Lately, I’ve been thinking about the role that depreciation, terminal values, and ongoing capital expenditures play in affecting investment returns. With most assets, the value lies in something physical that deteriorates/depreciates over time. If you buy a rental property and rent it out to a tenant, the IRS gives you a 27.5 useful life for the property according to the schedule. If you don’t replace the roof, remodel the kitchen, fix the foundation cracks, or get the termite treatment, you won’t be able to charge much for rent in 2047, if there is even a house left at all at that point.
In the context of investing, it stands to reason, the worst businesses are those that perpetually require additional capital to maintain its cash-generating capabilities, and the best businesses are those that continue to throw off cash with minimal capital investments or even manage to grow in value on their own without an additional capital contribution. The latter is quite rare, and is usually found in the context of intellectual property (i.e. “brand names”) that grows stronger and stronger with each passing generation.
In my recent case studies, I keep coming back to Chocoladefabriken Lindt & Spruengli AG, the Swiss chocolatier that has participatory shares trading in the United States under the ticker symbol LDSVF for $6,950 per share. It is a generally neglected stock because it only pays out a small portion of profits as dividends, it is subject to Swiss taxation, and let’s admit it, investors get put off by stock prices in the four digits. My view is that an investor should incorporate all of that information and still come to the conclusion that Lindt & Spruengli stock is destined to compound shares at a 12% annual rate. It will be a $20,000+ stock in 2030.
Why am I so confident about its prospects? Because it owns great intellectual property in the Lindt name, and it is actively enhancing its intellectual property by trying to make better chocolate rather than see what kind of cost cuts it can get away without the customers really noticing. Over time, brand equity gets built.
In 2000, Lindt had a 3% market share in North America. Now, it is up to almost 10%. That is an incredible shift within a single generation for the normally stodgy chocolate market in a well-developed economy. But while Hershey has cut the quality of its ingredients and used cheaper packaging, Lindt has maintained the same packaging and has maintained its formula.
In the case of its vanilla chocolate, it has actually upgraded to pricier Madasgascar vanilla extract to create a better product (at Wal-Mart alone in the United States, Lindt is now responsible for 1 out of every 9 forms of white chocolate sold compared to 1 out of every 47 in 2000). It has raised prices for its vanilla chocolate by 87% since 2000 while improving the quality of its offerings. That is how you manage a brand.
It earns 29.8% net profit margins on each piece of chocolate that it sells. What I like about is that it is not really the chocolate ingredients themselves that drive the profits, but rather, it is the increased mindshare for quality chocolate by way of reputation capital that Lindt has gained in the minds of its North American customers in particular over the past generation.
The sugar, cocoa butter, milk ingredients, lactose, soya lecithin, Madagascar vanilla flavour, and Madagascar vanilla extract are not particularly expensive, and they are expenses that can be managed over the long haul. The real value of the enterprise, though, is not the combination of those ingredients but rather the mindshare of the customer that can tell a piece of Lindt chocolate has a slightly higher quality than its peers on the shelves.
By merely executing on this formula over and over again and meeting the expectations of its customers, the intellectual property of the “Lindt & Spruengli” brand functions as an asset that increases in value over time. In comparison, a stock whose value is derived from its physical assets depreciates with the passage of time.
Most investors recognize this inherent advantage of intellectual property over a physical asset that generates value through use, but typically, intellectual property has a short shelf-life or is subject to extreme competition. Lindt chocolate’s intellectual property in the form of a brand name is different than most because it is not a technological company subject to obsolescence with the next upgrade nor is it an app-based idea subject to extreme competition.
In the case of Lindt, it’s a chocolatier that is maintaining its brand while Hershey, Mondelez, and Nestle are actively trimming costs (note: this should not be read as a criticism of those other three stocks as investments, as they have such extreme competitive advantages and economies of scale of their own that they can take a little self-abuse in spots and still deliver wealth to their shareholders). By making the brand synonymous with high-quality chocolate ingredients, the company is protecting its brand-name intellectual property over time and becoming more valuable as it gains market share.
When you look at an investment, you should always be thinking: “How much capital must be fed to the beast to keep the profits rollin’?” Some, like Microsoft and Adobe, require almost no capital to steamroll ahead and their stock prices have risen accordingly. Others, like Carnival Cruise Lines, Alcoa, and U.S. Steel, perpetually consume ever-increasing amounts of capital and deliver returns that are a mere fraction of what could be had with an S&P 500 Index Fund.
In the case of Lindt, it collects an almost 30% return on every chocolate bar it sells with somewhat modest production costs and brand value that it enables it to raise the prices in excess of inflation each year while simultaneously gaining market share because it does not lower its product quality. Great wealth awaits those who really understand why Chocoladefabriken Lindt & Spruengli AG trounces the rest of the market, and then acquires shares of the firm and similarly-situated firms.