Nate G. Weisshaar

Portfolio Manager

The New Economy: Are These Dynasties About to be Dethroned?

As I write this, we’re in the thick of the NCAA Tournament, the annual capstone of the college basketball season, complete with buzzer-beaters, Davids and Goliaths, upsets and Cinderellas – not to mention billions in lost productivity.

While I like my basketball games with a bit of drama, when it comes to investing I don’t want a close game. Give me the dominant No. 1 seed any day, and a portfolio that makes for terrible TV.

For decades, the owners of strong consumer brands – household names such as Coca-Cola, Procter & Gamble, Kraft, Nestle, Unilever, Philip Morris, and Anheuser-Busch – have been the top seeds for investors because of their strong, predictable returns. These companies have been special because they’ve historically been what Warren Buffett calls franchises – companies with pricing power. That means they have the ability to set prices aggressively without sacrificing sales, and the ability to dictate prices to the market means a company can grow revenue and profit with minimal additional investment.

In the case of consumer goods, the pricing power comes from a combination of strong brand loyalty, meaning customers are willing to pay up for perceived quality or stature, and distribution prowess, meaning these companies know how to get their products in front of as many people as possible.

But these advantages can erode over time, and ever since the financial crisis I’ve been watching several intertwined threats to these consumer-goods Goliaths and wondering if their franchises may be losing their mojo. If they are, they could see a materially reduction in their value.

The Customer’s Always Right

The first threat came from a shift in consumer behavior, and it approached from two angles. First, the financial crisis revealed how overextended many shoppers in the U.S. and Europe were, and the ensuing pullback turned many into price-conscious coupon clippers.

Second is the recent move toward healthy, organic, and eco-friendly products. As you might expect, this trend causes trouble for the makers of products such as Oreos, Haagen-Dazs, Hellmann’s, and Coca-Cola.

The two questions I’ve been asking are these:

  1. Will consumers trade up to name brands again once they feel more financially secure?
  2. Can the consumer-goods giants pivot fast enough to meet this new type of demand?

The results have been a bit mixed, but not all that reassuring: Unilever, Mondelez, and Procter & Gamble recently reported only modest growth or sales drops in North America and Europe – tellingly, on the back of price declines. Meanwhile Coca-Cola, and Nestle continue to see growth, albeit much slower growth last year than in previous years.

What’s in Store

Grocery stores and other retailers are taking note of the consumer shifts, and they’re making moves to shore up their own thinner margins in this new environment.

For one thing, they’ve been moving strongly into organic and natural products. Sales of organics have grown by double digits for the past five years and now stand at over $50 billion. Organic foods today make up 5.3% of total food sales.

Second, these companies have been investing heavily in store brand products. Historically stigmatized, so-called generic brands offer a much higher margin for stores, and the quality of in-house labels has improved to the point that cost-conscious shoppers see them as viable substitutes. Consider that Target’s private labels and owned brands contributed one-third of the company’s 2016 sales. Last year, meanwhile, more than 17% of Kroger’s sales were in-house brands, worth $21 billion.

The trend may just be gaining momentum, as only 14.5% of consumer packaged-goods sales in the U.S. are private label. Over in the UK, store brands have 51% of the market, and the number is in the 30s in both France and Germany.

Drifting Apart

While many people attribute the success of companies such as Coca-Cola and Nestle to brand recognition and loyalty, a key part of their success comes from their financial relationships with retailers.

For decades, consumer-goods companies have paid retailers for space on their shelves and rebated the stores for moving volumes by running promotions. This flow of cash has effectively stuffed shelves with the brands that could pay, crowding out opportunities for start-ups.

As you might imagine, sharing shelf space with a store’s far cheaper brands creates tension between the store and name-brand sellers. We saw this tension manifest in a Marmite shortage in Britain in 2016, as Unilever and leading grocery chain Tesco got into a spat about price increases to offset currency moves.

At the same time, dominating physical shelf space is losing its value. More and more, non-traditional advertising such as social media and YouTube, along with new shopping experiences such as direct-to-home delivery services – think Dollar Shave Club, Stitchfix, Birchbox, and Fresh Direct – mean consumers are being exposed to far more brands than ever before, all without ever stepping inside a store.

What It All Means

At Motley Fool Asset Management, we like companies with competitive advantages. It’s one of the four main criteria on which we judge potential investments, in fact. But the sustainability of that advantage is a key consideration.

It’s too early to call this game, but it’s obvious that the momentum has shifted away from the old consumer-goods dynasties. The change in consumer mentality and mounting competitive pressures in a digital age are making life harder for these one-time sure things.

Their existing dominance and impressive cash flow put companies such as Nestle and Coca-Cola in a good position to defend their legacies, but the shifting tide of retail may be eating away at their competitive advantages, which means investors may need to reconsider the prices they’re willing to pay for these companies.

As of 2/28/2018, 1.23% of the Motley Fool Global Opportunities Fund was invested in Nestle. 1.90% of the Motley Fool Emerging Markets Fund was invested in Coca-Cola Icecek AS.

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