Consumer giants hoovering up their smaller competitors can ironically lead to their own demise, according to Schroders’ Kevin Murphy (pictured), who warned against the staunch belief that these global-facing stalwarts are safe investor havens. 
The manager, who heads up the £1bn Schroder Recovery fund alongside fellow FE Alpha Manager Nick Kirrage, explained in his latest blog post that expensive acquisitions can lead to companies increasing the price of their products to cover the shortfall.
While this can indeed cause profit growth and therefore bolster their share price, this then provides a space in the market for smaller competitors selling cheaper products to take back some of the market share.
“Companies generally increase their prices to increase their profits. Shareholders like companies that increase prices as it causes large profit growth and so the share price goes up. This cycle keeps repeating until the company puts prices up too high,” Murphy explained.
“Once prices are considered too high by the consumer a new competitor is allowed to enter the market as they’ve become uncompetitive.
“For example, when the big supermarkets put prices up too high and the discounters entered (Lidl, Aldi etc.). Or when the large beer companies started charging over the odds for a pint of beer it allowed smaller craft brewers to enter the market due to the increased margin potential.”
“The consumer giant then has to show they haven’t lost market share to the new disruptor. So they buy it to protect their existing business, essentially buying back their customers. This purchase is usually for a lot of money as by definition the disruptor is growing fast and the new sexy thing on the market.”
The manager highlighted Diageo’s recent acquisition of Hollywood star George Clooney’s tequila company Casamigos as a prime example.
The share price seemed to react badly to the news – which broke on 21 June - despite the acquisition further strengthening the company’s significant stake in the US’s fast-growing premium tequila sector.
Performance of stock over 1month
Source: FE Analytics
While Diageo is largely favoured among several quality growth investors (Nick Train, Hugh Yarrow & Ben Peters and Anthony Cross & Julian Fosh to name but a few), Murphy remains sceptical of this business decision, which resulted in the firm paying the equivalent of $4,000 per case for Clooney’s tequila.
“[This] is four times what it paid for another tequila brand, Don Julio, in 2015,” he reasoned.
“The same analysis suggests Casamigos will have to grow its sales by between 30 per cent and 35 per cent a year just to break even by year four. Clearly one could argue the epithet ‘super-premium’ is as applicable to the deal’s price-tag as to any tequila.”
This isn’t the only example the manager recalls of consumer giants paying a premium for green competitors, either.
Another instance he referenced is Unilever’s purchase of Dollar Shave Club, a men’s grooming business founded in 2012, which was purchased by the consumer giant three years later.
According to Murphy, the company bought the firm in a bid to compete against Procter & Gamble within the North American razor market.
“As we said before, you do have to wonder if there is something more going on here than companies looking to establish or grow their market share,” he warned.
“We have now reached a stage where some investors can look at the likes of Diageo or Unilever – or Danone or Nestlé or whoever – and convince themselves they are able to predict the future.
“They see these huge consumer goods companies with their portfolios of global brands generating solid income streams and they tell themselves they know what is going to happen – not just two years but two decades down the line.
“They believe these businesses are so dominant they will continue to grow their market share and this belief justifies the significant premiums now being paid for shares across the sector.”
Playing the devil’s advocate, Murphy said constant (and often expensive) acquisitions every time there is a small start-up selling products within the firm’s sector raises questions as to how successful their business models really are.
“The irony of the Dollar Shave Club story is that the start-up was taking on a sector that has been so successful it has a business model named after it,” the manager pointed out.
“The ‘razor-razorblade’ method is a tactic where two interdependent items are sold at very different prices – one (a razor, say, or a video game console) comes at a discount while the other (razor blades or video games) retails at a much higher price.
“One of the most successful business models of all time it may be but Dollar Shave Club managed to upend – or ‘disrupt’ – the sector it was named after in the space of three years, in the process persuading Unilever, which did not have any share in the US shaving market but wanted to take on the dominant player Procter & Gamble, to pay what most commentators agreed was over the odds for it.”
Murphy said purchasing these small and unknown start-ups actually destroys shareholder value, despite appearing to improve it over the short term.
If these consumer giants overpay for the story and therefore the growth the company offers, he explained they have overpaid to create the illusion of stability for investors.
“Ultimately, there is a limit to the effectiveness of brands and their pricing power,” the manager concluded. “As we have argued before, these companies are not the one-way bet their investors seem to believe or their valuations appear to imply.”
Since Murphy and Kirrage took to the helm of Schroder Recovery in 2006, the £1bn fund has outperformed its average peer and benchmark by 76.33 and 75.17 percentage points respectively with a total return of 179.74 per cent.
Performance of fund vs sector and benchmark under Murphy and Kirrage
Source: FE Analytics
It has a clean ongoing charges figure (OCF) of 0.91 per cent.