Big doesn’t always mean boring

Editor’s note: In early October and after time of print, it was reported that Unilever no longer plans to consolidate its headquarters in the Netherlands, following opposition from British shareholders.

Since Britain’s June 2016 vote to leave the European Union, Brexit’s fallout has been a concern for global investors. The market’s fear of a no-deal exit, where Britain has no defined trade relationship with the EU, has put downward pressure on the pound and on GDP forecasts. London’s status as a financial hub is also at risk.

But there are still investment opportunities in the U.K, especially in sectors that tend to survive—and sometimes thrive—during tough times, says Eric Benner, vice-president and portfolio manager at 1832 Asset Management in Toronto. Brexit will matter less for businesses with minimal U.K.-focused profits whose global reach will help cushion exposure, he says.

Benner says he was more concerned when it seemed Britain’s exit would be “uncontrolled” and “without a plan.” He and colleague Ryan Nicholl, a portfolio manager at the same firm, see an increasing chance of a hard, as opposed to a soft, Brexit but they’re more focused on finding attractive businesses through bottom-up analysis.

One sector that’s remained attractive despite the turmoil is consumer staples, given people will always need essential items like personal, home and healthcare products, they say. They point to two companies with strong ties to England that they’ve invested in over the last two years: Unilever and Reckitt Benckiser (RB).

Both have remained major players, mainly due to their focus on global growth. “Not much of either company’s business is in the United Kingdom,” Benner says, with the U.K.-based sales for each sitting at less than 10%. “We love diversified, global businesses,” especially those that adapt, he adds.

He and Nicholl explain how one company has outpaced the other in terms of growth and upside.

HIT: Unilever (EN:UNA)

The growth of this now Netherlands-based global giant is driven by its enduring product lines, Benner says. Unilever had a second headquarters in London until March 2018, although the company said Brexit didn’t spur it to consolidate offices. Officially founded in 1929, Unilever’s history stretches back to the 1870s.

“Unilever is pretty well-known, but not as well-known as its brands,” says Benner. Those brands include Dove, Degree, Knorr, Lipton and Axe.

Benner also liked Unilever’s commitment to sustainability—in its investments, reporting, packaging and product lines—and its presence in emerging markets. More than half of the company’s revenue comes from emerging markets, says Benner.

“Some investors think Unilever is boring and that it’s too big to provide significant outperformance or attractive returns. We disagree,” Benner says. “If you look at the stock price charts of any of the largest businesses, you can see that there are opportunities to add value.”

The pair also looks for lower-risk, GARP stocks, so “we don’t mind boring,” Benner says. Unilever “generates high margins on sales, very high returns on invested capital,” and has a healthy balance sheet and good management team, he adds.

Benner and Nicholl also say Unilever was well-positioned to face competitors over the long term.

For consumer staples companies—which they find are more stable and “forecastable” in terms of growth and sales than, for example, technology businesses—they look out as far as 10 years, but focus most on the next two to four, says Benner.

They made their first Unilever purchase in late September 2016 at €40.50, compared to nearly €43 at the beginning of the month. The opportunity surfaced because the U.S. election was approaching, interest rate hikes were on the horizon and, more importantly, “the U.S. economy was starting to recover from the doldrums of late 2015, early 2016. The market got more excited over U.S. businesses and more concerned about the U.K. after Brexit. The global market was interested in cyclical stocks versus more stable stocks like Unilever,” Benner says.

The company’s shares had also been “modestly weak” ahead of the purchase, Nicholl says, after some weaker emerging market sales and “a general lack of excitement in the earnings story.”

They started with about a 1% position, even though a typical core position in such a company would be closer to 2.5%, he says. The managers increased exposure to 2% between October 2016 and January 2017, with the price between €36.50 and €41 (total average price was just over €39).

Turning point

To realize profit or excess returns, Benner and Nicholl were prepared to wait. But their investment thesis for Unilever, which they expected to be a “global champion,” played out “very quickly.” They didn’t set near-term targets for the stock, but saw “underappreciated growth and earnings potential,” Nicholl says.

They weren’t the only ones watching the company: Warren Buffett and 3G-backed Kraft Heinz announced in February 2017 that it was putting together a bid for Unilever—a deal that would have led to one of the largest-ever takeovers and the creation of the world’s second-largest consumer goods group.

“Shares pretty quickly appreciated from around €39 to about €44,” says Benner. “Since we had our doubts that an acquisition would be straightforward, because Unilever is a very big company and was not, to our knowledge, open to being acquired, we trimmed our position from 2% to about 1%.” They saw average gains of €5 on those shares.

Though the Kraft Heinz bid was swiftly rebuffed, the takeover threat lit a fire under Unilever management for more aggressive margin expansion targets and to use the company’s under-leveraged balance sheet to enhance shareholder returns, Benner says. That led Unilever’s stock to rise from around €41 in mid-February to nearly €47 in late March.

“We completed our final sale of those shares at an average price of €45,” or a return of approximately 15%, Benner says, noting the final exit price was €46.50. “Over a six-month period, that’s very attractive for us.” The average price was approximately where they had expected to exit, as €45 marked a return to fair value, he says.

Results

The stock’s short-term appreciation in early 2017 was the main reason Benner and Nicholl sold. “There were other consumer staples names we liked and other companies in other sectors that offered as much upside as Unilever did when we bought it,” Nicholl says. “We had lots of opportunity to redeploy the capital.”

The tables turned again one year later, however. After Unilever rebuffed Kraft Heinz in 2017, Benner says, it didn’t take long for the market to get “kind of bored with it. Nothing bad actually happened, but the stock began to sell off over the course of 2017 and in early 2018,” as interest shifted to stocks that would benefit from higher interest rates, economic growth and the U.S. tax cuts, for example.

Unilever peaked at nearly €52 in October 2017 and then fell to less than €46 by mid-January 2018, even though the market was rising. For Q1 2018, the Euronext exchange reported a 15.9% bump in overall revenue from a year earlier, and both EPS and volume growth.

Starting in January 2018, Benner and Nicholl chose Unilever again, increasing their position through a series of purchases that, on average, were around €46. “We started buying again at around €46.50 and then added to it over the course of February and March, in the range of €42 to €45,” Nicholl says. They started with a 1% position and increased it to 1.5%.

By this time global markets were trading higher. The MSCI World Index, for example, “had increased by 20%, so the value of stocks on average were 20% higher,” Benner says. “So when we’re looking at something like Unilever, it was actually cheaper, materially, than at the last point where we had sold it.”

As of early September, the shares had returned about 6% over their cost base, Nicholl says, plus dividends. “That’s a decent outcome for a half year, and that’s come in the context of a consumer staples sector that’s struggled. [Unilever’s] outperformed its peers, and the story is not finished.”

MISS: Reckitt Benckiser (LON:RB)

England-based RB’s product lineup isn’t as diversified as Unilever’s, and it was founded more recently (in 1999) but its history also dates back to the 1800s. Its brands include household names such as Clearasil, Durex, Strepsils, Lysol and Air Wick.

During their analysis, Nicholl and Benner found RB’s strengths included stable and growing product demand, consistent revenue growth, strong management, and the highest margins among its peer group of major consumer companies in the European household and personal care space.

But the company’s valuation was too high throughout 2015 and 2016. RB was a quality business that was recognized as such, trading more than 20 times its price-earnings ratio, Nicholl explains. “That was a bit expensive.” The stock rose from approximately £51 at the start of 2015 to nearly £69 by the end of 2016.

By fall 2017, things had changed. The share price had dropped from nearly £80 (where it had stayed throughout summer 2017) to less than £70 by mid-September.

Nicholl and Benner didn’t delay: they bought at about £68 in early October, when the company was also trading at lower price-earnings multiples.

Turning point

“Similar to Unilever, we did an analysis of RB’s product categories and country combinations, and built long-term assumption models for revenue growth, margins, and capital and balance sheet items. But our growth thesis mainly relied on Reckitt’s historical success,” Nicholl says. It was “a market-share gainer.”

He and Benner say the stock and valuation’s fall 2017 dip was primarily due to short-term issues (including a major cyber-attack in July 2017, and a failed product launch) that had caused a “valuation discrepancy.” Markets were also getting used to RB’s February 2017 US$16.6-billion purchase of infant formula maker Mead Johnson, Nicholl says.

They expected RB would once again be a global leader after it “lapped” those short-term problems. However, the company’s sales and earnings growth failed to rebound. The stock dropped below £60 in late February 2018, approximately £8 lower than Benner and Nicholl’s purchase price.

The company’s problems began to emerge as “structural issues,” Nicholl says, noting he and Benner were also worried about RB’s growing list of competitors. “Disruption looked to be more of a concern than we initially gave credit, and moreso than we saw with Unilever, given that company’s emerging-market and personal-care skew.”

Amazon was disrupting a broad range of product lines, Nicholl says. Online shopping puts pressure on companies like RB because it “reduces the power of their scale and ability to dominate shelf space in traditional brick-and-mortar retailers.” As well, new online entrants in Europe and Asia are gaining market share, affecting the volumes and prices of legacy businesses in that region.

RB is more dependent on Europe and North America (as of September, only 35% to 40% of its business was in emerging markets) and home-care products (e.g., detergent), Nicholl says, and those products “evoke less of an emotional connection with consumers.” Thus, RB was “more exposed to new threats than their peers,” and he and Benner were concerned about topline growth despite the firm’s effective cost-cutting through the years.

Results

By March 2018—shortly after they had repurchased Unilever—the managers decided to drop RB.

The two companies don’t compete directly in a large percentage of their businesses, Nicholl says, so they weren’t opposed to owning both. However, he and Benner had revised down their valuation for RB, leading them to sell it for around £59 in late March—nearly £10 lower than their purchase price, though a rising UK pound partially cushioned that loss.

By late August, the share price had rebounded to around £68, but the PMs don’t regret the choice. That rebound was equivalent to the growth of the consumer staples space over the same period, Nicholl says, and he and Benner had chosen to reallocate the funds into other names like Unilever, which were outperforming RB.

“When we review our miss on Reckitt, we see we had given them credit for what they achieved in the past: they had a successful track record of driving sales growth and market share gain, and margin expansion. But we had perhaps overestimated their ability to overcome the increasing threat of destruction they faced in many product categories,” says Nicholl.

In hindsight, they should have viewed the company’s industry-leading margins as a headwind, he says. “Unlike Unilever, which has significant room for cost-cutting and margin expansion, the same isn’t likely available for Reckitt.”

However, Nicholl adds, “it would take years for us to determine whether there’s a durable rebound in sales, growth and margin expansion. If that happens, then we would have made a mistake.”

Company stats

HIT: Unilever

Ticker: NA:UNA

HQ: Rotterdam, Netherlands (Unilever N.V.) and London, England (Unilever plc)

What: A British-Dutch consumer goods company that focuses on food and beverages, cleaning and personal care products. It boasts 400 brands, is the world’s largest ice cream manufacturer (it offers Ben & Jerry’s, Klondike, Popsicle, and more), and its net profit for 2017 increased 16.9% to €6.5 billion. More than half of its business (58%) is in emerging markets.

Initial purchase price: €40.50 in September 2016

Sell price: €45, on average, in early March 2017, after trimming position 1% in February 2017

Second purchase price: Between €42 and €47, from January to March 2018

Current price: Close of €47.69 on Sept. 26

MISS: Reckitt Benckiser

Ticker: LON:RB

HQ: Slough, England

What: A multinational consumer company that focuses on health, hygiene and home products, with approximately 30 brands available in 200 countries. It reported net revenue of £11.5 billion for 2017 and total reported growth of 21%, though the company says last year’s growth was “not good enough” to outperform its markets.

Initial purchase price: ~£68 in early October 2017

Sell price: ~£59 in late March 2018

Current price: Close of £68.24 on Sept. 26

Katie Keir is Content Editor of Advisor’s Edge.