Sizemore Capital Management Analysis of the Luxury Goods Sector

The following is a Sizemore Capital Management internal investment memo, reproduced with permission from Sizemore Capital Management.

EXECUTIVE SUMMARY

Given the host of issues facing the global economy—and the European sovereign debt crisis in particular—we have decided to do a periodic review of Sizemore Capital Management’s allocation to the luxury sector in its actively-managed Tactical Portfolio. We find that at current valuations, the luxury sector remains an attractive holding due primarily to its exposure to the emerging market consumer. Weakness in the euro should translate to higher earnings, as the majority of revenues for the European brands that dominate the industry comes from outside of Europe.


COMMENTS AND ANALYSIS

This report is an analysis of the luxury goods sector with respect to Sizemore Capital Management’s allocation to the Claymore/Robb Report Global Luxury Fund ROB and its constituent holdings.

As earnings releases for the first quarter come in, the results have generally been quite encouraging. As a whole, the luxury sector is enjoying a continued rebound in sales as luxury shoppers have largely recovered from the 2008 meltdown.

Though we prefer quantifiable facts and statistics when doing an investment analysis, there are times when anecdotes can be far more valuable. As legendary investment writer Dennis Gartman is fond of saying, “All economic information of any value is initially anecdotal.” Compiling comprehensive data is time intensive and generally involves a significant time lag, whereas anecdotal news happens in real time. When time is of the essence—as it always is when making investment decisions—random bits of news can be very instructive. We find this to be particularly true when attempting to judge the spending behavior of the world’s wealthy. So, for the majority of this report, we will rely on anecdotal information that we have collected in recent weeks.

One gauge we use to track the world’s wealthy is the Liv-Ex 100 Wine Index (see Figure 1). Liv-Ex is an online marketplace for merchants trading fine wine, and the company has created an index to serve as a benchmark for wine prices. Per Liv-Ex,

The Liv-ex 100 Fine Wine Index is the industry’s leading benchmark. It represents the price movement of 100 of the most sought-after fine wines for which there is a strong secondary market and is calculated monthly. The majority of the index consists of Bordeaux wines – a reflection of the overall market – although wines from Burgundy, the Rhone, Champagne and Italy are also included… [T]he index is designed to give each wine a weighting that corresponds with its impact on the overall market.

Sizemore Capital Management considers this index to be a useful “rule of thumb” indicator as to the spending behavior of the wealthy.

Figure 1: Liv-ex 100 Index


After falling steeply during the crisis in 2008, the index stabilized and formed a long base throughout the first half of 2009. Since then it has been nearly straight up—implying that the rich are back in the fine wine market and buying with reckless abandon. Much of this demand, however, is not from wealthy Westerners but from the new rich in emerging markets and from China in particular.

We have commented for quite some time that the luxury story was really an emerging markets story. Though emerging markets have significantly lower average incomes than the United States or Europe, their upper middle class and wealthy consume a disproportionate amount of the world’s luxury goods and services. As Asia and Latin America continue to develop, the ranks of luxury consumers should continue to swell.

Consider this headline from the Financial Times: “Asian Demand Drives Winemakers’ Hopes for a Bordeaux Bonanza,” June 5, 2010. The FT writes,

“Wine producers in the Bordeaux are gearing up to reap the harvest of last year’s highly-praised vintage. After three lean years, prices are expected to smash records thanks in part to unprecedented demand from Asian buyers…

“China imported more than 10 million cases of still wine last year—50 per cent up on 2008—with France as the largest supplier…. Wealthy Chinese are investing in expensive wines with Hong Kong auctions of fine wines now becoming more important that those in London.”

Chinese purchases of fine wine soared by 50% in a year in which the global economy was reeling and demand for most consumer goods was tepid at best.

It’s not just wine that the Chinese are consuming. Luxury jeweler Tiffany TIF is also seeing improvement due in no small part to new demand from Asia. Tiffany saw its sales to Asia, excluding Japan, jump by 50% in the first quarter of 2010, while comparable-store sales rose 21% on a constant currency basis.

Of course, the world is bigger than just Asia. Latin America has also been a source of growth for luxury goods makers. Consider this Financial Times headline from May 27: “Burberry Looks to Emerging Markets for Growth.”

The FT writes,

“Burberry…said it would step up investment in emerging luxury markets like Latin America…. The group plans to open 20-30 wholly-owned stores this year, with most emphasis being placed on the Americas and Asia-Pacific region…. Burberry recently opened its first store in Brasilia and it plans another four stores in Brazil this year.”

Furthermore, with many of the world’s premier luxury brands based in Europe, the recent collapse in the price of the euro should translate to higher profits. This would be particularly true of Chinese sales—because the Chinese yuan is pegged to the U.S. dollar, a stronger dollar means a stronger yuan.

VALUATION

The luxury goods sector is highly concentrated in Europe. Thus it should come as no surprise that luxury stocks have been hit hard by the European sovereign debt crisis. During bear market panics, correlations converge to 1 and virtually all stocks fall together.

Crises often create opportunities, however, and the prices of many luxury goods makers are now quite attractive. Given the conservative financial structure of many luxury companies and the massive (though intangible) value of their brands, these stocks should trade at a premium to the broader stock market.

The ROB ETF currently trades at a trailing P/E ratio of 19. Though expensive compared to the S&P 500 at 15 and the MSCI EAFE at 12, we do not consider this price to be excessive given the improving outlook for forward earnings. Many of the ETF’s constituent companies look quite attractive at current levels.

Sizemore Capital Management is not alone in this opinion. In Vito Racanelli’s May 31 Barron’s article “10 Great Stocks,” Racanelli attempts to find bargains in Europe’s battered stock markets and in its export sectors in particular. He puts together a list of “10 Europe-based global powerhouses that are relatively less exposed to the sovereign debt uncertainties. They have healthy balance sheets and dividend yields, often better than those available from U.S. peers, as well as stable business models with roughly 50% or more of their sales outside Europe.”

Interestingly, four of the ten stocks he recommends are luxury goods makers:

• BMW BMW, the high-end automaker
• Moët Hennessy Louis Vuitton MC, the high fashion and wine and spirits conglomerate
• Pernod Ricard RI, the high-end wine and spirits company
• Luxottica LUX, the Italian maker of high-end sunglasses such as Ray Ban.

CONCLUSION

The rich are officially back. After a brief lull during the 2008 credit market meltdown and the ensuing recession, consumers of luxury products have returned to stores. Company earnings releases are confirming anecdotal evidence of a recovery in the sector.

Though currently not as attractively priced as they were a year ago, we continue to see value in the luxury goods sector. We see demand in Western markets and Japan stabilizing, while emerging markets should provide healthy revenue and profits growth. At current prices, we continue to view the luxury sector as a way to get exposure to the explosive growth of emerging markets while not accepting the risk inherent in direct investment in emerging market stocks. Sizemore Capital Management will maintain its allocation to the luxury sector.

Respectfully,

Charles Lewis Sizemore, CFA

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