Head of Equity Research
Many of the most successful investments often concern companies that are relatively immune to economic risks; companies that can steadily grow and reward shareholders whatever the market conditions. So-called ‘Quality Compounders’ are rare, but should form the backbone of any well-constructed portfolio.
The final quarter of 2018 gave us a stark reminder that all investment involves risk. Equity markets have been buffeted by a range of concerns including Brexit, international trade, monetary policy, rising bond yields and deteriorating – though by no means poor – economic fundamentals.
A good starting point when looking for Quality Compounders is to look for product categories that people buy day in, day out, week in, week out. They are the type of products that people can’t put off buying when they are more cautious; they can be found in nearly every supermarket trolley and cover food and drink products, personal care items and tobacco. Nobody needs a new sofa each week but everybody needs to eat.
The sales of these companies do change over time, just not in line with any normal economic cycle. Far longer term demographic, economic, and consumer trends are more important.
Over recent decades, population growth and higher wages in several emerging markets have enabled more people to purchase many types of consumer products. The opening up and deregulation of economies like India and China, combined with improved education and infrastructure has enabled countries to move closer to their economic potential, and resulted in higher global purchases of Western products like Corn Flakes, Persil and Bell’s Whisky.
Maslow first identified a hierarchy of needs in 1943. First people want to meet their physiological needs such as the requirement for food, water and shelter. Desires move through safety and belongingness to ’esteem needs’ that play into the strengths of global consumer company marketing departments. Consumer companies such as Unilever are very good at selling products to all income levels. In India, Unilever market hair care products from the equivalent of 1p to over £13.
The changing desires of consumers as income levels rise has proved to be very similar to developed markets. People who have never bought toothpaste or commercially produced beer before have now begun purchasing such products as their incomes rise.
Sales growth for consumer companies is not confined to emerging markets. Western consumers rarely have unmet physiological needs but many companies are very good at creating a desire in consumers’ minds and then meeting it. Nobody has a physiological need for a Cadbury high protein chocolate bar or Dove Nourishing Secrets Avocado Invigorating Body Wash, but many people desire them and gain self-esteem from their purchase.
By developing the need factor of such products, companies can increase their prices, so increasing the value of their sales without having to promote increased usage.
The ideal ‘consumer compounder’ has sales diversified across many categories and geographies so that it isn’t unduly hurt by particular economic problems in any one country. Colgate enjoyed over 90% market share in Venezuela before the country’s self-inflicted economic crisis decimated sales. But Colgate’s global positions helped to insulate the group from difficulties in one market.
For an investor it is not just sales that are important, a company’s ability to convert sales into profits is equally critical. The most successful companies can increase profits faster than sales. Growing sales creates operational leverage – meaning higher profits as sales grow faster than costs.
An increasingly globalised economy has enabled companies to do this to a far greater extent than before. The decisions by Mondelez and Imperial brands to move chocolate and cigarette production to Poland were bad for workers in Bristol and Nottingham but good for shareholders.
A company that can steadily grow its sales and raise its operating margins – regardless of the prevailing economic or political conditions – will normally be rewarded with a steadily appreciating share price. Quality Compounders should constantly be investing in their businesses to ensure continued growth in the years and decades to come. The best companies are constantly fostering product innovation, improving distribution and advertising to strengthen brand equity.
Diageo is a good example of what we look for. In their last financial year, sales grew 5% (balanced between higher sales volumes and rising average prices), profits per share increased 9%, the annual dividend was raised by 5% and the company announced an additional £2bn share buyback plan. This combines to justify the strong share price performance seen above.
No company is completely immnue to market movements, but Diageo’s characteristics as a Quality Compounder mean it has delivered a total return of approximately 3% since the beginning of September to time of writing (early December 2018). This is despite the market turbulence investors have experienced and substantially better than the 9% loss from the average UK company.
Of course, anyone looking at Diageo’s share price will see that performance has not always been strong, with notable weakness in 2009/10 and 2014-16. The first period was due to elevated economic worries in Europe, an important market for the company, and the latter when management execution was not of the quality we would have wished.
The structural opportunity for many Quality Compounders remains. Despite the enormous progress of the past 30 years, China’s per capita GDP still remains less than a quarter of that of the UK, with India further behind, at only a tenth. The long-term trend is for these economies to catch up with Western living standards, resulting in significantly higher sales for many consumer orientated companies.
While Quality Compounders can be mismanaged, and their products lose appeal, careful stockpicking can help to avoid this. A long-term allocation to these types of companies can offer investors important benefits, including a source of steadily rising dividends, which can then be reinvested when markets are more volatile and companies are trading cheaply. Drip-feeding your own money in at these times can be difficult; automatically reinvesting your dividends is much simpler!