the time of publication, however it does not make any guarantee as to the accuracy of the information provided. While many of the thoughts expressed in this document are presented in a factual manner, the discussion reflects only Kingsway’s beliefs and opinions about the financial markets in which it invests portfolio assets following its investment strategies, and these beliefs and opinions are subject to change at any time.

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