Why Procter & Gamble is Our Largest Investment
Recently, we’ve been getting some questions asking us to explain why Procter & Gamble (PG) is our largest holding. In answering these questions, we realized that our reasoning for owning P&G in such size could prove instructive and thus decided to post a detailed write-up of the investment. Hopefully, by the end of this write-up, you’ll understand not only a little more about why we like Procter & Gamble, but also a bit more about how we think through investments and portfolio construction in general.
We try to construct a portfolio that maximizes our investment return under the constraint that we want to have a very low chance of long-term permanent loss of purchasing power. We attempt to accomplish this goal in the following ways:
First and foremost, we strive to construct a portfolio that we believe meets our constraint of a very low likelihood of long-term permanent loss of purchasing power. In order to meet this constraint, we generally favor and invest in what we consider to be “high quality” businesses that have certain innate characteristics that make their cash flow streams less vulnerable to unexpected shocks (even very severe ones) from competition and the economy. Factors that we believe make businesses less vulnerable to these shocks and thus “high quality” include 1) consistent high returns on tangible assets, 2) geographic and product diversification, 3) low cyclicality, 4) high profit margins, 5) conservative use of debt, 6) stable or improving industry structure, and 7) a high likelihood of continued organic growth in their main product categories. This constraint doesn’t mean that we will never invest in lower quality stocks. Rather, it means that we will require a significantly higher expected forward rate of return in order to invest in any lower quality stocks. It also means that we will likely never have a portfolio consisting entirely of very cyclical or very levered companies, given their correlated risk of precipitous cash flow declines in severe economic downturns such as the Great Depression or the Global Financial Crisis.
Once we’ve met this constraint, we try and construct a portfolio that we believe maximizes the investment return per unit of risk. Thus, the higher quality the business, the lower the expected return we require, and the lower quality the business, the higher the expected return we require.
So, let’s look at Procter & Gamble in this framework. In our opinion, P&G possesses almost every high quality characteristic on our list.
1) It has both consistent and high returns on tangible assets.
2) It has huge product and geographic diversification. The company sells a variety of products in a number of different categories like fabric care, baby care, hair care, male grooming, beauty care, home care, and feminine care. These products are sold throughout the world with roughly 39% of sales in North America, 19% of sales in Western Europe, 18% in Asia, 10% in Latin America, and 14% in CEEMEA (Central and Eastern Europe, the Middle East, and Africa).
3) The vast majority of these products are relatively non-cyclical, inexpensive necessities for daily life.
4) Procter & Gamble has the #1 or #2 market share in most of these products, giving it economies of scale on manufacturing (leading to lower costs) and on advertising and R&D (leading to higher prices as familiarity, habit, and superior performance breed a willingness to spend a few extra cents or, in some cases, even dollars on P&G products), leading to robust and consistent operating margins of approximately 20%.
5) Procter & Gamble has net debt, inclusive of capitalized operating leases, of about 2x EBIT and interest coverage of over 17×.
6) There are a handful of global companies that account for the majority of sales in most of P&G’s product categories, leading to relatively stable market shares and industry structure over time. There are occasionally private label concerns, but these concerns have generally proven to be cyclical in nature.
7) While the U.S., Western Europe, and other developed markets may have slower growth in the future than in the past, we believe the under-penetration of P&G’s product categories in the emerging markets will allow the company to grow its revenue at roughly 5% per year over the long term. We believe this growth rate is highly achievable given that it is approximately equal to our estimate of the long term nominal global GDP growth rate, to P&G’s product categories’ recent growth rate, and to P&G’s historical revenue growth rate.
Clearly, on our metrics, P&G is one of the highest quality businesses around. However, since we recognize that even a great business purchased at a high price is a poor investment, let’s now look at our estimate of the expected return at the current price.
In order to determine the expected return, we first spend a significant amount of time assessing normalized cash flow (cash flow adjusted for cyclicality in sales and margins) and then adjust for often-overlooked items such as option issuance, pensions, and “moat-protecting” (as opposed to truly additive) acquisitions that will reabsorb the cash generated. Some businesses are “hungrier” than others and require a high percentage of their supposed free cash flow in order to protect and grow their business. Others, such as many of the companies we currently own, are so “capital-lite” that they have the potential to grow their businesses at global GDP or higher rates while still returning 80-100% of their earnings back to shareholders in the form of true free cash flow. Once we understand the cash generative power of the business and how much of that cash is truly free to shareholders, we calculate an expected rate of return based on the prevailing market price.
In P&G’s case, based on our calculation of its free cash flow (“FCF”), roughly 110% of its earnings over the last seven years have been available to return to shareholders in the form of share repurchases, dividends, cash buildup or debt repayment. Additionally, while margins have generally been stable at P&G over the last ten years, they’ve moved around a little and are currently slightly depressed relative to the 10 year average, making free cash flow understated relative to earnings by an additional 10% or so. We believe margins are depressed both as a result of a bloated cost structure and as a result of recent mismanagement of P&G’s brands that has led to subpar growth relative to the rest of the industry (for instance, P&G’s 2012 organic revenue growth was only 3% vs. Unilever, Colgate, Kimberly Clark, and Clorox at between 4% and 7%).
Thus, in a base case, if the current next twelve months earnings yield is roughly 5.3% ($4.32 a share) but we believe that earnings can be converted to FCF at about a 105% rate and that margins are understating FCF by an additional 10%, then the normalized FCF yield is almost a full percent higher at 6.2% (roughly $5.00 a share). Adding in the 5% growth rate gets an expected return of 11.2%, our base case estimate of expected return.
In a negative case, P&G may only convert 90% of earnings into free cash and margins may drop further to 90% of their current level, resulting in a 4.5% FCF yield (roughly $3.50 a share). Assuming FCF growth of only 4% over the long term leads to an 8.5% forward rate of return.
However, our bullish case is that newly reinstated A.G. Lafley achieves the 24% EBIT margins that he highlighted as a goal in October 2005 after the Gilette merger (and that also happen to be equal to best-in-class competitor, Colgate). If he achieves these margins, then our normalized free cash flow yield goes up to over 7% (roughly $5.75 a share). With 5% growth, that’s over a 12% forward rate of return.
While we would argue this return distribution is very favorable in absolute terms, the question now becomes whether we can find any stocks that have even better risk vs. return characteristics. So far, the answer is no. Almost all of the stocks that we analyze are lower quality than P&G under our metrics, yet, at current prices, the vast majority offer comparable rates of return (or lower), though with a much wider bell curve of outcomes. While we own a few that we believe have higher expected returns than P&G, none offer enough of a return premium vs. the extra risk assumed to justify our making them bigger positions than P&G. The few businesses that are comparable in quality to P&G mostly have long-term forward rates of return that we estimate at around 8.5%-9.5%, not much better than our negative case of 8.5% for P&G and well under our bullish case of over 12%.
As a result, we’ve made Procter & Gamble our biggest position.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Nothing said in this piece may be considered to be an offer to buy or sell any security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Data presented was obtained from sources deemed to be reliable, but no guarantee is made as to its accuracy. Past performance is no guarantee of future results.