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The stocks and funds to play an exciting turning point for this sector
Thursday 11 Feb 2021 Author: James Crux

Covid-19 vaccines are being injected into the arms of a grateful global populace, paving the way for a full reopening of the global economy, a rebound in intercontinental travel and an explosive release of pent-up demand.

The world could be entering a new ‘Roaring Twenties’ decade as fortunate individuals still with jobs are liberated from their homes and start to splash the cash saved during Covid hibernation.

In turn, the well-heeled among a vaccinated population may seek to make up for lost time by partying with wild abandon and spending big on premium or aspirational brands, boosting sales across the luxury goods sector.

Companies behind high-end, aspirational fashion brands or premium drinks brands are typically blessed with pricing power and high margins, enabling them to generate oodles of cash which can be used to fund acquisitions or progressive dividends.

LOTS TO LIKE ABOUT LUXURY

Investment bank Berenberg says the sector ‘is not cheap, but luxury never is’. Investors have to pay up to access its attractive growth prospects, high barriers to entry, robust pricing power, strong cash generation and superior profitability compared to other consumer discretionary sectors, such as general retailers.

Yet the bank’s analysts also argue that the recent de-rating of the luxury sector reveals interesting ‘quality growth’ opportunities. They say: ‘Luxury has not been immune from the pandemic and near-term visibility is low. But, regardless of the shape of recovery, we believe medium term luxury demand will be largely unaffected, since all the long term structural drivers to long term demand remain fully intact.’

Moreover, Berenberg sees double-digit market growth to 2025 driven predominantly by China and digital channels, with conglomerates such as LVMH and Kering taking greater share of a market that remains highly fragmented. The bank’s analysts expect the pandemic to accelerate mergers and acquisitions in the near term.

‘Regardless of whether the recovery takes the near-term bull or bear case path – which ultimately depends on the speed that tourism can recover – luxury demand will be largely unaffected by the pandemic on a five-year view, since all the underlying structural drivers to long-term luxury demand remain fully intact. Covid-19 has likely created pent-up demand, which will be a tailwind for future years as the luxury demand catches up,’ adds Berenberg.

These structural drivers are the growth of the Chinese middle class, the unstoppable rise of digital sales and the ascendancy of Millennials and Generation Z, the internet-savvy cohort that has been driving all the growth in personal luxury.

UK-listed stocks in the luxury space

Investors can gain exposure to the luxury theme through London-listed stocks including Burberry (BRBY), the trenchcoats-to-cashmere scarves seller that appears to be over the worst of the pandemic.

Famed for its iconic Equestrian Knight Device and the Burberry Check, the London-headquartered fashion house is blessed with a strong and enduring brand, and while third quarter sales dropped 9% on a like-for-like basis, efforts to reel back markdowns helped shore   up profits.

Watches of Switzerland (WOSG) joined the UK stock market in June 2019 and has since seen its share price rise by 144%. The Rolex, Omega, TAG Heuer and Breitling watches retailer has coped well with the impact of lockdowns in both the UK and US thanks to strong online demand. UK online sales shot 121% higher year-on-year in the third quarter.

Also on the UK stock market is posh handbags maker Mulberry (MUL:AIM) where Mike Ashley’s Frasers Group (FRAS) has built up a near-37% stake.

 

A TOUCH OF LUXURY

The global market in personal luxury goods was worth €281 billion in 2019, according to a study by consultancy Bain & Co with Europe accounting for €85 billion or around 30% of sales and the US being the single biggest country accounting for €75 billion of sales.

However, 2020 was a rude awakening for the sector with consumers cutting their spending in general, and spending on luxury goods in particular, because of the restrictions on international travel.

Sales are estimated to have shrunk by almost a quarter last year to €217 billion, the first drop in a decade and the biggest drop on record, taking the industry back to 2014 levels.

‘The world has experienced a difficult year of rapid, unexpected changes and luxury has not emerged unscathed,’ says Claudia D’Arpizio, partner at Bain & Co ‘The industry has suffered from a pause in global travel and ongoing lockdowns, and a change in the way consumers shop and what they value.’

Sales in the first quarter of last year fell 22%, followed by a fall of 50% in the second quarter, the worst on record. However, third quarter sales are estimated to have fallen just 12%, and the range of forecasts for the fourth quarter is -5% to -20% with a base case of -10%.

The impact on profits for the luxury sector has been brutal, with Bain & Co estimating a hit to 2020 operating profits of 60% and a decline in profit margins from 21% to 12% on average.

For 2021, the study sees a range of possibilities, from a 10% to 12% recovery in sales to a 17% to 19% recovery, depending on how fast the economy and particularly the travel industry return to something approaching normal, and also depending on consumer confidence.

The sector is not seen getting back to 2019’s level of sales until late 2022 or early 2023, while profits are seen taking longer still to recover.

However, it is important to remember that the stock market is forward looking and will be pricing in an earnings recovery well before it happens, hence why the sector is ripe for investing now.

Can you play the luxury theme game via funds?

The answer is yes. The easiest way to play the space and get diversified exposure to lots of different luxury names is through exchange-traded fund Amundi S&P Global Luxury ETF (LUXG).

This product tracks the S&P Global Luxury index which is made up of various companies involved in the provision or distribution of luxury goods or services, including LVMH, Daimler and Estee Lauder. We write more about this ETF towards the end of the article.

Alternatively, investors can get exposure through various funds and investment trusts that have stakes in luxury goods companies as well as other businesses which may not be related to this space.

For example, GAM Multistock Luxury Brands Equity Fund (B637645) has 7.3% of its portfolio in LVMH according to Fe Fundinfo.

Buy and hold investor Nick Train from asset manager Lindsell Train likes companies with luxury, premium or aspirational brands. His Finsbury Growth & Income Trust (FGT) holds cognac and liqueur maker Remy Cointreau, FTSE 100 constituent Burberry which he hopes will become a much bigger company in years to come, as well as spirits maker Diageo (DGE) which owns the Johnnie Walker, Don Julio and Casamigos brands.

Zehrid Osmani-managed investment trust Martin Currie Global Portfolio (MNP) invests in Kering, Italian luxury apparel brand Moncler and luxury carmaker Ferrari.

US CONSUMERS TO DRIVE THE RECOVERY

As the largest single market for personal luxury goods, the strong position of US households bodes well for spending going forward.

The US accounts for 34% of global private consumption according to analysts at Morgan Stanley. The investment bank believes US household finances are ‘as healthy as they have been in years’ having entered the latest recession in a positive state with a stable debt ratio.

US consumer debt levels were the lowest in 11 years going into the pandemic, and in general they haven’t risen so there is no need for balance sheet repair as there was following the great financial crisis.

Instead, the investment bank sees US consumers going on a huge spending spree this spring as the economy reopens thanks to the massive fiscal stimulus provided by policy makers.

MONEY IN THEIR POCKETS

While the recovery in the labour market has been uneven and households have lost roughly $400 billion in total income from April through November 2020, the administration has underwritten these losses in an unprecedented manner with transfers exceeding $1 trillion, according to Morgan Stanley.

In addition to this excess transfer of more than $600 billion, savings forced on consumers due to Covid-related restrictions helped US households amass around $1.4 trillion of savings as of November 2020.

A second round of stimulus payments of $1,400 per head is likely to push excess savings to $2 trillion very soon or the equivalent of 14% of personal consumer expenditure and 9% of GDP.

As vaccinations are rolled out in the spring and warmer temperatures have a downward impact on the number of new Covid cases, consumers will open their wallets, analysts believe.

To begin with, spending is likely to focus on going out, which is good for the foodservice and restaurant industry, hotels and casinos. Consumers will then likely turn their spending to durable goods such as clothing and footwear, beauty products, consumer electronics, home furnishings and luxury goods.

As hiring picks up again this should drive a virtuous circle of income gains and more spending, meaning growth could last into 2022, says Morgan Stanley.

CHINESE CONSUMERS TO SPEND MORE

A recovery in global consumer spending will have a two-fold effect on China, boosting demand for Chinese exports and increasing economic growth.

JP Morgan Asset Management’s global market strategist Mike Bell forecasts a base case growth rate of 4.4% per year on average for the Chinese economy over the rest of this decade. While this may be slower than the last decade, it still means the economy could be 50% bigger than it currently is by 2030.

If per capita earnings also rise by 50% from $10,000 to $15,000, the multiplier effect on consumer spending would be enormous given China’s population of 1.4 billion. Bell believes the Chinese middle class could rise from 40% of the population to more like 70% by 2030, which will be an enormous driver for luxury goods sales.

Mainland China was the only region to see growth in luxury sales last year, with consumption rising across all categories, channels and price points according to the Bain & Co study.

Analysts at Berenberg forecast double-digit annual growth in personal luxury goods sales driven predominantly by Chinese and online sales. The bank’s proprietary survey of more than 4,500 Chinese consumers shows ‘a clear willingness to spend more in 2021 and to travel as soon as borders reopen’.

THE STRONG ARE GETTING STRONGER

As several observers have noted, there is a clear trend among consumer goods companies towards scale and consolidation with the strong getting stronger in terms of market share and reach.

In the highly fragmented luxury sector, ‘scale is winning with clear market polarisation as the “megabrands” continue to outperform,’ says Berenberg.

French conglomerates such as LVMH and Kering have gained a larger piece of the pie over the last three years. Smaller brands within their respective stables have been able to leverage the benefits of scale they couldn’t enjoy if they were standalone brands.


SHARES’ TOP PICKS

Amundi S&P Global Luxury ETF (LUXG) at £156.15

This is probably the easiest way for a UK investor to get diversified exposure to the luxury goods space.

The Amundi product is an exchange-traded fund tracking a basket of companies involved in the provision or distribution of luxury goods or services.

Buying the ETF will get you exposure to such names as LVMH, Kering, Hermes and Richemont, as well as luxury drinks providers Diageo and Pernod Ricard.

The portfolio also includes car companies Tesla and Daimler, and Nike which sells high-end collectable trainers as well as more affordable products.

The ETF has a 0.25% ongoing charge and returned 31.6% in 2020, according to Morningstar.

Burberry at £17.27

A luxury ‘mono brand’ boasting strong heritage, Burberry’s exposure to spending by globe-trotting, free-spending Asian customers proved a headwind at the height of the pandemic, derailing the momentum built under chief executive Marco Gobbetti.

In 2021 and beyond, the investment case hinges on a potential turnaround being led by creative director Riccardo Tisci and the continued economic comeback in China; encouragingly, Burberry reported strong third quarter growth in mainland China and Korea.

Burberry has an extensive store estate in China, coupled with a strong digital proposition. Berenberg believes there is clear scope to leverage the digital platform, which can support growth and margin expansion.

Even if the brand turnaround proves unsuccessful, downside is arguably limited by the fact Burberry is credible takeover target given its low relative valuation and less prohibitive ownership structure. The stock trades on 23.5 times forecast earnings for the year ending March 2022 and 20.7 times for 2023’s estimates.

For the current financial year, Berenberg forecasts a 30% decline in adjusted pre-tax profit to £290 million, ahead of a 36% rebound to £396 million in 2022, rising to £449 million in 2023.

LVMH at €498

French firm LVMH is the world’s largest personal luxury goods company in terms of market share, owning many of the oldest and most iconic brands such as Louis Vuitton, Christian Dior, Loewe and Givenchy.

Despite playing on the heritage of its brands, the group – worth €251 billion – is also highly innovative and has the strongest momentum with consumers, according to Berenberg.

‘Product innovation is critical to brand momentum and pricing power. The market tends to underestimate the growth potential of brands with accelerating brand “heat”, so identifying inflection points in momentum is crucial,’ the bank says.

As an investment, the business offers unparalleled scale and best-in-class execution, along with the financial firepower to continue consolidating and growing its market share, as shown by its recent acquisition of iconic US luxury brand Tiffany.

Fund manager Terry Smith recently invested in LVMH for the first time, adding the stock to his flagship Fundsmith Equity Fund (B41YBW7).

Smith is a highly-discerning investor – his mantra is ‘buy good companies, don’t overpay, do nothing’ – so the purchase is one that should make investors sit up and take notice. LVMH is a classic Fundsmith holding, as it is very profitable, enjoys high margins and benefits from strong brand loyalty.

The shares are listed on the Euronext Paris exchange under the code ‘MC’. Investors wanting to own the shares will have to be comfortable buying overseas-listed stock and understand that this could come with some extra foreign exchange fees.

Disclaimer: Shares’ Editor Daniel Coatsworth has a personal investment in Fundsmith Equity referenced in this article

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