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The Benefits of Buying Quality
We often say that investing in defensive global consumer franchise stocks - companies with great products, low financial risk, geographic spread and size - is a more attractive, lower-risk way of investing in equities compared to investing in a broad-based equity index such as the S&P 500, an index made up of the largest companies in the US.
For example, in 1999 a basket of defensive global consumer franchise stocks that we cover was trading at the same lofty price-to-earnings ratio as the S&P 500 (an historically high 30 times earnings), and yet these stocks generated decent returns between 1999 and 2016, and better returns than either the S&P 500 or bank deposits: this article explains why this occurred, and highlights that history is poised to be repeated from here.
The defensive global consumer franchises' superior earnings growth record is a function of their brands: each company owns a suite of brands that is recognised worldwide by consumers - McDonald's, Nurofen, Gillette, Band-Aid, Colgate and Guinness are just some of the many brands these companies control. In addition, many of these items are either relatively low cost, everyday essentials that are purchased repeatedly, or are "necessary luxuries". Thus, consumers either have to buy these products on a regular basis - or would rather not do without - and can't put off the purchases given the essential, everyday nature of their use. This gives the defensive global consumer franchises an element of pricing power and control over their market, as well as defensiveness in recessions when consumers cut back spending on other non-essential goods.
On our website, we cover a basket of sixteen European and US defensive global consumer franchise stocks which we believe fit the bill of being true blue-chip stocks. Only a select number of companies can be called true consumer franchises and most of their names or brands will be very familiar to readers. Companies such as Unilever (Tresemmé, Ben & Jerry's), Reckitt Benckiser (Nurofen, Dettol), Nestlé, McDonald's and more are included on our list.
Paying Up for Quality
In this article, we present a simple case for readers that demonstrates the superiority of the defensive global consumer franchises.
We ask the question: how would an investor in 1999 have fared if he/she had invested in fourteen of the defensive global consumer franchise companies that we cover versus an investor that simply bought and held the S&P 500? We choose 1999 as our starting point as it was a point of particularly high overvaluation for equities - the fourteen stocks in the theme traded on an average price-to-earnings ratio of 30 times, versus 30 times also for the S&P 500. We exclude two franchises from the analysis because they couldn't reasonably have been included in the theme in 1999 given their small size at the time.
The chart above shows how these two investors would have fared over the sixteen years since 1999. The Defensive Global Consumer Franchise Investor would have turned an initial investment of €14,000 into €60,100 by April 2016 for a compound annual growth rate of 9.4% (assuming dividends are reinvested). Even if we exclude one company which performed particularly well - Reckitt Benckiser - we still get a value of €45,300 for a compound annual growth rate of 8.0%.
The S&P 500 Investor, also assuming dividends are reinvested, would have turned an initial investment of €14,000 into €24,300 for a compound annual growth rate of 3.3%. Given how overvalued the S&P 500 was in December 1999, the S&P 500 has certainly performed well - but nonetheless it has been trounced by superior growth from the defensive global consumer franchises which were equally richly valued.
Why did the Franchises Perform Better?
Over this period, which encompasses two major bear markets, the defensive global consumer franchises have generated at least twice the annual returns of the S&P 500 with about 20% less volatility to boot.
How did they manage this? The key to understanding this outperformance lies in the franchises' superior earnings power: the US defensive global consumer franchises (we haven't studied earnings in-depth for the European franchises) have grown earnings at 8.8% compound per annum since 1988, compared to 5.4% compound per annum earnings growth from the S&P 500. Thus, the franchise stocks more quickly worked off their overvaluation, whereas the slower earnings growth for the S&P 500 meant that the index had to spend a longer amount of time working through the overvaluation to justify the price-to-earnings ratio attained in 1999.
It Still Pays to Hold Quality
Today, the sixteen defensive global consumer franchise stocks that we cover trade on an average price-to-earnings ratio of 21.2, versus 20.7 for the S&P 500. Neither the franchises or the S&P 500 are as overvalued as they were in 1999 but we know that we would still prefer to hold the defensive global consumer franchise stocks at this point over the S&P 500 given the quality of their earnings streams and business models.
Going forward, we believe that these franchises will continue to exhibit above-average earnings growth, leading to above-average returns for investors over the long-term. To our minds, owning a basket of these sixteen stocks is a far superior, and lower risk, way of earning the returns available from equities.
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28th April 2016