Originally published by Cuffelinks
Australians may be busy paying for groceries rather than a new Ferrari, if last month’s Bureau of Statistics figures showing a strong rise in the cost of living is anything to go by, but local investors can benefit from demand for luxury goods, even if it’s not to park a Ferrari in the driveway, yet.
Some luxury goods companies have the brand equity to keep their prices high, and the business strategy to benefit from structural growth in global economies. This is aligned with Hyperion’s investment philosophy to take a bottom-up approach to invest in extreme quality companies with solid fundamentals and structural growth opportunities, and why global equities should be front of mind for Australian investors.
Why quality luxury goods stand out
Where do we see value at the moment?
One sector we particularly like is luxury goods, which continues to benefit significantly from the growth of economies like China and India, and the rise of the middle class.
However, not all luxury goods are created equal. It’s important to focus on high-quality businesses with strong growth prospects, large and growing addressable markets, low levels of gearing, and predictable medium to long-term earnings streams. Two such companies are French high-fashion house Hermes (PA:HRMS) and Italian car manufacturer, Ferrari (NYSE:RACE).
Both companies have been around for some time, Hermes since 1837, and Ferrari since 1947. Unlike some of their competitors, both have eschewed offshore manufacturing for home factories where they can control the quality of the brands they rely on.
Both companies have strong brand equity which gives more pricing power than any of their competitors. Both produce items which are considered significant status symbols, and their strategy of strictly limiting supply has seen demand for their products hold up strongly. After the GFC, Ferrari sales fell a tiny 4%, compared with other ultra-luxury cars (except Lamborghini), which fell 40% over the same period. The typical wait for a Ferrari is between 18 to 24 months, and, even after three years, a Ferrari typically retains 93% of its value and will actually increase in value after 20 years.
The power of the Ferrari brand means that its competitive position in its market is secure, its pricing power will not diminish, and its capacity to profit from a growth in demand is second to none. And, in our view, these markets remain underpenetrated, giving a lot of capacity for growth.
Hermes has a similar story and a similar business model. When President Xi Jinping began implementing anti-corruption reform in China in 2012, the crackdown on gift-giving saw a significant drop in retail sales generally, and in sales of luxury goods in particular. As a result, 2013 was a difficult year for many luxury retailers in China. Growth in sales fell from 7% in 2012 to 2% in 2013, according to a report by Bain & Co, and average spending of China’s high-net-worth individuals also decreased significantly. Yet, against this backdrop of difficult retail conditions and falling sales in luxury goods, Hermes was one of the few not affected, and was in fact able to grow sales by 16%.
The importance of looking beyond our own borders
Australian investors have long had a strong domestic bias when it comes to equity investment, and historically, quality Australian businesses have had the ability to produce growing and sustainable earnings. However, overseas markets offer a much larger universe of stocks and a greater diversity in industries to choose from. The economies in which these companies operate have higher growth potential. This means addressable markets are typically larger than those on offer in Australia (often significantly larger). In many cases, internationally-based companies offer superior economics and scale and better long-term growth pathways.
As the world economies are growing, they are also becoming more accessible to investors. Before the digital revolution and advances in technology, Australian investors were at a significant disadvantage when it came to accessing in-depth information and on-the-ground intelligence about international companies. The time difference and our physical location at the end of the world meant investors on the spot had a real advantage.
The evolution of technology changed all that. Australia’s physical location is not the barrier to investment it once was, and Australian investors now have the ability to trade and access information 24 hours a day. This doesn’t mean it’s no longer important to travel to overseas markets, and to talk to company management face-to-face, but it does mean that the ability to identify quality growth businesses both here and overseas has been enhanced.
The numerous quality-investment opportunities on offer globally are often better from a relative value perspective. With a few exceptions, global companies are of a higher quality than their Australian counterparts, and current five-year earnings forecasts are also higher – all of which, translates into stronger returns for investors with relatively lower levels of risk.
The bias towards the home market has served many well, but the opportunities on offer in the larger, more diverse economies overseas should improve the risk/return profile of any portfolio if the right stocks are chosen. International companies with large addressable markets, market dominance and consistent earnings, like luxury goods providers Hermes and Ferrari, are exceptional businesses, that can produce strong, sustainable returns to investors over the medium to long term. And it’s those fundamentals, regardless of domicile geography, that will drive investors’ wealth.
Mark Arnold and Jason Orthman are the Chief and Deputy Chief Investment Officers respectively at high-conviction equities manager, Hyperion Asset Management.