Colgate-Palmolive - Part 4

Finally, we have here a quick cheatsheet of Colgate's financials.

Basically, it's a company earning USD 4bn on a revenue base of USD 16bn every year and we can expect this to grow maybe 13-15% for the next few years. This growth factors in all we have talked about, including P&G's entrance, GDP growth etc.

Toothpaste is a business that doesn't need a lot of capex, so basically free cash flow is used to pay shareholders. It's free cash flow is about USD 2.4bn, and the FCF yield is 6%.

The interesting part about Colgate's financials would be its balance sheet. Some would argue that it's not exactly great. Debt at USD 3.4bn is greater than its equity of USD 2.8bn. So isn't this risky?

My take is that the management has basically optimized the balance sheet to the hilt. Why is the equity so low? If you notice, equity at USD 2.8bn is the same as a single year's net profit.

This implies that the co. has been paying back equity to its investors. Bcos the business doesn't need money to grow. Whatever excess money made is paid back to shareholders. Although dividend is 3%, Free cashflow yield is actually 6%, I am guessing that the other 3% is used to buy back shares.

And the debt of USD 3.4bn can be easily paid back in less than 2 yrs, using its free cashflow.

However, having analyzed all these, I must admit Colgate is not cheap. PE is 13x two years out, while growth is also roughly 13%. Looking at other measures, EV/EBITDA is a good 10x. This stock is simply trading at its intrinsic value.

The bet here is that the intrinsic value will grow over time. From its track record, it doubles every 8 years or so. Given its current outlook, with growth from emerging markets and some margin improvement, it might take a little shorter than that.

So buy Colgate-Palmolive, get that 3% dividend and see it double to 6% in 6 years and double again to 12% in 12 years! That's a Dividend Aristocrat for you.

Colgate-Palmolive - Part 3

Every stock has its risks and here we talk about Colgate's.

Colgate's biggest risk comes from its competitor - P&G. This company is the nemesis of Colgate, like Jedi vs Sith, Windows vs Mac, Man U vs Liverpool. You get the idea!

P&G has 24% of the oral care market, just a tad smaller than Colgate's 26%. P&G owns Crest - the other big toothpaste brand in US and some other parts of the world (but not in Singapore) and Oral B, the toothbrush specialist.

As we can deduce from our own personal experiences with these brands, P&G probably has a bigger market share in the not-so-profitable toothbrush and other oral products (like floss, denture solution, rinse etc) and a smaller share in toothpaste, where Colgate is really the gorilla here.

Now P&G has been trying to break Colgate's dominance in toothpaste, hence they are been aggressively pricing their products in various important markets. They are really pushing toothpastes of Crest and Oral B into the emerging markets and the biggest market - the US.

This perhaps explained the weakness in Colgate's earnings and stock performance over the past 12 to 18 mths. P&G had some moderate success and Colgate's sales growth in emerging markets indeed slowed in the recent quarters.

With risks in investment thesis, it is also usual practice to come out with mitigating factors, which would help dilute the risks. So for P&G, I guess the mitigating factor would be that the situation would probably be temporary.

This is bcos once P&G reach a optimal market share where it enjoys economies of scale as well as optimal profitability, it doesn't make sense to cut prices to gain volume any further bcos the marginal profit goes down significantly.

Let's rationally thinking about this. In a market where 80% of people uses Colgate (like Brazil or Singapore), there are probably some people who would switch to P&G bcos of price. So we can expect Colgate's share to fall. But after it falls to 60%, ie P&G now has 40% of the market, does it make further sense to throw a ton of money into advertising, sales rebate to get shelve space, and to further price cuts to gain the additional 10%?

Toothpaste is a very personal choice, there would be a group who would never switch from Colgate bcos they like the taste, or the colour or whatever. So it gets harder and harder to get more share.

Of course, P&G also risks Colgate's retaliation. Colgate has lower manufacturing costs bcos of its bigger scale and its first mover advantage. Colgate's local factories are probably built years ago, fully depreciated with more experience staff and sales people. If Colgate embarks on a price war, P&G will lose.

Hence it is likely that P&G would stop cutting prices once it has gained some share and some loyal customers. P&G stands to gain more by maintaining prices, improving margins and just enjoying the organic growth of the market. As the market is growing rapidly, I believe there is room to accomodate 2 players. This means that Colgate would not get to same spectacular growth it enjoyed bcos of P&G's entrance but it's still respectable growth in a great business in the right geographical regions.

As a last note, in a industry where there are only a few players, it make sense to maintain some price discipline such that all the players can make good margins. This is something akin to the Prisoners' Dilemma that we talked about. Both players stand to gain if they cooperate rather than fight.

Colgate-Palmolive - Part 2

Colgate is very big in toothpaste. This is something that is well-known but yet underrated. When I tell people Darlie also belongs to Colgate, most people are pleasantly surprised.

But what really surprised me was when I went down to my local supermarket and saw that the toothpaste segment basically sells just these 2 brands. I mean, Colgate and Darlie dominate the shelves! There are a few tubes of Sensodyne (by GSK), which is now competing with Colgate's own Sensitive Relief Pro. And there is kids' toothpaste. That's it. The rest is all Colgate.

Here's Colgate's market share in some of the world's biggest markets.

Australia 69%
Brazil 67%
Chile 33%
China 33%
Mexico 80%
Russia 33%
Singapore 80% (my personal guess)
UK 47%
US 35%

Isn't this co. amazing? This firm basically dictate what human beings should use when they brush their teeth.

Why can Colgate exert such dominance?

1. Distribution

Colgate is obviously very strong here, it is already distributing toothpaste in the most remote part of the world when people are talking about BRICs. Next time you visit some of our neighbours like Myanmar or Cambodia, take note of the brand of toothpaste they use!

2. Taste

Again, I think people simply don't like new tastes when brushing their teeth, hence they will keep buying the same brand unless prices are raised by 300% or something.

3. Brand

This is something we talked about countless times. When asked to think about toothpaste, what comes to mind? Colgate's mindshare simply dominates.

So there is little threat that things will change in the next few years. Colgate will continue to dominate the markets and grow. Given its high market share in a few regions, it's OPM is also exceptionally high in these regions, at 30% or more. So as these region gets bigger we can expect marginal improvement in the firm's overall blended OPM. But not much, maybe from 25% to 28% or so, over a few years.

Next post - Risks!

Colgate-Palmolive - Part 1

There should always be an investment thesis behind every investment. An investment thesis is a statement to describe in a few words why you bought the stock.

The investment thesis for Colgate would be something like this:

Colgate-Palmolive is the biggest player in the oral care industry with a dominant market share in toothpaste globally. Colgate enjoys the stable growth of the consumer staples sector but has significant exposure to the growing emerging markets (Latam and Asia). Earnings is likely to grow at double digit for the next 3 to 5 years.

After writing the investment thesis, it is usual practice to put down a few positives, risks, valuation, snapshot of the financials and other relevant details.

First let's look at Colgate's geographical breakdown

As you can see, most of Colgate's profits are coming from outside developed markets (US and Europe). There is a segment called Pet Nutrition, although it's probably exposed to developed markets, it's a growing segment with a respectable 15-20% growth. So just roughly calculating, around 65 to 70% of Colgate's business is actually growing fast, ie double digit growth. From there, we can then think of the overall co. blended growth, which would be roughly 8-10% at the topline or revenue level.

At the operating level, margin is at a high 25%. Colgate is a very well-run firm, it's operating margin or OPM has been expanding for the last 7-8 years. However we cannot assume that this would go on indefinitely, maybe 28% would be a peak. There are a few supporting factors:

(a) Emerging markets has higher margins
(b) There is some success launch in high end toothbrushes
(c) Colgate has come up with toothpaste for sensitive teeth, which is grabbing share in developed markets

So, for 8-10% topline growth, with some margin expansion, Colgate can actually grow its earnings at teens for the next few years. In fact, that is exactly what Colgate had achieve for the last 10 or even 15 years, with even lesser topline growth.

Colgate's tremendous but yet stable growth is demonstrated by its dividend track record. Colgate has increased its dividend for the last 47 years! Needless to say, it's one of those admired Dividend Arisocrat and it's just going to keep growing!

Next post, we look in detail at its dominance in oral care!

The Oral Care Industry

Value investors love mundane sectors and what could be more mundane than brushing your teeth? Nobody ever talks about brushing their teeth, how they enjoy it or how they look forward to it every morning. Well basically I think nobody does, that’s why it’s never been talked about.

But as far as investing is concerned, this is one of the best business to be it. We will talk about a few important points:

Everyday Necessity (Consumer Staples)

Well, first of all, everyone brushes teeth at least twice a day right? Toothpaste runs out fast, and people just buy back the same brand without thinking too much. Even if prices were up like 20%, they will still buy it. After all it’s something going into your mouth. If it’s going from $5 to $6, most people wouldn't risk switching to something that doesn’t taste right.

And toothbrushes, they wear out fast too! Not to mention dentists keep recommending that you change yours every 2 months. So it’s a business with growing recurring demand, as long as world population grows.

This is also the beauty of consumer staples. Hence they usually trade at a higher multiple vs other cyclical sectors.

The Industry Structure

The business model may be great but if there are too many competitors, it drives margin down and there is little money to be made. The strange thing about the oral care industry is that globally, there really aren’t that many players. Basically there are only 5, and they control 70% of the world’s market. The top 2 guys alone, Colgate and P&G, controls 45%. So it’s an oligopoly.

When the industry structure is such, the top players have the pricing power and they call the shots and the 3 minor players will follow. Of course they are also cognizant that they can only raise prices to the extent that consumers won’t be put off. If toothpaste becomes $20, I think a lot of alternative brands will appear and most people will switch to them immediately.

However the top players would choose to raise prices just enough to keep people from switching. In fact, given their size, they can lower prices to kill competition when they see fit. That is the power of oligopolies and monopolies.

Well, it’s not so good for the consumers though.

Emerging Market Growth

As with most consumer staples, we can expect steady growth as long as consumption grows. Specifically for oral care, growth rate can actually be high single digit driven by volume increase (as global population increases) and price increase (which should keep in pace with inflation, if not more) over the long run.

It is worth noting that this high single digit growth is also mostly driven by emerging markets. The number actually breaks down to low single digit growth rate for developed markets and teens growth rate for emerging markets.

So having exposure to this industry is basically another way to bet on the growth in the emerging markets. The difference is that you probably pay a fraction of the multiple of the actual consumer staples in emerging markets. (Well the growth rate is also lower bcos the base includes developed markets)

Next, we look at the main player in the market!

DB Brazil ETF - Part II

The second risk is China's decreasing steel consumption.

The last five years saw China's big ambition to develop its infrastructure and mass market condos for its people and hence steel consumption went through the roof, resulting in the bull market in steel and shipping (of iron ore to make steel). That party is now probably going into its 11th hour and Cinderella is ready to drop her glass shoe.

China needs to shift its economy from manufacturing to services, which would need less steel and hence less iron ore. Not to mention that after getting squeezed by the Australian and Brazilian iron ore producers for so many years, China is also aggressively pursuing new avenues of supply in other regions like Mongolia and Africa. This means new supply, less pricing power. So the iron ore story might not have a happy ending.

The saving grace for the iron ore producers would perhaps be bargaining power. With 3 guys controlling 80% of the market, basically they call the shots. They manage the supply, make sure there is always just enough. They manage the spot market, make sure that it stays elevated, then the contract pricing would have to follow.

In the longer run, it is also worth noting that steel consumption is very much integral to the development of our civilization and it will continue to grow. China may have peaked, but S.E. Asia needs a lot steel in the next few years. Not to mention Latin America would probably step up, which will benefit Vale. After that we have India. So maybe there is still hope.

To sum it up, the Brazil ETF makes a lot of sense, especially for the long run. Pricing wise, it is currently 25% below its all time high. It is likely to surpass that in the next 5 years.

As to downside, well, there is about 70% to its Lehman low, but it's not likely to go there bcos there is some valuation support. I would say it might go to 1.3x PBR or PE of 8x, ie 30% decline from current levels. But if that happens, then it's time to buy more!

Well just to sum up here:

Pros:
Exposure to Energy, Iron Ore and Brazil
Cheap valuation at PER 11x with 3% dividend yield
High single digit long term growth rate
Often at discount to NAV (due to tracking error - see below)

Cons:
Replacement of oil and China's slowdown
Low liquidity (10,000 shares traded per day only)
High tracking error (does not track the index well)
70% from absolute low

DB Brazil ETF - Part I

Last checked, there are now 75 listed ETFs in Singapore. As blogged a couple of times, ETFs present an easy way for lay people to invest into stocks and shares without having to put in too much effort (ie do a lot of study and research). Basically, you just buy into the regional/sector growth of the ETF. To learn more, simply click on the ETF label at the end of this post.

Today's post is about Deutsche Bank's Brazil ETF listed on SGX. It seemed like this might be one of the cheaper ETFs out there amidst global bullishness on Emerging Markets.

Brazil has the 8th largest economy in the world and it is projected to be in the top 5 in the next 20 years. GDP growth should be a high single digit for the foreseeable future, although a tad weaker than China, its cheaper valuation more than make up for it.

The Brazil ETF trades at a PBR of 1.7x, 1 yr forward PER of roughly 11x and gives a dividend of close to 3%. Although not as mouth-watering as in early 2009, I find such valuations quite acceptable, given its growth profile. And definitely cheaper compared to China.

The components of the ETF are basically just 4 items.

1. Petrobras, the oil giant with its mega oil-field currently under-development.
2. Vale, the iron ore major, which depends on China's appetite for steel.
3. The banks, which basically mirror the growth of Brazil.
4. The consumer staples, discretionary and utilities sector in Brazil, ie the Brazilian economy.

These four sectors roughly make up 25% each of the ETF. So basically, for every dollar put in, 50c is betting on Energy and Resource, and the other 50c on Brazil itself.

The first big risk here would the replacement of oil. As we all know, when oil hit $150 per barrel during the heydays, it really gave a wake-up call to the guzzlers of the world (which is pretty much everyone), reminding us that being held hostage by the Arabs is no fun and we better start to reduce our dependency on this energy source derived from the remnants of the dinosaurs.

And so, the techies of the world started their engine and ventured out there looking for new energy sources. We are now going big into nuclear, wind, hydro, oil sands, shale gas, solar and even human dynamo in Africa. Of course, we are also trying to use less at the same time, ie more hybrid cars and EVs. Now this is definitely no good for Petrobras.

Well, fortunately, I think the mitigating factor would be that it takes a long time for these alternatives to actually come to the market and finally free us from the Arabs. So meanwhile, we want to develop other big oil fields to limit their market share of oil. And this is where Petrobras and its mega oilfield comes in. And it is in the interest of the world to develop this and make it work.

Next post, we touch on another risk and round-up this topic!

Habits and Snowballing

The Snowball, the much talked about book on Warren Buffett sits on my shelf waiting to be read. It would probably take me some time to get to it, as my reading list is so damn long, with at least 10 books on it. Not to mention the other big book that also lies in waiting: Poor Charlie's Almanac.

The concept of the title was made known by its author, again both simple and insightful and really apt to describe Warren Buffett. Perhaps you might already have heard of it. Anyways, here is my interpretation of it.

Basically, the idea is that something which starts small can grow very big given enough time, consistency and momentum, just like a snowball. When you first push a small snow ball, it rolls and gathers a bit of snow with every turn but stays small. It takes a while for the consistency to set in, more effort, and finally the momentum kicks in and it can cause an avalanche if you want it to.

It also reminds me of this mass email that basically transpired the same concept. A picture showed a beautiful field of tulips, or was it lavender? But anyways, what was interesting was the signboard next to the field which says:

Who: A woman
How: 1 tulip a day for 60 years
Why: For everyone

Or something like that.

Value philosophy shares the same idea. It is not about quick profits or the next trade of the year. It is consistency, patience, effort and time. One angle of it is about identifying companies that are basically doing that. These are the great consumer staples that basically keep growing their markets by selling the same products with the same strategies. Look at Coke, just do the same thing over and over again in different parts of the world, and the earnings will follow. They were in Asia long before we started talking about it. Now they are in Africa!

One big plus why these companies can do it is because they have planted enough seeds such that their brand is entrenched. Just like the field of tulips that take our breath away when we see it. It is also about mindshare - market share of people's minds. When it's as big as Coke or the tulip field, it's difficult for you and I to start a new drink today to compete. The snowball just keeps rolling until it causes an avalanche.

The other angle is how we as investors exercise and implement this idea thoroughly. That is how we consistently implement the same investment process, find good stocks, at a very cheap price, wait for them to grow and see the return compound to some astronomical number. It is not as easy as it sounds. The big hurdle is, as usual, ourselves. Or more specifically our emotions which inhibit our ability to make rational decisions.

This is the habits part. Good habits adopted at an early stage bring profound results over time. Think about exercising just 15 mins a day, or saving just $20 a day. Bad habits ruin lives: smoking, drinking alcohol. Investing is then also about adopting good processes or good habits.

I would say some important do's would be like reading a couple of newspapers daily, talking to at least a few experts per week. Specifically when looking at stocks, it would involve pouring through at least of couple of years of the firm's financials, trying out the products, talking to other users and finally waiting for the right price.

Don't's would naturally be don't buy on tips/rumours, don't look at the share price daily, don't sell to take 20% profits.

With good habits cultivated, it would then be applying the same processes over and over again when buying each and every stock or investment, for many many years, and hopefully the returns will snowball into something big and meaningful.

Steel Industry

After 186 posts about value investment philosophy, I think it’s about time to write about something else. Well, after all, value philosophy can actually be surmised into just 3 words. So, I am actually quite amazed why I could write so much. So going forward, hopefully I can write about industries and individual stocks. As and when new ideas hit, I will still talk about value philosophy and the big picture. Ultimately, that is what’s most important and what will drive long term return for investors.

In this post, I would like to talk about the steel industry. Steel is a basic commodity used by humans and has been pretty integral throughout the development of our civilization. Sadly as a business, it sucks. The industry as a whole doesn’t really create much value for shareholders although there are periods where it churns out enough cash to whet some appetite.

Today, about 1 billion ton of steel is consumed every year. China accounts for half of the usage. Outside of China, Asia including Japan, accounts for bulk of the rest. Well, this is unsurprising as steel is mostly used in construction and infrastructure which Asia needs, a lot.

The business model is simple enough. Buy raw materials like iron ore and coking coal, throw it into a blast furnace, out comes molten steel, add some other metal to make it better (like nickel for stainless, or zinc coat it for shine) and process it into sheets or beams etc. This in itself is not bad. What is bad is:

1. Both the input and output prices are uncontrollable.
2. Competition is very, very tough
3. It is very capital intensive

Raw material prices are controlled by the ore majors: BHP, Rio Tinto and Vale. Specifically, they dominate the spot market and use the spot prices to determine contract pricing. So the steel makers have no say in pricing. The final product prices are also determined by the spot market. There are international market prices for a variety of steel products including the most famous hot rolled coil (or HRC), for H-beams used in construction, for pipes etc.

The reason why such spot markets developed is probably bcos there are simply so many players in the market that is just have to be done for the benefit of both the steelmakers and their buyers. With such markets, products could be standardized, distributors can handle them easily and lengthy negotiations could be avoided. But that’s bad for profits.

But why are there so many steelmakers globally? Well, in the past, it was a country’s ambition to have its own steel mill. It’s a symbol of strength for the nation. The western countries had it. Japan still has it. Korean has it and now China and India are building theirs. What’s worse is when the various provinces or prefectures also decided that they should have, hence you have all these few hundred steelmakers all over the world, each having less than 1% of the global market.

In the middle of this decade, someone decided to restructure the whole industry. His name was Lakshmi Mittal. So he started buying small steel mills all over the world. But he realized that wasn’t enough. There were just too many. In a move that shocked the industry, he decided to buy over one of the biggest steel players globally. Today, his company is called ArcelorMittal and it has capacity of 100mn tonnes or 10% of the market.

But still, 10% is nothing in a world where the suppliers and customers are much stronger and you still have over a few hundred competitors. ArcelorMittal, amazingly, has been able to generate good cashflow by squeezing cost and investment. Unfortunately, the money has to be used to pay down debt and it will take another 5-6 years to bring debt down to a comfortable level. Not to forget, by that time, it probably needs to resume its capex plans as well.

Which brings us to the 3rd point. Steel is insanely capital intensive. It takes USD 1,000 to bring 1 ton of new capacity on. For ArcelorMittal to increase capacity by 10%, it will cost USD 10bn! That’s one sixth of its equity base today. Most other steelmakers are not even that half its size and a new blast furnace project almost always means new financing.

So in short, the steel business, though integral to the development of our civilization, is bad business. There is usually nothing left for shareholders, after everything is said and done.

Well, that is the big picture. Value investors are also stock pickers and hence the dynamics can change for individual companies.

Buffett had a stake in the Korean steelmaker POSCO for the longest time. The story for POSCO is that the company is the No.1 leader in a country that is perpetually in short of steel despite being one of the biggest exporters of steel intensive products like ships, cars, and consumer electronics. What is more amazing is that POSCO is also one of the world’s lowest cost producers of steel. It can achieve this bcos it has the most integrated high capacity steel mill in the world and it also attracts the best talent in Korea to work for the firm. To that end, it even has its own university!

Hence the firm consistently generated free cashflow and paid dividends while having a clean balance sheet with no debt. Having said that, the wheels of fortune might be turning as Hyundai tries to break its monopoly in the Korean steel market while the company had also tried unsuccessfully to expand into the Indian market. In recent times, the dividend has fallen to 2% while free cashflow yield is also below 5%.

So that’s a short summary of one of the oldest industry on earth. In short, it’s best to avoid, as the industry had not been very profitable for shareholders except for the 5 years starting 2003 when the whole world got into a once in 30 year situation whereby there was a shortage of steel. This happens when a big country industrializes after a long drought and no new investment was made in steelmaking. The last country before China was Japan, which started the steel boom in 1970s.

Next on the list is India, but that might be 2030, if we use the once in 30 year rule.

A Girl in the Convertible

There were some academic studies done on capital structure some years ago by two professors. I only remember the study as the M&M theory. M&M being the initials of the two professors. Both professors subsequently won Nobel Prizes! The same theory also talks about dividends, and I thought that the conclusions are worth sharing here.

According to the study, in a perfect world where there are no taxes, no legal or accounting fees and stocks are infinitely divisible, then it doesn’t matter whether stocks pay dividends or not. Bcos investors can just sell part of their holdings whenever they feel like paying themselves some money.

In the bigger scheme of things, it also doesn’t matter what the capital structure of the company looks like. The firm’s capital can be 100% debt or 100% equity or any other makeup, it doesn’t really matter. What matters is that the firm will only be able to generate enough profits to keep it from going bankrupt, and the market price of the firm is always the right price, ie its intrinsic value. And this is the basis of the Efficient Market Hypothesis.

Luckily the world is not like that and dividend matters. A bird in hand is worth two in the bush. Or as Warren Buffett puts it, a girl in the convertible is worth five in the phonebook. So as investors, we want some dividends to come to us, regardless of what Nobel Prize winners theorize.

Hence, I personally like to find good dividend stocks, and hopefully the firm also enjoys a bit of growth over time. The Dividend Aristocrats of the S&P500 is really a good hunting ground for high quality global names. As for Singapore, I have generated some dividend stock lists in the past couple of years. The most popular one is at the right column of the blog.

Some would question why this huge emphasis on dividends? If a high quality firm can compound its growth much faster, it would be wise to let the firm keep the money and use it to grow. This is the excuse most growth co.s don’t give dividends. Even after they become ex-growth, and they happily squander the cash in stupid ventures or M&As.

Perhaps the best positive example is actually Berkshire Hathaway. Since Buffett can compound growth much better than most people, it doesn’t make sense to pay dividends to his other shareholders. However it is difficult to find managers who can efficiently use capital to compound growth better in the first place. So returning excess cash to shareholders or doing share buyback when the stock is cheap is what a good CEO would do.

Paying an ok dividend also signals that the management have shareholders in mind. (This is also called the signalling theory). Ok being like 2-3% dividend yield, which is whatmost of the Dividend Aristocrat stocks are paying currently. The thinking on this would be something like: Well we don’t need ALL the money to grow, bcos we are in such a fabulous business, we can still grow with limited capex and can generate good cashflow too. And so we would pay our shareholders some dividends, while we continue to grow. Just as we did in the last 25 years.

The long and short of this all is that a stock has a good track record of growing its dividend payment is probably one of the best deals out there (if you can grab it at a reasonable price). Which is probably why Warren Buffett holds quite a number of Dividend Aristocrats like J&J, P&G and Becton Dickinson.