Let Them Eat Cake - (EPA:MC)

Let Them Eat Cake (EPA:MC)
Have Their Opulence Feed Your Avarice

You would have to be living a fairly spartan existence to have not noticed or seen that wealth and income inequality has gotten quite out of hand lately. However, in the spirit of inclusion, I’ll provide a catch up for those who are working flat out and have enough common sense to not engage with the media; wealth (think assets minus liabilities) and income differences between the top and the bottom are out of control. Another interesting wrinkle is that consumers are switching to less common purchases of higher end goods. A company that sits at the centre of a host of luxury brands is LVMH (Moët Hennessy Louis Vuitton - It’s backwards because it’s European, apparently). Without any doubt, there are risks embedded in any investment in the luxury goods segment and LVMH specifically and we will touch on them in detail. However, with that said, we will also look at how LVMH might fit into the wider portfolio at MMT and why you are very likely to be better off buying an index fund anyway, no matter how smart you are (or think you are). What follows is entirely my fault.

Wealth & Income Distribution

Focusing on the United States of America and China we can see that in the former roughly 70% of all wealth is held by the top 10% of the population. In China, a full ⅓ of the wealth is held by only the top one percent of the population. Why the focus should be on these two will be important later.

Interestingly, the top 10% of all income earners in the US take home 45% of all the income. There is a measure of how a society is going on the ‘sharing is caring’ front when it comes to income. The measure is called the Gini coefficient. The basics of it are this; if the number is 1 then one person has all of the income, if it is 0 then everyone has the same income. The USA has roughly the same income level per capita as Denmark but has a Gini coefficient about 50% higher. All else being equal it means fewer people are earning larger amounts of the national income pool.

Stories of $298 steaks are demonstrating that consumers, who have been locked up on and off for a few years and unable to spend, are ready to seriously splash out. There is a serious amount of savings burning holes in rich people's pockets right now. Just imagine the indignity of not going on a yearly $200k, first class, holiday to the ski resorts in Switzerland or Colorado. Well, after at least 2 years of this some families have come out of lockdowns ready to spend up a storm.

This is dovetailed very nicely with the 2022 research by consulting firm Bain & Company showing that the surge in luxury spending was almost entirely driven by Gen Z and Y (ages 13 to 42). More and more people are now choosing high quality over sheer quantity. Even with some consumers suffering through an interest rate rising cycle, increases in rent, and general increases in the cost of living, they are going out and ‘splurging’ on name brand products for special occasions such as birthdays and anniversaries.

The Company

LVMH sits at what might be the epicentre of the growing demand for luxury goods. The empire that is LVMH was pieced together by Bernard Arnault (now the world's richest man) in 1987. Since that time they have accumulated more than 75 prestigious brands including Tiffany & Co., Christian Dior, Marc Jacobs, Sephora, TAG Heuer, and Bulgari to name only a handful. As of this writing LVMH is the most valuable company in Europe.

Powering this behemoth is 2022 revenue of 79 billion euros (or $128 billion Australian), up from 64 billion the year before, and 44 the year before that. Each of these years has shown a steady 65% gross margin and net margin that has increased to 18% (or €14 billion). If we take a look at the cash flow statement we can quickly see how the margins on LVMH sales look. For my eyes, it appears that LVMH has a 66% margin on goods sold. Last year they also paid out €6.8 billion in dividends and bought back €1.6 billion in their own shares. As it happens, LVMH have recently authorised another 6 month program of share buy backs worth another €1.5 billion. Given their operations churn out ~€18 billion in free operating cash flow each year this feels fairly sustainable.

With Bernard Arnault placing his son as CEO and Chairman of Christian Dior (parent company to LVMH) all five of his children are now firmly ensconced in senior positions within the business. This process of succession planning has been long and laborious as Mr Arnault is loath to see the company put asunder in the event of his death. This is, all told, a decent risk mitigation strategy for his own family and the investors as a whole.

Touching on why the US and China were used as examples for wide wealth and income inequality you just have to take a look at the LVMH market sales data to see how LVMH has been earning such lucrative returns. Of the €79b in global revenues a full 57% comes from those two regions alone. Whether LVMH expanded into growing markets or the growing income and wealth boosted the sales (or a combination of the two) is largely irrelevant now that the business lines are in place for LVMH moving forward. With so many baby boomers set to pass down trillions to their descendants, LVMH sales may be set to remain high for a generation to come.

On a purely diversified front, it is helpful to have so many sales take part in countries and currencies other than the hometown (Paris, France) Euro. Given the conglomerate structure of LVMH there is a level of built in diversification. Well, at least the regional and currency diversification. Obviously the company is deeply ensconced in the high value luxury end of the market which could present an issue…

The Risks:

There is a risk here that LVMH could go out and make terrible acquisitions. The history of the company would suggest that this isn’t the case but I would like to walk you through one local example just to put your mind and ease and perhaps even get you to take a closer look at another local company that might find itself in some trouble.

Cape Mentelle was bought by LVMH as part of the company's expansion into luxury wines produced around the world. In the last few years LVMH quietly put the winery up for sale as it both didn’t fit the larger luxury brand profit expectations and LVMH hadn’t made further inroads into the local market. Fortune upon fortune, in walks Endeavour Group (ASX:EDV) who pays a full value $20m for the asset. This works perfectly for every party. Endeavour is on the long term plan of buying up high end wineries and becoming a value creation machine from the winery grape vine all the way to the Dan Murphy bottle shops they own. Is this a good idea? Time will tell but we can probably paint a similar story with another local example.

BHP purchased a set of oil and gas assets at the very top of the market 15 years ago. Since then multiple CEOs have written down the value of those (mostly US) assets to match the fact they weren’t as profitable and the oil price wasn’t as high as they had expected. And here is the most fascinating part of trying to hive off a portion of your company when you are the CEO. You simultaneously need to say the following things “gee whizz, we have a heap of shitty assets we can’t wait to get rid of” to your current shareholders. You then need to turn to the potential buyer and say “But, you know, I think you would do a great job of running these assets. Not like me. No. You’re much better than me.” So is the story of the Woodside growth by addition of the BHP oil assets. BHP is (even after hiving off their oil assets) a $220b company. Woodside (after gaining those same assets) is a $65b company. If BHP had honestly thought oil and gas was a great idea they could have bought the entire Woodside company and not blinked. Instead, Woodside, in desperate need of more oil and gas reserves and growth opportunities, now has assets BHP didn’t want. No wonder the Harvard Business Review states that between 70 and 90% of acquisitions fail. This is a fairly long winded way of saying, perhaps, LVMH saw the writing on the wall and made the capital disciplined move to exit and sell to an over eager buyer.

Another risk, and perhaps the one you will think of first when you google the share price chart, is that you are buying at the top of the market. To this I can only say that, yes, you are. But then in recent memory you would have bought into Novo Nordisk, just as we did, at the top of the market and still it would have ground its way higher. But perhaps, using fictional characters, I can paint a better story.

In the TV show "Billions" Bobby Axelrod berates his team member for recommending Apple shares at the 14 minute mark of season 1, episode 2 as an investment idea. At the time Apple was a high flying, highly priced, company. His comment was to the effect of “our investors don't pay 2% (management) and 25% (performance fees) so we can buy Apple." The implication is that buying Apple was akin to buying an index or playing it safe. They needed real edge. The irony is, from the share price of Apple at the airing of that episode (24th of Jan, 2016) to today, Apple shares are up ~520% (over 7 years) plus dividends. Needless to say given how shitty some of his deals were on Billions but Axe could have used that 520% of performance…

The more systemic risk to LVMH is that governments around the world will band together and tax people's wealth, limit tax haven use, increase income taxes, mandate worker to CEO salary limits (300 to 1 is ok, right? RIGHT?!), or any other of a thousand different progressive tax and redistribution policies. The reality, I’m sad to say, is that this is not only highly unlikely, but almost certainly impossible. Everyone in the halls of power likely now has at least some vested interest in keeping this chimera of a money printing machine going until the wheels completely fall off. And don’t for a moment think that a recession hitting the working class and debt holders of the world should slow down LVMH too much. After all, higher interest rates are ultimately stealing from the poor and giving to the rich. It must be nice when your business model's only existential risk is a complete undoing of the whole global capitalist system.

Portfolio Construction:

It would be fair to ask why you haven’t heard from me in a while. Well, to be honest, it is because there haven’t been that many compelling investments out there. After all, in the investing world, isn’t slothfulness a good thing? Just think of all the trading costs that aren’t being paid while we sit around trying to think of a decent idea. If you would like a more concrete, real world example of what that might look like look no further than Berkshire Hathaway. With only 5 major investment decisions Berkshire has filled 70% of its portfolio. Not a bad run rate for a 61 year span of investing.

With LVMH being added to a stable that is very thin it is important that we touch on a small amount of portfolio construction and the risk/reward that goes with this style. It can of course be a double edged sword. If you get it right then your returns are fabulous, get it wrong and you are cooked. I’ll demonstrate with two examples. One is Andrew ‘Twiggy’ Forrest, the other is Blue Stamp Company.

Andrew Forrest basically went all in on one business, in one industry, and with very few assets. There was a time, in 2015, when the price of iron ore was $35/tonne and the FMG breakeven was $39. Andrew Forrest went off to the US and secured a few billion in debt at credit card interest rates just to keep the show going. What happened next was an iron ore price boom to rival all others and now Twiggy is one of the richest men in the world and is paid yearly dividends of hundreds of millions of dollars. This is an example of no diversification working out extremely well.

So Blue Stamp Company is a story I've wanted to write for a while. This dude, Luke Trickett, is the CEO/founder and investment guru. It's a fairly basic 'boy done good' kind of story. Australian athlete, who married one of Australia's biggest swimming stars, Libby, finishes with elite sport and starts his own investment fund.

If you Google him or his company you'll see a bunch of interviews come up. Some random podcast is where I first heard of him but at the time of listening to it a was overcome with a weird "something isn't right" feeling. It could be that he was routinely belting his benchmark (20%+ returns compared to 7% for the index). But it might have been that he was way too easy to claim credit for returns that were, at least in part, due to good luck. It might have also been that every interviewer was fawning over this guy even though he had a very short track record and no background before starting his fund.

I just want to make a small note here for future investors. Fund managers almost always are out in front of the media if there is something in it for them. Yes, some are very much addicted to the limelight, but for the most part they are (or should be) busy running their investments. What usually happens is that a fund manager will go and give a series of interviews for one of two reasons. Reason one is that they made a big call and got it right. This is a great reason to see a fund manager in the news. Reason two is that they need to drum up more investor dollars. Either they are expanding their funds under management or they are losing clients and need to plug the gaps so they don’t have to liquidate (sell) assets. This can be a warning sign.

In any case, the returns and investor letters on the Blue Stamp website looked like he was belting it. Then, all of a sudden after the 2020 full year letter in November of that year, he stopped posting annual letters or reports. At first I thought it was strange and would periodically check the site over the next few years for updates. Finally, given it's 2023 and all, I did some digging.

Turns out, old mate Luke, was using leverage to boost his returns. At the end of 2020 he was running a fund of about $150m. It's hard to tell much of what happened with the leverage side of things given there are no reports but we can track how the Blue Stamp Company holdings fared from the end of 2020 onwards. What you're about to see probably explains why he stopped braggadociosly posting his annual letters.

Returns from listed investments held by Blue Stamp as of Dec 2020:

1. ASX:NXT (I wrote about these guys being a bubble exactly as Blue Stamp was increasing its stake) = peaked just before the report was written. 26% loss since

2. Facebook/Meta = 30% loss

3. ASX:SLC = 32% loss

4. ASX:SIV = 42% loss

5. ASX:MP1 = 63% loss

6. ASX:APT (afterpay) which peaked as the report was written, lost 66% of it's value before being rolled into block, which has lost 33%

7. ASX: BGL = delisted. 100% loss

8. ASX: DWS2 = delisted 6 weeks after report written. Result 100% loss

Keep in mind, this list makes up ALL of the Blue Stamp listed investments. They have a few unlisted investments but they are hard to value without the reports and I wouldn't exactly call the current market friendly to an IPO liquidation opportunity. However, I can tell you about the one major unlisted asset they own; Marmalade. It's an invoice factoring company. Basically, think Greensill (Honest, read the book). Unfortunately, Marmalade only got to $1m in revenue in late 2022. This is clearly not driving profits at Blue Stamp right now.

The unit holders of Blue Stamp are nursing some almighty large capital losses right now. Before you ask if those losses have been ameliorated by dividends, no, they haven't. Every dollar earned within the fund was reinvested, with not a single dollar paid out. The lesson of this is that a concentrated portfolio might get stunning returns but it can turn on you really quickly if you've backed truly shitty companies. Even if your fund manager has a ten year record of smashing returns you just don't know if it was all dumb luck, favourable interest rate settings, or anything else.

The rate of return shares give you, above the rate of bonds and cash, is called the equity risk premium. In theory, this is the added return you are to be paid for taking on the additional risk of (potentially) losing your money, not being paid dividends, being last in line in a bankruptcy, compared to bonds and cash. For everyday investors it is far more reasonable to assume you can get mildly wealthy with an index fund spreading your risk around than it is to end up like Twiggy who owned an enormous amount of the overall company. Consider then that high concentration might not be the safest or smoothest method of getting to your financial goals. Just take the equity risk premium of the index and have a relaxing life.

Conclusion:

Do I wish I'd written this in April last year when I first started speaking about it? Given it was at a ⅓ lower price, yeah, I do. Perhaps the better question is this; when is a bad time to buy a great business? When looked at that way we are probably peering into a company that could be taking care of your wealthy friends' needs for a long time to come.

Should you invest? Almost certainly not. Investing in single shares is a recipe for disaster. You are almost certainly not smarter or have more (illegally obtained) "edge" than a ruthless hedge fund manager. In fact, to close the loop on our earlier Axe Capital example in Billions, you might be interested to know that the Bobby Axelrod character is based on Steven A. Cohen of SAC capital who was said to be running a super shady operation (see the parallels?). Anyway, if that is your jam you could do worse than read Black Edge. Second to that is the near certainty you can't beat a basic, no frills, index fund over the next 10 years, let alone 30. If you want a few books to help you on this learning journey try some Common Sense and a Random Walk. In fact, not one out of 2,132 funds beat its index over the last 5 years alone in the US.

But for those with a more mischievous streak, perhaps defiant in increasingly long odds, then this might be the shot for you. In one fell swoop you are picking up household (well, the rich and wannabe rich anyway) names that will be selling their overhyped and overpriced wares for decades to come. After all, isn’t it time that you benefited from the rich eating cake?