Fascinating mail-bag question I wanted to answer: Tim, which area of traditional blue-chip investing currently concerns you the most and why? -Alex.
Right now, my biggest concern is the blue-chip stocks related to the production of food. A lot of people blame 3G Capital for production deterioration, but it really got started with Breyers Ice Cream which has been owned by Unilever since 1993. In the late 1990s, Unilever tried raising the price of ice cream as cream, sugar, and milk shot up in price. But passing the costs onto consumers didn’t work–the sales went down a bit, and Breyers found itself not gaining much (if anything) from raising the price.
Then, it tried shrinking the size of the containers. That works, up until a point. Then, it consolidated operations and cut costs by moving all the Breyers ice cream production to Green Bay, Wisconsin and Englewood Cliffs, New Jersey. This kept earnings per share from the ice cream segment at Unilever climbing into the early 2000s, but eventually all of the tactics were used. With the staffing lean, the container shrunk, and the price unable to be raised much more, Breyers turned towards the only option it believed it had left: lowering the input costs.
By 2005, Breyers was no longer ice cream and had moved into the shudderous terrain we call “frozen dairy dessert.” The original formula of milk, cream, sugar, and toppings had been replaced with this cocktail: milk, artificial sugar enhancement, corn syrup, whey, mono and diglycerides, cream, carbon bean gum, guar gum, carrageenan, natural flavoring, annatto, vitam A palmitate, and tara gum.
Warren Buffett often speaks of those invisible decisions that do not show up on the balance sheet but carry huge implications for future generations of shareholders. I can’t speak for him, but I believe this is such an example. When you start cheapening the components of a brand, by definition you are diluting the brand equity and harming the franchise. The economic cost over the long-term is the decreased pricing power that is the result of creating an inferior product.
The reason why everyone reading this post knows what Clorox bleach means–whether you are reading this from an office in St. Louis, Missouri or checking this post on your phone in the Anchorage, Alaska wilderness–is the result of the Clorox management team refusing to dilute the Clorox bleach brand during The Great Depression. Money was tight, and Clorox didn’t dilute its quality, and it suddenly gained market share and prospered.
There are free market remedies for this. As Anheuser-Busch has thinned the quality of bottles and literally watered down its beer since the Inbev takeover in 2008, a microbrewing revolution has sprouted up throughout the country. Anheuser-Busch has gone from shipping out 105 million gallons of beer to 95 million gallons of beer in the United States in the past seven years. Neither one of these facts exists in a vacuum. As Anheuser-Busch has diluted the quality of its brand, some customers wanted better ingredients. Hence, craft beers have arisen to fill the niche for people who are willing to pay more in search of a better taste.
Although the free market does self correct, there are at least two public policy issues: First, a 2002 University of Iowa study indicated that people accustomed to corn syrup came to prefer it over the taste of sugar in soft drinks. Due to some legacy bottling contract issues, you have a situation where Mexico has higher quality Coca-Cola than many parts of the United States because it uses actual sugar instead of a fructose sweetener.
But there is a reason why old people tend to get excited about Mexican Coke in a way that younger people don’t. If you’re over the age of 35, your taste buds are being reawakened when you are having the authentic beverage. But, if you only experienced the inferior quality first, and spent a lifetime drinking it, your taste buds build a preference for it that rejects the taste of real sugar in Coca-Cola. Depending on how this all extrapolates, you could have a situation where the American children of today actually build up a preference for the processed ingredients compared to actually being exposed to the traditional/natural ingredients that actually made up these foods originally.
And the second public policy concern is that the market self corrects in a way that will give rich and middle-class children a superior food supply to those of lower income children. This has perhaps always been true in every civilization, but there at least used to be some paternalism built into the system–in the 1950s, the doctor’s kid would be just as likely to consider Breyers ice cream an indulgence as the janitor’s kid. If Breyers tried to pull this in 1960, you would have heard the loud objections of the doctor’s family that might force the executives to reconsider.
Now, the combination of multinationalization of food products as well as niche product creation removes this potential source of paternalism. Someone’s parents can just look up the local ice cream with the best ingredients, pay the premium, and go on their way. They won’t just do this for ice cream–they’ll apply it to all their regular food purchases. When specific brands are no longer part of the shared experience, there is nothing really stopping companies from competing only price only by racing to the bottom with the cheapest ingredients.
I mention this not to pick on Unilever specifically, but to use an example that tells the story of what is happening at Kraft-Heinz, Mondelez, Kellogg, General Mills, and even to a certain extent Nestle. Each of the strategies have been exhausted–prices of food have been raised, the sizing has been shrunk, people have lost jobs, and now the product quality is diminished. As a result, you now have this cycle created the pricing power of the brands is diminished because the brand itself has become inferior.
Take a look at something like Kellogg. It is an outstanding business. If I had to commit to owning 50 stocks for the next seventy years with no turnover, Kellogg would get a spot on that list. Agnes Plumb sat on Kellogg stock for fifty years and watched her position grow into 1.3 million shares that cut her $2 million in dividend checks until her death almost two decades ago. Since 1982, it has returned 12% per year. It has a diverse collection of brands churning out $1.2 billion in annual profits, and there are a lot of reasons to hold through the coming decades.
But the question “Should I invest heavily into it right now?” is an entirely separate matter. To me, a blue-chip investment involves three qualities intersecting: (1) high earnings quality, (2) high growth prospects, and (3) reasonable (or better) valuation. That’s it. That’s how you invest for generations. You wait for those three factors to come together, and then act aggressively.
When I look at the food sector right now, I only see the first factor. Yes, Kellogg’s has high earnings quality. But there is no growth. It made $1.2 billion in profits in 2011 while selling $13.1 billion worth of cereal and convenience foods. Expectations for this year? Kellogg is on pace to make $1.25 billion against $13.8 billion in sales. They’ve actually cut labor costs by $200 million during this time frame–the reason profits aren’t up is the result of higher advertising costs.
It’s been four years, and there hasn’t been any growth. It made $3.38 in 2011, and it’s going to make between $3.45 and $3.55 this year depending on how the final quarter shakes out. And those buybacks were funded by debt. It doesn’t get much attention, but Kellogg has been quietly leveraging itself to the gills these past few years–it now carries $7.5 billion in debt against $1.2 billion in profits. Based on current earnings power, I would like to see debt in the $3 billion to $5 billion range at most.
We all understand that companies go through hard times. Often, these hard times provide good investment opportunities if the problems are ultimately solvable and the stock gets cheap as a result of the operational difficulties. That’s why I like IBM so much–it’s not that the company is growing fast–it’s that the valuation is under 10x earnings.
But that’s not what is happening with the food companies right now. Kellogg is selling at $69 per share–that’s a valuation of 20x earnings for a company that’s not growing. Heck, you could get the stock at 18x earnings in the early 2000s when earnings per share were growing at 7%. If the stock came down 20% to 16x earnings or cheaper, the food stocks would be interesting companies to buy based on the premise that the valuation looked good and the growth would eventually work itself out. But right now, you have to pay a price for food stocks that is reflective of “business as usual” growth rather than the actual realities they face.
Again, I should reiterate that I’m speaking about the industry in general rather than a company like Kellogg specifically. General Mills is loading up on debt to binge on buybacks, too. It carries $9.4 billion in debt against $1.7 billion in profit. Guess what? General Mills was making $1.7 billion in profit three years ago. However, earnings per share increased from $2.56 to $2.86 during this time because it borrowed money to retire 50 million shares of stock. Again, food industry growth isn’t happening right now, and that’s why I don’t want to pay 20x earnings for something like General Mills.
There’s nothing wrong with owning a business working its way through stagnation. If you own 100 shares of General Mills, you’ll own 103 shares by the end of the year. The dividend will go up a bit, and earnings ought to be a little higher. But unless it’s selling at a steep discount, you don’t want to put the bulk of your available capital into a sector of the economy that has been struggling to grow for years and is trading at valuations that don’t suggest anything is wrong.
Food companies have some of the highest earnings quality of any enterprises on the globe. It gives you the confidence to reinvest each quarterly check because you know the enterprise will still be standing years from now. If you buy these stocks when you’re a young man, they’ll still be around and churning out profits when you’re an old man. But you want to make future contributions into companies that have more than high earnings quality alone. You want to see growth or discounts to fair value. Right now, American food stocks offer neither of those two, and for that reason I would not want to make a large lump sum investment into the industry right now.*
*= Nestle may be an exception because it is diversified outside of cereals and the segments of processed foods that are currently struggling.
Originally posted 2015-11-23 11:20:47.