Tuesday, June 14, 2011

Tweedy, Browne: Strong Consumer Brands for the Emerging Middle Class

Some excerpts from the Tweedy, Browne Annual Shareholder Letter.

The letter highlights companies like: Diageo (DEO), Unilever (UL), Philip Morris International (PM), Kimberly Clark (KMB), Nestle (NSRGY), Heineken (HINKY) and Novartis (NVS) and others.

...our Funds' portfolios today include many large, globally diversified companies, many of them branded consumer products companies, that conduct a considerable amount of business in faster growing parts of the globe where a new middle class is emerging. These are companies such as Nestle, Heineken, Diageo, Unilever, Philip Morris International, Kimberly Clark, Henkel, and Novartis, among others. While our interest in these businesses wasn't predicated on this idea of a rising middle class, but rather from the fact that these businesses were attractively valued at various points in time, their strong consumer brands and global operating experience gives these companies a leg up when competing for this new and rapidly growing source of demand.

In the letter, some important shifts that are likely to occur over the next 5 to 10 years are highlighted:

...by 2015, for the first time in 300 years, the number of Asian middle class consumers will equal the number in Europe and North America.

It also points out that it is very likely over the next ten years for Europe and North America's nearly 1 billion combined middle class consumers will remain essentially flat. In contrast to that, Asia Pacific's one half billion middle class consumers should easily triple in size.

Consumption in Asia Pacific, around $ 5 trillion already (nearly the same size as North America alone), is expected to roughly triple over the next decade.

Some comments were made on specific stocks that benefit.

Here are two:

On Philip Morris International
Philip Morris International, another one of our holdings, is the world's leading international tobacco company, with seven of the world’s top fifteen international brands. Approximately 35% of company profits derive from the emerging markets. In the 4th quarter of 2010, it reported a 15% increase in profits driven largely by a 24% surge in volume in Asian markets such as Indonesia, the Philippines, and South Korea.

The letter points out that Philip Morris International is the only international tobacco company to strike a deal with the Chinese National Tobacco Corporation to sell the Marlboro brand. Philip Morris has a good prospects going forward even if nothing material happens in China. So I wouldn't count on China producing terrific economics for the company but consider it upside.

Philip Morris International has a great combination of assets and future prospects but the recent extremely cheap valuation of the shares is no longer there. Still, if bought and held for 20 years I'd be surprised if it did not produce good investor returns.

Historically, I've preferred accumulating shares in tobacco companies when legal clouds have been at or near their darkest. For me, any additional shares would likely be bought as a result of some new ugly headlines. For now the legal front is relatively quiet but you never know when that will change.

It was easier to buy at a discount when Altria (MO) owned Philip Morris International's assets. When it traded as one stock, it made the specific risks associated with the legal environment in the U.S. (those that directly impact the U.S. tobacco business) hurt the valuation of those assets that are now separately Philip Morris International.

On Diageo
Diageo, the world's leading spirits company, today derives about about one-third of its sales from the emerging markets, with much of that growth coming from China, where drinkers are consuming more and more Johnnie Walker Scotch and Guinness beer. Ivan Menezes, the company's President, North America and Chairman, Asia Pacific, expects that in just a few years, 50% of its business will originate in the emerging markets. An important factor in this growth has been "premiumizing" or the trading up to higher priced brands. Diageo has eight of the top twenty brands in spirits.

At its current size, Diageo is not the fastest growing spirits company but the economic moat that comes from its brands and distribution is significant. It's also an expensive stock. A short-term disappointment (sub-par growth, poor execution, the macro environment or something similar) in the future is probably going to be needed to make the stock sell at a more attractive level.

I understand some will not buy the so-called sin stocks for reasons that go beyond investing. For those preferring non-tobacco and non-alcohol related businesses in their portfolio, the other branded consumer companies noted in the Tweedy Browne letter have assets that should produce solid future returns (though I'd prefer Pepsi: PEP  or Coca-Cola: KO at the right price).

The specific risks and opportunities of each, of course, do differ significantly but if bought at the right price most would make a worthwhile long-term core holdings in my view.

Adam

Long positions in DEO, PM, MO, PEP, and KO established at much lower prices

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