Since 2020, global equity markets have been significantly volatile with extreme movements, both up and down. When markets are this tumultuous, we have found that there can be opportunities to invest in high-quality companies trading at attractive valuations. Although 36ONE has a style agnostic approach to investing, we do have a bias towards quality companies, especially when investing offshore where our investable universe is larger.
Quality is a highly subjective term in investing. We think that a quality company has several characteristics, including a strong balance sheet and attractive industry. However, one of the key differentiators for a high-quality business is its capital allocation – the ability to consistently reinvest its cash in new investments with an attractive return or, alternatively, return the cash to shareholders. In this article, we will share how we assess a company’s capital allocation skills, using our investment in LVMH Moët Hennessy Louis Vuitton SE (LVMH) as an example.
LVMH is a high-quality business that has outperformed the market
Last year we had an opportunity to invest in LVMH which has been on our watchlist for a while. LVMH is the largest luxury goods company in the world with exposure to a broad range of products from champagne to apparel and cosmetics. The group houses about 75 major brands including Bulgari, TAG Heuer, Christian Dior, Tiffany & Co. and, of course, Louis Vuitton.
LVMH has consistently grown its revenue and expanded its margins over the last ten years, despite the large scale of the company. This superior financial performance has led to the company outperforming the market during this same period. LVMH has many attractive attributes which have supported this success. These include being owner-managed (which creates alignment with shareholders) and operating in an attractive industry, but we have been particularly impressed by the company’s capital allocation skills.
Exceptional capital allocation
LVMH has achieved its consistent growth both organically and inorganically. Growing inorganically (by acquisition) is an exceptionally difficult way to consistently outperform, as evidenced by the well-known statistic that 70-90% of acquisitions fail. LVMH has a track record of acquiring good brands or creating brands and optimising them by leveraging group learnings in marketing, distribution, and other areas. LVMH has shown its ability to efficiently and profitably reinvest its capital in this way.
When assessing a company’s capital allocation, we assess both quantitative and qualitative factors which we believe are critical to executing the company’s strategy. We believe that LVMH has a few key qualitative differentiators that have supported the company’s unique growth strategy, including:
- Decentralised management structure – This kind of structure lowers acquisition integration costs and time to realise synergies as the acquired business is not materially disrupted. Managers of acquired companies can focus on running their own brands. It also enables head office to focus on capital allocation and strategic engagement rather than day-to-day management. This ensures that group capital is directed towards the most value-accretive projects that sustain brand heritage and enable growth.
- Specialist M&A team/expertise at senior level – LVMH’s Chief Financial Officer (CFO) is the former Head of Mergers and Acquisitions at Lazard Frères with an impressive career in corporate finance. His expertise, coupled with the experience of the founder and CEO, Bernard Arnault, makes a formidable leadership team that makes executing acquisitions a part of their management of the group. This means that acquisitions rarely take away management attention, another reason why acquisitions can fail. Instead, they are a core part of their responsibilities.
- Systematic playbook that can be repeated – Despite executing different types of transactions (e.g. listed vs private companies), this management team are experts in how to grow luxury brands optimally. Their playbook is easily deployed and ensures value from acquisitions is realised efficiently, as evidenced by their most recent acquisition of Tiffany & Co (Tiffany).
- Price discipline and patience – The value of luxury companies is normally well appreciated which can make it difficult to complete transactions at attractive valuations. This team has shown discipline in waiting for the right opportunities.
- Fragmented market in which company can expand – Luxury is a broad industry with many categories. Despite the large number of brands within the group, LVMH still has room to grow in categories such as luxury watches and cosmetics.
These qualitative characteristics along with strong financial performance give us confidence that LVMH can more likely than not continue to maintain its growth and profitability in the near term, driven by this superior capital allocation.
Tiffany: A case study in successful acquisitions
As LVMH becomes larger, one would assume that needle-moving acquisitions would be harder to come by, but the recent Tiffany acquisition has shown that they can still grow, despite their current scale. The 2021 acquisition is a recent example of LVMH’s superior ability to realise value from acquisitions, even large ones where most companies fail. Tiffany is an iconic brand which has been featured in many Hollywood films (most notably Breakfast at Tiffany’s) and is known for its unique jewellery box colour, known colloquially as Tiffany-blue.
The $16bn acquisition was initiated in 2019 but only completed in 2021. The deal was interrupted by the Covid-19 pandemic as LVMH tried to retract its offer, given the uncertainty. It was eventually completed at a lower price – $131.50 compared to the original $135.00 per share. At the time, the valuation did seem high at a P/E of c.30x. However, since joining the LVMH group, Tiffany has grown considerably.
Extract from LVMH FY22 Earnings call (26 January 2023):
“Tiffany, for the first time will exceed the EUR1 billion in profit from recurring. We were barely at half that when we acquired the business. Everyone said to me, why you buying this business at that price, it's far too much. Well if today the business were to be listed -- well, we never know, but I mean wasn't perhaps managed in the most dynamic way. I won't dwell on that at the time, but if it were listed today, probably worth twice as much”. …“ it's a very good investment, continues to work very successfully.”
The acquisition has been a financial and commercial success. It expanded LVMH’s presence in the jewellery category and has introduced the brand to a younger demographic through improved marketing.
Looking ahead
At 36ONE, we are long term investors and balance this mindset with a strong sell discipline. We believe that LVMH still has room to grow organically and through further acquisitions as the company continues to execute its tried and tested playbook. At the same time, our investment process includes continuously monitoring the value of our current and potential investments to ensure we remain disciplined in selling companies with prices reflecting their fair value, and redeploy that capital into better opportunities. We also take profits along the way to responsibly “let our winners run”. We will continue to apply this approach to LVMH and all of our investments. This ensures we effectively defend and grow our clients’ capital.