This week, Jamie talks about how the phrase ‘quality investing’ has been distorted and why complacency in investing can be really bad for your returns. He then explains why he thinks Unilever, a darling of quality investment portfolios, might not be as good as some perceive.
As is so often the case, seemingly minor events can have profound effects on the way one’s life turns out. I went to university and like many people did not really have an idea what I wanted to do after I graduated. I started out studying Computer Science for reasons that escape me now. I found it a rather miserable subject and decided that even though coding might be the future, it wouldn’t be my future. Thus, I switched to Mathematics, which was always my best subject growing up.
Changing to Mathematics over Computer Science as a degree enormously expanded the range of career options available to me. This increase in opportunity is an advantage, but it made deciding what I wanted to do with my life much more difficult. When I was in my second year, by chance I remember reading about Warren Buffett in some discarded newspaper in the student union. He had made bucket-loads of wealth ‘investing in the stock market’, whatever that was. My thought process was embarrassingly simple at that point, and went no further than ‘he seems happy and rich, I should do what he does, easy!’
Off I went to learn how to be Warren, which naturally led me to read the Intelligent Investor by Ben Graham. I maintain there has never been a better book written on investment than this text. I also read Common Stocks and Uncommon Profits by Phil Fisher as was recommended by Mr Buffett. I was hooked – broke, but hooked. Now at least after having been foolhardy enough to abandon a perfectly good degree and randomly reading an article about Warren Buffett, I suddenly had a goal – to be a Fund Manager.
Years later, once I achieved my goal, my understanding of markets and investments became more nuanced and, I’d like to think, sophisticated. At some point, like Warren Buffett, I realised that some of the very best investment returns are achieved through remaining invested for a long time in companies that had a sustainable competitive advantage. This allows the powers of compounding to do the work for you.
At the time, this was known as quality investing since quality businesses are synonymous with competitive advantage. What it meant to be quality covered a multitude of things including:
- Management that demonstrates good awareness of optimal capital allocation decisions.
- Unquantified intangible assets that create sustainable competitive advantage. These can include brands, network effects or natural monopolistic positions.
- Predictable earnings streams.
- Favourable economic backdrop.
The main thing linking these factors is that they refer to characteristics that are difficult to quantify in a company. However, there is a quantitative measure that you usually see in high-quality investments, which is high levels of return on capital employed (ROCE). ROCE is essentially the profit generated proportional to the net operating assets of a firm. The higher it is, the greater the evidence of a competitive advantage since, were the advantage absent, a new entrant could enter the sector and compete away those returns. The slight problem here is that not all companies with high ROCE are quality businesses and not all quality companies have high ROCE.
Nonetheless, at some point in the last fifteen years or so, there has been a shift, with many investors looking at high returns on capital and assuming high quality. The reason is simple. The rise of systematic (low-cost) investment products that identify ‘factors’ and invest in them. The builders of various ETFs are able to create Quality ETFs (for example). Somewhere along the way, the meaning of quality investment has mutated into something that can be easily packaged up and sold to asset allocators (more on low-cost mediocrity here). And therefore, what used to be known as quality is not the same as ‘Quality’ in the modern sense.
I would never consider myself an investor in ‘Quality’ but even putting semantics aside, I‘m not even convinced that the old meaning of quality investing is the panacea. I realise now that investment in pure quality businesses is not the only way. In fact, some amazing returns have been generated by investors in other types of stocks.
Returning to Mr Buffett, he is often quick to witty remarks, which as I’ve explained before contain far more complexity than we may appreciate. One of his best known is ‘our ideal holding period is forever’ The implication of this short remark is he wants to buy a business with a sustainable long-term advantage and allow it to compound – forever. This is a lot easier said than done. We are all able to look at a company that has made huge returns over say a 25-year period and identify that it had a sustainable competitive advantage. Identifying one that will have so in the following 25-years is much harder.
When Quality Stops
A fortnight ago, I compared investment analysis to observing the big picture of a fractal. I also mentioned that over time, one of the seemingly minuscule tendrils of the fractal has the capacity to become much more important over time, but you as an analyst have a fiendishly difficult task of identifying its emergent importance. This summarises why the buy-and-hold forever strategy is dangerous. It presupposes that the characteristics of a company are immutable and predictable.
This kind of thinking is complacency in action and leads to inertia. The necessarily qualitative characteristic that leads to high returns cannot be measured, by definition. Further, a change in a business from one of steadfast dependability to average or worse can be drawn out and subtle enough to go unnoticed for a long-time.
Don’t fall in love with investments, regularly challenge whether the thing that makes the company so special is still there. If you don’t, then one day you might wake up and realise that the terrific business you invested in five-years ago has done nothing but underperform for half a decade. Sadly, time is linear, you aren’t getting those five-years back so don’t waste them being invested in something disappointing.
Unilever – darling of ‘Quality’ mega-cap portfolios
Unilever has returned a lot over the years to shareholders who have been patient. It is a global mega-cap fast-moving consumer goods (FMCG) company. It makes its money because of brand value. Dove soap for example sells for a higher price than generic brands because people pay for the brand recognition. That brand recognition along with the other brands Unilever owns has been built up for years. It has been done through spending a considerable amount of money every year on marketing.
This takes the form of anything from television adverts all the way through to giving big supermarket chains favourable working capital arrangements in order for Unilever’s products to be placed at eye level on the shelves. It’s no coincidence that the same products appear at the same height across different supermarket chains – it’s so you see that product first.
If you look at the period from 1980 to 2010, the general rule for Unilever was approximately as follows; it can either generate a 15% operating margin or it can grow, but it can’t do both. Without growth, the long-term returns for a business like Unilever will necessarily be stunted. Therefore, the sweet spot for Unilever was a margin of 13% to 14% and a growth rate of 10%, with 3% coming from volumes, 2% from price rises and 5% from acquiring new brands. In recent years, however, Unilever has generated margins of as high as 19% and consistently over 16%. Moreover, it has done so whilst growing. How has this happened you may ask.
- Unilever reported operating margin
Once upon a time, advertising was hugely expensive because by far the most effective form was television adverts with the adverts during the most watched programs being the most expensive slots. There were very few, heavily watched channels and very limited advertising spots. This created a scale advantage whereby very large companies could buy all the expensive advertising and upstarts could not. This entrenched the brand value of companies like Unilever and suffocated the potential competition.
A number of developments changed the backdrop. The most important was the advent of the internet and the proliferation of vast amounts of niche entertainment content. Also, massive data harvesting means that companies like Alphabet and Meta are able to gain enormous insight into the consumers of the content allowing for extremely well-targeted adverts. This way of doing things has lowered the cost to launch new products and brands massively and in the process created competition for the large incumbent FMCG businesses. Consider in the UK the examples of Fevertree and Warpaint. Both of which have been built up through much lower capital bases than traditional FMCG businesses and rapidly built-up tremendous brand value in a way that couldn’t have been done twenty years ago.
My theory on Unilever and other large FMCG businesses is that they are currently in the phase of benefiting massively from the reduced advertising costs by ripping out marketing expenses and exploiting more modern ways of building and maintaining brand value. However, underlying this is that it has become much easier to launch brands and therefore the brand strength and qualitative aspects of these businesses is under serious threat. My concerns with Unilever and businesses like Unilever is that they are currently in the afterglow of a cost-cutting exercise but in time, emergent characteristics which threaten the quality of the businesses is chipping away.
Sometimes people are asked ‘What would you buy if you couldn’t sell it for ten-years?’ That’s always a difficult one to answer but I know I wouldn’t be holding Unilever or many of the other large FMCG businesses.
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Jamie Ward
Jamie doesn’t own shares in Unilever.
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