Friday, November 30, 2012

High Quality Global Businesses Selling Lower-Ticket Consumer Products

Jeff Auxier, manager of the Auxier Focus Fund (AUXFX), was interviewed a few months back by GuruFocus.

From the interview:

"I like products that people buy frequently that are lower ticket, especially in tough economic times. The global population recently surpassed 7 billion. Most people just want to get through their day with a little pleasure. They want a cup of coffee, a bite of chocolate, a cigarette, a beer, a Coke, whatever, a little boost to get them through. So we like the fact that people are going to buy that product every day, by their choice."

Some of the best businesses in the world sell the stuff that's consumed everyday by the global middle class (according to Auxier the global middle class is ~1.8 billion and growing by ~150 million/year). Things like snacks, beverages, tobacco, and other lower ticket branded consumer products. Compared to just about anything else, many of the great global franchises have very significant and durable competitive advantages. As a result, the best among them tend to have relatively predictable, attractive long-term business economics and prospects. More from the interview:

"Recently throughout Asia and China, there is a movement away from the cheap knockoffs and a push for higher quality, especially with regard to food. They want the real thing. People want to buy quality Western brands. The disclosure provided by the internet is driving envy. People want to live better. I look at what people are using by their choice, what they like to do every day, and that source of demand. We have $400 billion a year in housing subsidies. How do you figure out the real supply demand there? Russians are going crazy over Doritos because they love the taste."

And big scale matters...

"If you look at the demographics related to food in Asia – the rapid urbanization – the thing is you need scale to hit that market. You can't do it as a small company."

Basically, the producers of things like snacks, beverages, and cigarettes with some scale are the exact opposite of technology businesses.

The difficulty with most tech companies isn't understanding what their business economics look like now.

The problem is understanding what those economics will look like in 10 or 20 years.

Not an easy thing to do. Tech businesses reside in environments that are fast changing and unpredictable. There is a wide range of possible outcomes and, as a result, they require a much larger margin of safety. 

Mostly, they are not worth the trouble unless extremely cheap to protect against the worst possible outcomes. With technology businesses, too often the storm clouds don't emerge with enough warning. Cheap is often not cheap enough. I realize some are very good at identifying the next big winner in technology, but that's a tough thing to do consistently well. Besides, potential big winners often reside in the same neighborhood as potential big losers and sometimes they're difficult to tell apart. 

Avoid the big losses and the returns usually follow.

As I explained here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries.

That's precisely what makes them unattractive long-term investments.

No matter how good business looks today (or how high the expectations are), it's just not that easy to predict their economic prospects many years from now.

With the best businesses that's not the case. Occasionally, certain tech stocks have sold at enough of a discount that it made me willing to own some shares. Even then I'm only willing to slowly accumulate very limited amounts. They've always been and always will be, at most, very small positions. To be worth the bother, the shares must sell at an extremely low multiple of free cash flow and, even if lacking growth prospects, have cash generating capabilities unlikely to fall off a cliff.*

In other words, I'm not exactly trying to anticipate the next big thing in tech. I'll let others try to figure that sort of thing out. It's buying inexpensive cash flow and, in some cases, lots of net cash on the balance sheet. Cash that, even if not put to brilliant use, just needs to not be allocated in very dumb ways. (Though it's better to assume that some poor capital allocation will happen then end up pleasantly surprised. The price paid should reflect that assumption.) The margin of safety must be large enough that nothing great has to happen to get, over several years, a good investment result. It must also be substantial enough to protect against all but the very worst unforeseeable rather bad tech business outcomes.

Tech businesses, in general, are involved in exciting, dynamic, and highly competitive businesses. That's precisely what makes them unattractive long-term investments. 

I'd buy more shares of my favorite businesses (some are in Stocks to Watch and the Six Stock Portfolio), with the intent to hold them indefinitely, if they were selling at just a nice (but not extreme) discount to intrinsic value. In contrast, even if bought extremely cheap, most tech stocks are just not for the long haul in my view.**

So, if there's a very large margin of safety, I'll consider some limited technology exposure but that's it. Well, at least until that margin of safety shrinks a bit. In general, they'll always play a small supporting role.

Jeff Auxier later added this in the interview:

"If the food dynamics are growing 2 to 3 times faster than the economy, who's going to do it? It's going to be like a Tesco, and a Pepsi and a Wal-Mart."

The portfolio he manages is certainly consistent with his thinking. 

Here's the top ten positions in the Auxier Focus Fund:

PepsiCo (PEP)
Molson Coors (TAP)
Tesco PLC (TSCDY)
Philip Morris International (PM)
Merck (MRK)
Microsoft (MSFT)
Procter & Gamble (PG)
Wal-Mart (WMT)
Medtronic (MDT)
Hospira (HSP)

According to Morningstar the annual portfolio turnover is 8%. So what's in the portfolio is generally held for quite a while. The top 10 make up roughly 21% of the portfolio.

The problem is getting shares of the great franchises when they're truly cheap. Unfortunately, it happens too rarely and most are not at all inexpensive right now. 

In fact, the financial crisis provided the first window in quite a while to buy shares of the best businesses at big discounts to intrinsic value (conservatively estimated). These days, most of them are much tougher to buy. They remain fine businesses but there's, by definition, lower returns at more risk if bought at these higher prices.

Unfortunately, the window that opened -- as a result of the financial crisis -- to buy shares of higher quality businesses at very attractive valuations has mostly closed.

Check out part I and part II of the interview.

Adam

Long positions in PEP, PM, MSFT, PG, and WMT established at lower prices (in some cases much lower). Also, very small long position in TSCDY.

* Though I actually do prefer that the share price falls even further in the short-to-medium term. That way the cash generating abilities can be used to buyback shares at an increasingly large discount to value. I'm perfectly happy to see a stock I've already bought temporarily go down further if I think management will use the opportunity buyback in a smart way.
** I rarely invest in anything -- and that includes tech stocks -- unless I'm willing to own the shares for several years or even longer. Frequent traders might consider several years to be long-term, but I consider that time frame really the bare minimum for almost any investment. The difficulties that have caused a security to be cheap and mispriced are unlikely to be sorted out in less time than that (though I realize several years is hardly a trade). To me, a long-term investment is something that can be owned indefinitely and deliver good results. (Indefinitely, unless there's damage to the economic moat, valuation become extreme on the high side, or opportunity costs are high.) 

Generally speaking, that's just not possible with tech stocks. 

So investing in tech stocks is a much different investing model than what I traditionally favor but worth the trouble if the mispricing is substantial. My preferred investing model is to own shares of good businesses indefinitely. Even when bought at just a fair price, the high quality enterprises tend to produce very satisfactory long-term returns with much less risk of permanent loss of capital.
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