(Image: A. Davey)
The big picture
Before embarking on stock picking exercises, let’s take a look at the macro environment. The general market is still living under the weight of several uncorrected excesses and it has only been authorities’ intervention that has kept the whole system together. Now and then, the financial system look at the brink of disaster and that’s when policymakers intervene.
For instance, look at China in the beginning of 2016. The debt problem in zombie state corporations went mainstream; it was a moment of truth. And what happened? Authorities came in and borrowed more money. The problem is still there, it’s just under the carpet waiting to get out stronger than before. However, for investors this means the market tested the Chinese credit market and it passed. Unless we have some unforeseen event, it seems like we’ll have a couple of quarters before problems arise again.
Graph 1 – 1 Year performance graph for SSE Composite Index (Source: Google Finance)
The situation in China is stabilized (for now), which means that a Chinese credit contraction is now less likely. If the Chinese stock market keeps a calm and moderate rising, I’m betting on and consumption recovery in China, Honk Kong and several economies in the Asian region.
Brexit special case
The character John Tuld (represented by Jeremy Irons in the movie Margin Call) said: “If you’re first out the door, that’s not called panicking.” I guess that’s what the Britons must be thinking about leaving a tendentiously disintegrative EU. Although in the short term the exit is bound to be negative for the UK economy, if the housing market is sustained, the economic outlook might be brighter than expected.
For the European states, we can expect added volatility sometime down the road. Politically, we can expect a flight towards protectionism in European states. Just look at the Brexit phenomenon and the whole nationalistic wave among EU members.
There is the risk of a credit contraction in the UK. If the available income contracts there are good chances of having a consumption and credit contraction. However there are counterbalancing effects like a devalued currency and added exports. We will have to wait and see how this plays out, but so far the initial panic reaction has been controlled.
In the European side, there are several political risks. We have two main factions at Brussels: on the defends a divorce in good terms, the other wants British blood. A bloody divorce will be bad for both parts, but European burocrats have an urge to enforce rules, even at the expense of what’s best for everyone. And here lies the main risk: more economic distress and further nationalistic waves converging to accelerate an European disintegration process. However, there will be sometime before this will have a real impact in financial markets.
The bubble market… sorry… the bond market
Nevertheless, since 2007, some excesses have been corrected. Western Banks reduced leverage and improved capital standards and corporations streamlined operations. Basically, the fit ones survived, some with the help of central banking liquidity steroids. This brings us to what I believe to be the biggest point of concern: a potential bubble in the bond market provoked by the liquidity injection in the system. The reversal of the liquidity will have unforeseen consequences but one might guess that it won’t be good for the financial system.
On the other hand, we have the example of the Japanese economy that has endured decades of ultra-low interest rates. Only an inflationary wave could bring a fast rise in interest rates that could provoke a disruptive tension in the system. The fact that we are living in an era of cost of life convergence between the west and the east reinforces the view that manufactured products prices will be kept low. We can never be sure, but inflation trend in the western world seems to favor the current state of affairs in the bond market.
Looking for pearls
Having laid out the rude strokes of our near term picture, the analyst’s job is now finding suitable asset allocation spots.
During the last 3 years, investments denominated in USD were very successful and it wasn’t hard to find USD denominated companies with strong performances. However, at this stage I would be happy if we could find an alternative currency for investments (in the major currencies).
Fortunately, I believe the Brexit might have brought us one. The Brexit added uncertainty and a devalued pound to an already nervous market. UK fortunes will be heavily dependent on the housing market trends and on the size of business relocation to other countries.
Graph 2 – UK average house price 2005 – 2016 (Source: Bloomberg.com)
So far the exit’s shock isn’t producing alarming indicators, quite the contrary. Additionally, the Bank of England has injected liquidity in the market, while the government is keeping the housing market under vigilance. UK’s policy makers are even preparing a housing stimulus program.
For now, it seems the situation has stabilized. We’ll have to wait further economic statistics but, so far, the UK deserves a closer look for investment purposes.
Summing up, two main scenarios seem to be materializing: a better than expected Brexit for the UK and a credit test successfully passed by the Chinese market. There is one possible negative, the bond bubble. If the bubble bursts, one can only imagine the impact on borrowers like homeowners, indebted corporations and governments. The most troubling thing about the bond market bubble is my perception of authorities’ lack of attention. On the positive side, there’s the interminable Japanese experience with lower/negative interest rates that, so far, didn’t spark a bubble burst. All-in-all, we might have some time to start cautiously deflating the whole thing.
Therefore, and assuming a sudden burst won’t surprise us in the bond market, our macro review incites us to find investment opportunities in the UK and China or both. An investment denominated in GBP, with a good business exposure to China and that’s also sufficiently solid, so it doesn’t fall apart at the first wind blow, seems an attractive idea.
After running a few stock screenings, I found at least one stock worth investors’ attention. The company is quoted in GBP, it has a significant exposure to Hong Kong and China, it has dropped 30% in market value since 2015 and it has a powerful brand working as competitive advantage sustaining its business model. I am talking about Burberry (BRBY).
We have seen a top-down angle; it’s time to see our trade idea from a bottom-up perspective. A while ago, I’ve read the book Trigger Points by Michael J. Kami. Among other ideas, he defended the notion that the middle class was being split between upper classes and lower classes. A trend reinforced by the advance of globalization. This is too obvious; however, the implications are subtle. The middle market is evaporating, which means in the end we’ll only have companies targeting the low end or the high end of the consumer market. The ones positioned in the middle will be out of business, sooner or later.
To be positioned in the low end of the market, corporations need to be low cost producers, to be on the high end, companies need to own desirable brands. Burberry fits perfectly in this analysis. The brand is present on the high end of the market and, throughout the years, it has sustained an enormous desirability, which is reflected in the business margins:
Table 1 – Burberry Margins 2016 – 2013 (Source: Burberry Financials)
These margins are clearly stemming from a business with a huge moat (using C. Munger’s analogy).
Additionally, the company has a low debt profile and it is consistently cash-flow positive. These features make Burberry a conservative investment per se, but we can also use it to play a rebound on the GBP and on the Chinese economy without really adding much risk while benefitting from the potential upside. Even a GBP downfall, could work well if Burberry sales remain stable around the globe. In that case, profit could improve significantly because of its international operations. This could work as a great hedge for UK based investors, including a positive carry around 2% (dividend yield).
Graph 3 – Burberry sales by region (Source: Burberry 2016/2015 Financial Report)
What makes this investment even more interesting is the fact that the stock price for Burberry hasn’t gone anywhere during the last 5 years. This means the company is trading at 19 times FY2016 earnings. The reason is clear: the sales are not increasing at a breathtaking rate and investors got spooked with the political and economic mess surrounding the stock.
Graph 4 – BRBY vs S&P 500 5-year comparison (Source: Google Finance)
The turnaround thesis
So yes, we are analyzing this company as a way to play a rebound on the GBP and the Chinese economy. However, I like to sleep well and, most of all, I like my trades to have conviction. This way, if I mess my timing due to a poor macro view, I can always expect my stock picking thesis to play out (as long as it is still valid).
Burberry has a timeless appeal stemming from its British cultural roots and prestige. However, brands need constant care in order to thrive.
First, Burberry needs to increase its brands consistency by reducing labels and streamlining assortments. Companies’ actions to regenerate brands, usually, include refocusing on key product lines and key labels. I believe there are some moves in this direction but we will have to keep monitoring the managements work.
Additionally, since the end of a 35 year-license, the company now fully controls its presence on the Japanese market. This is a great step. Great brands control every aspect of their products, from design to the final consumer. Licensing an entire market like the Japanese to a 3rd party is bad business. In Burberry’s line of business having a great retail footprint is essential. I believe the move towards retail in Japan is sign that management team gets this.
Summing-up: Burberry is doing good strategic options. There a couple of other minor positive moves, but overall, the company seems well positioned to keep a moderate growth.
If the company is capable of growing at 7% per year and sustaining a 13.5% profit margin, during the next 5 years, Burberry might achieve the following numbers:
Table 2 – Valuation in the positive scenario
On the downside, I envision a sluggish scenario with the company growing at 1% per year, while achieving a profit margin around 11.5%.
Table 3 – Valuation in the sluggish scenario
As you can see, I adjusted the multiples accordingly, assuming the positive scenario will, naturally, yield a higher earnings multiple and vice-versa.
Our analysis reveals that in the best case scenario, we are talking about an appreciation around 100%, while in the worst case scenario, we are talking about a 25% depreciation (assuming the current 1,319.54 market price). This is a very good upside/downside relation.
Obviously, these are only projections based on the factors previously explained and several other factors might alter the course of events. However, I believe that the previous analysis reveals good indicators that might warrant serious consideration for investment purposes.
(Disclosure: I do not own BRBY, but I may initiate a Long postion in the next 72 hours)