The consumer staples sector is “a walking profit warning”, Mark Costar, manager of the Morningstar Silver Rated JOHCM UK Growth fund, told the Morningstar Investment Conference on Tuesday.
Interest rates having been at a record low for so long means we’ve seen “capital mis-allocation on a grand scale” by corporates, as they attempt to satiate an investor base that has been starved of yield at the expense of investing in their businesses for the long-term.
These firms have been rewarded by the market, with those more prudent companies being unfairly punished, Costar says.
Meanwhile, this search for yield has led investors to perceived safe sources of yield, like bond proxies and infrastructure assets. This behaviour has “inflated the wrong type of asset at the wrong stage of the cycle”.
“We’ve seen capital markets allow corporates to borrow at negative rates; bond markets have provided capital to serial defaulters like Greece and Argentina; and private equity dry powder is at a record high eight years into a mature bull market,” says Costar.
The capital mis-allocation has come in many forms, Costar notes. These include “highly egregious long and wholly inappropriate remuneration schemes, eye-wateringly expensive M&A, sustained under-investment and some examples of corporates quite literally mortgaging the company’s future by borrowing money off the bond market and using it to fund often inflated equity”.
Now we’re seeing the fruit of those decisions, with Costar picking out just three recent examples from the FTSE 100.
Over-Stretched and Under-Invested
Capita (CPI) is the “textbook example of capital mis-allocation”. Poor-quality earnings per share, enhancing but value-destructive acquisitions and under-investment in its core businesses led to a profits warning, dividend cut and rights issue. Shares are now down almost 75%.
Micro Focus (MCRO) has over-stretched and under-invested, while Sir Martin Sorrell at WPP (WPP) “overstayed his welcome, paid himself too much and missed the key structural threats in that industry”. Now, we’re likely to see that empire dismantled.
These are not isolated incidents, adds Costar, asking who will be next. He suggests that the “consumer staples sector is very much in the firing line”. “These businesses are persistently under investing,” he continues.
“They are the poster child for value destructive M&A – Reckitt buying Mead Johnson; BAT buying Reynolds; Unilever paying multiple billions for essentially loss-making businesses.”
Meanwhile, he says, “despite perceptions of bullet-proof balance sheets, there’s actually uncomfortably high leverage through this sector”.
Another worry Costar has is the three key pillars these franchises have been built on – brand, distribution and scale – “is being systematically undermined”. This is due to the ease and cheapness of building a brand; the ease and cost-effectiveness of distribution; and consumer brand loyalty being lower than ever.
“Put it all together and we think this sector is potentially a walking profit warning. We’ve seen one from Philip Morris already and we think we’ll see a lot more,” he concludes.
