Ollie Smith: Welcome to another Morningstar Analysis. I'm Ollie Smith. Joining me to discuss Morningstar's latest report on the world of luxury brands is the company's senior equity analyst, Jelena Sokolova.
Jelena, your report describes how luxury brands have experienced a strong V-shaped recovery from the worst moments of the Covid-19 pandemic. What's the journey been there? How has luxury been performing through Covid-19 and why?
Jelena Sokolova: Luxury has been actually through quite a perfect storm, you can say, in 2020 with store closures, with travel restrictions, massive decline in sales and profits. However, so far, 2021 looks like actually a blue-sky scenario by contrast, with a very strong V-shaped recovery, with many companies reporting sales and earnings already above the 2019 levels. And actually, it was a surprise for investors. We were more in the camp that we expected the fast rebound, but it was even – the magnitude was even surprising for us.
We think there are a few reasons behind that. One is very resilient luxury consumer incomes. The second is the wealth effect. So, the stock markets recovered sharply. The real estate markets were quite resilient. And then, also, people couldn't spend as much as they usually do on travel or on experiences, all those things that were actually most affected by the lockdowns. So, that left them with extra savings. And finally, last but not least, psychologically people need to reward themselves after moments of stress. So, that might have played a role as well.
OS: And what trends do we see post pandemic? I was interested to know that – obviously, China has been a huge part of this picture for some time with its burgeoning middle class. But the report talks about a sort of moral backlash against people engaging in conspicuous consumerism. So, what kind of trends are we seeing there? And how sustainable are they?
JS: Yeah. So, I think I dug in in this report into the trends that we have been seeing post-pandemic, and actually, none of the trends that I have discovered justify the very elevated valuations of the sector. We think that U.S. rebound in consumption is quite temporary, also affected positively by payment checks and also GDP rebound, which we don't expect to be sustainable. And on the China side, I think that's still a long-term strong growth story. However, there are risks on the horizon with common prosperity push, which can increase taxation and also make conspicuous consumption not very popular with people, and also, near term Covid-19 infections rising again in the region as well as concerns about the property sector, which is an important savings outlet for most Chinese consumers.
OS: Okay. So, on that note then, what are the actual investment opportunities here then?
JS: I think the sector looks quite overvalued in my view at the moment. So, most stocks that we cover trade in 1 to 2-Star territory. There are actually quite a few opportunities left. For investors that want to be in the space and want to be a bit contrarian, I would recommend The Swatch Group [SWGAY]. The shares are trading in 4-Star territory, some 20% upside to our fair value estimate. We like the very strong cash backed balance sheet, around one-third of market cap is in cash and precious metals. There is also upside for profitability improvement from mix effect and automation. And also, I think that's the stock that is pricing in the most headwinds from luxury consumers in China in sort of weakening. So, I think for the long term, it would be an interesting opportunity.
OS: Thank you so much, Jelena, for your time. For more investing and analyst insight, visit Morningstar.co.uk. Until next time, I've been Ollie Smith for Morningstar.
