Diageo strategy pays off

Magellan Asset Management

July 2022

In the mid-2010s, UK-based distiller Diageo invested in proprietary technology tools to uncover growth opportunities and improve returns on marketing spending. The analysis revealed the US was a ripe market for premium tequila, an alcoholic brew made from the blue agave plant that flourishes around the town of Tequila in the western Mexican state of Jalisco. Tequila volumes in the US doubled from 2003 to 2015, as Hispanic influence took hold and millennials-come-mixologists began making margaritas or sipping the liquid straight.

Diageo's key step in its campaign to penetrate the high-end US tequila market came in 2017 when the company spent US$1 billion (including a US$300-million 'earn-out' based on sales) to acquire Casamigos tequila, a company founded four years earlier by US actor George Clooney and two others. Casamigos, which translates to 'house of friends in Spanish, was the fastest-growing (40%+) 'super premium' tequila in the US. With the purchase, Diageo added Casamigos, which Clooney still promotes, to its tequila portfolio that includes complementary brands such as Don Julio.

By 2021, the campaign's success was obvious. Diageo's 'organic net sales' of tequila in fiscal 2021 had soared 79% from the previous year, numbers that meant tequila sales comprised 8% of the company's organic net sales. (This sales measurement excludes the effects of currency translation and takeovers and divestments.) The company subsequently announced it would spend US$500 million to expand production in Jalisco where it has two tequila plants.

Thanks to strategic portfolio adjustments such as this, Diageo has outperformed peers in the US, which accounts for nearly 60% of group operating profit. Globally, the owner of Baileys Irish Cream liqueur, Captain Morgan rum, Johnnie Walker whisky, Tanqueray gin and Smirnoff vodka posted sales of 12.7 billion pounds in fiscal 2021, an increase of 12% from the year earlier.

Diageo, whose spirits hold the No. 1 spot in six of the nine biggest spirit categories, extends beyond spirits. The company brews beer including Guinness, makes wine and offers ready-to-drink (pre-mixed) options. All up, the company boasts more than 200 global, local, and luxury brands that are sold in more than 180 countries. Through a 34% stake in LVMH's Moët Hennessy, Diageo stretches into the high-end cognac and champagne categories.

Spirits represent about 80% of Diageo's revenue - scotch generates 25% of Diageo sales, while vodka accounts for 10%. Beer brings in about 15% of sales while other categories such as ready-to-drink products and wine generate the remainder. In terms of locations, the company sources about 40% of sales in North America, 20% in Europe (including Turkey) and another 20% in Asia Pacific.

The modern history of Diageo, which can trace its start to 1759 when Arthur Guinness leased a brewery in Ireland, began in 1997 when Guinness and GrandMet merged. This union and subsequent bolt-on acquisitions have created a company with three key competitive advantages.

The first is that Diageo owns the best brands for which consumers are prepared to pay a premium. Spirits variants are distinguishable in terms of flavour, production process, provenance, and vintage. Such points of differentiation allow distillers to charge higher prices for luxury categories. Johnnie Walker's 18-years-to-produce Black Label scotch, for instance, sells at 3.7 times the price of Johnnie Walker Red Label whisky.

Diageo's second competitive advantage is that it has secured superior access to distribution channels. Bars, bottle shops, pubs, restaurants and supermarkets have finite space to display drinks. They favour brands that sell quickly and deliver higher margins. They want brands that can be supplied and restocked by a reputable and reliable company such as Diageo.

The third advantage is Diageo has the turnover to achieve economies of scale in advertising, data analytics, distribution, manufacturing, research and development and procurement of ingredients. Lower average costs mean competitive pricing and higher margins.

Diageo's three key advantages mean that the company is likely to generate superior returns for the foreseeable future, the attribute that stocks must possess to enter the Magellan global portfolio.

To be sure, Diageo faces challenges. Hot categories such as tequila inevitably attract competition. Celebrities Dwayne Johnson (the Rock) and Kendall Jenner have launched tequila brands in recent years that they promote via their widely followed Instagram accounts. There is a risk that this could dent category returns, as new brands take market share and prompt existing players to increase their marketing spending. The counterargument to this point is that new celebrity-backed brands generate buzz for the category, and they typically compete based on product differentiation rather than unhealthy price competition. Diageo must be quick to adapt to fresh competitive threats and new industry trends, as the company did when it stormed the top end of the tequila category in the US in 2017.

Sources: Dunn & Bradstreet, company filings and Bloomberg.

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

Important Information: This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 ('Magellan') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should read and consider any relevant offer documentation applicable to any investment product or service and consider obtaining professional investment advice tailored to your specific circumstances before making any investment decision. A copy of the relevant PDS relating to a Magellan financial product or service may be obtained by calling +61 2 9235 4888 or by visiting www.magellangroup.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any strategy, the amount or timing of any return from it, that asset allocations will be met, that it will be able to be implemented and its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of a Magellan financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Magellan makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material.  Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Magellan. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any trademarks, logos, and service marks contained herein may be the registered and unregistered trademarks of their respective owners. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Magellan.

Fundmonitors.com Spotlight - Past Performance Indicates Something…

FundMonitors.com

17 August 2022

One of the benefits of working at FundMonitors.com is the easy access to data on over 700 funds, and to be able to analyse different concepts for fund analysis and portfolio construction. This can also be a drawback as it's easy to go down "data" rabbit holes trying to prove or disprove one concept or another.

Recently we tested a portfolio that invested in those funds which performed best (based on returns) over the previous year, and then rebalanced at the end of year to a new list of the best performing funds. The premise of this idea is that the best performing funds in any year will continue to perform for 1-2 years, but accepting the reality that few funds remain on a "top ten" list every year.

Using the Portfolio Builder on FundMonitors.com, we created a portfolio in July 2017 with the 10 best performing funds in the previous 12 months (July 2016-June 2017). We then rebalanced the portfolio every 12 months in July, investing in the 10 best performers in each of the previous 12 months.

The results were interesting. Very few funds appeared in consecutive years, or more than once, and the geographic and sector exposure changed each year. Asian Equity Funds dominated in the 17/18 year, and the following year quality focused funds formed the bulk of exposure. Funds investing in the small and emerging sector made up the bulk of the portfolio's exposure the year to June 2020, followed by an increase in growth funds in the year to June 2021. The 21/22 year was dominated by funds investing in the tech sector, simply because of that sector's strong performance in the previous 12 months to June 2020.

The outcome of the portfolio was a return of just 3.17% p.a. over 5 years with volatility of 26.36%, and a maximum drawdown of -47.64% in June 2022 thanks to the end of the tech sector's boom in November/December 2021. The graph below shows the portfolio's performance versus the ASX 200 Total Return and the S&P 500 Total Return benchmarks.

To be fair, there were periods, particularly from July 2020 to December 2021 that the portfolio performed well, but the overall result, particularly in the 12 months to June 2022 was disappointing.

However, what happens if we used longer term performance periods as a guide and didn't rebalance?

Once again, using the Portfolio Analysis tool on FundMonitors.com, we constructed 2 portfolios, one comprised of the 10 top performing funds over a 5 year period to June 2017, and another with the 10 top funds over 3 years to June 2017. This time there was no rebalancing with the portfolio left to grow over the next 5 years to June 2022.

As you can see from the cumulative graph below both portfolios managed to beat the ASX 200 Total Return benchmark but underperformed the S&P 500 Total Return Benchmark.
 

Top performance means different things to different investors, and ignores ratios and KPI's such as Sharpe and Sortino, which adjust for risk.  What about a portfolio made up of the 10 funds that had the highest 5 year up capture ratio in June 2017, or a portfolio of the 10 funds with the highest 5 year Sortino Ratio?

The portfolio using the 10 funds with the highest Sortino Ratio shows some promising performance in this graph given the relatively low volatility. The portfolio only marginally underperformed the Australian Equity market with standard deviation of just 5.32% compared to 15.25% for the benchmark. For risk averse investors this might be an attractive option.

There were a variety of conclusions from the various approaches:  Certainly the most obvious is that chasing last year's "star" performers is not guarantee of future performance - if anything the opposite is the case as sector performance changes with the current economic and market conditions.  

Another is that rebalancing based on a specific time frame - in our case at the end of each financial year - ignores changes in the market.

Finally "performance" means different things to different investors.  For those just chasing high returns, accept that higher volatility frequently comes with it.

Undoubtedly the disclaimers are right…past performance is not an indicator of future performance. Careful research, diversification and an eye on the market and macro environment are essential.

Over the coming months we will continue to build out examples of portfolios created using the FundMonitors.com analysis tools. In the meantime, access to the Portfolio Builder is available to Premium Subscribers of FundMonitors.com and for those who want more information on what this tool can do, please have a look at this video.

A look at the poster child for Owner-Managed

Airlie Funds Management

July 2022

My love affair with owner-managed businesses began back in the mid-1990s when I was in my 20s, and naturally as one imagines at that age, an investing genius. Surely sensing my potential, my bosses allocated me a 'small-cap' company to cut my teeth on as an analyst (read: limit any potential damage to portfolios). The trading liquidity of the company was low, and it did not get a lot of airtime among the bigger, sexier companies. I took a good look at the company, reading all the (hard copy!) annual reports, and got a sense for the underlying quality of the business. The company - Reece Limited - was outwardly pretty boring - a plumbing wholesaler that was majority-owned by the Wilson family, a family that had no interest in spruiking the stock to pump up the share price. This put them at odds with 90% of other companies on the bourse, and pretty much all my experience of management teams thus far.

Over a few years, we slowly but surely accumulated enough stock in Reece to make it a meaningful holding in the portfolio. The results had been impressive, with the company growing profits at a meaningful clip and the share price following. So, expectations were high leading into another half-year result when I excitedly printed the results out - sales were up meaningfully! Double digit! ... but net profit was down ... meaningfully!

To better understand my consternation, perhaps a slight detour on how the market operates and concentrates on short-term performance. There ... that is the detour. In my experience, the market was (still is!) ONLY interested in the right here and now, and it wants profit growth NOW and the promise today of more of the same into the future with no detours taken along the way. The reward? A nice upward path for the share price. In my experience as an analyst to that point, this is what companies strove for each half year and they would move hell and high water to achieve it, egged on by market participants (buy and sell sides). The poster child at the time was US-listed General Electric with the lauded Jack Welch as CEO. It turns out the remarkable quarter-over-quarter profit growth that GE produced was an illusion, but that is another story.

"My love affair with owner-managed businesses began back in the mid-1990s when I was in my 20s."

So, I frantically looked at this profit result from Reece with a growing sense of sickness in my stomach - costs were way higher than the previous period, in my mind destroying a beautiful sales result. The 'market' in its short-term wisdom declared this a poor result and reacted accordingly. The stock fell. Now as I have mentioned, Reece was majority-owned by the Wilson family, with ownership of over 70% of the shares on issue. The family did not communicate much with the market, nor frankly did it seem to care what a bunch of financial analysts thought about how the company was run, rightly so as we'll see below. However, in my infinite wisdom I was determined to tell CEO Alan Wilson what was what, and didn't he understand the purpose of producing half-yearly profit growth numbers? Hadn't he heard of operating leverage?

So, with more patience and politeness than I deserved, Wilson heard me out and further explained the strategy that was already laid out briefly in the result commentary (had I bothered to read it). Where I saw a cost blow-out, he saw great opportunities for investment to grow - simply, rolling out the Reece store network in more locations around Australia, taking market share, and becoming ubiquitous within plumbing and bathroom. I hung up the call having learnt a valuable lesson. Now I had dutifully read the Warren Buffett letters and paid lip service to buying 'pieces of companies' not 'lottery tickets,' but in the cut and thrust of everyday markets, I too had absorbed the focus on the short term. The penny dropped that Wilson was investing now for future growth, and that the opportunity could be massive.

Now around that time in the late 1990s, Reece was actually half the size of the big player in the market - Tradelink (owned by the mini-conglomerate Crane Group). The chart below shows that Reece was half Tradelink's size in terms of sales and profits.

Reece versus Tradelink

Quality of Management: Benefits of an owner-managed business

Source: Company reports

Fast forward more than 20 years and Wilson's strategy has played out perfectly. From a relatively unknown company based in Victoria, the Reece name has become synonymous with plumbing and bathrooms nationwide. The chart below shows the result - sales in Australia/New Zealand up 8x and profits up 22x. Amazing results and all without raising any equity (until its expansion into the US in 2018) or meaningful debt. In fact, the company acquired property sites for a lot of its best-located stores along the way. Meanwhile, you can see what happened to Tradelink - 23 lost years where sales went nowhere, and profits backwards - overseen by numerous management teams and a new corporate owner (Fletcher Building).

Source: Company reports

Which now brings us to the lesson in all this. Standing in 1998, armed only with sales and profits of Reece versus Tradelink, traditional business theory would usually predict Tradelink would go on to dominate, given it had a larger store base and hence larger sales base to generate economies-of-scale benefits, etc. Yet we see that an owner-managed business can meaningfully outperform a competitor. Why might this be the case?

Firstly, it's worth defining how we think of owner-managed businesses. We break our definition into two groups:

1. High ownership, high control: By this we mean an owner/founder who retains a shareholding of more than 20% of the shares on issue and manages the business. Companies such as Reece, Fortescue (Andrew Forrest), Seven Group (Stokes family) and Harvey Norman (Gerry Harvey) fit this definition.
2. Low ownership, high control: This group is a bit more nuanced. For example, despite owning only about 14% of News Corp, the Murdoch family is unanimously considered 'owner-managers' of the company (helped by the family's higher ownership of the voting shares). Other examples include the Lowy family formerly at Westfield (less than 15% ownership) before its merger with Unibail-Rodamco, ARB Corp (4WD accessories) run by Roger Brown and his brother (less than 10% ownership), and even ResMed (sleep apnoea devices), co-founded by Chairman Peter Farrell and now managed by his son - Mick - despite the Farrells owning less than 5% of the company.

So why can companies that fit these definitions do so well? We believe it comes down to three fairly obvious factors:

• A strong focus on the core
• Long-term planning
• Resilience, leading to optionality (typically underpinned by conservative debt structures).

Using Reece as an example and running the company through the three factors:

Example: Reece

With a continuous management team implementing the above, the results can be powerful. Reece has had two CEOs in 50 years - Wilson and now his son Peter - while, as mentioned, Tradelink has had at least five different senior management teams over the past 20 years. The result of this continuity for owner-managed companies is that the 'culture' that is developed over time can be an amazingly powerful weapon in a company's success.

Owner-managed - The numbers re-crunched

We have been keen on this owner-managed theme for some time and indeed in the Airlie Australian Share Fund a third of our holdings are owner-managed companies. We first put together an owner-managed index in 2018 that backed up our view that owner-managed companies overall outperformed over the long term, because of the reasons listed above. At the time, we noted the limitations of our exercise:

• Had we captured all the owner-managed companies out there?
• Was survivorship bias distorting our data? (ABC Learning anyone?)
• What about when the owner-manager sold down or stepped back? (Computershare, Primary Healthcare)

"Owner-managed companies have outperformed the S&P/ASX 200 Accumulation Index over each period."

We have pored over the data set and re-crunched the numbers (with the help of Macquarie Equities) to test the limitations listed above. We have included all owner-managed businesses up until the point at which the owners stepped back. Some simple conclusions have been drawn (and the numbers are shown in the table below):

• As a collective group, large and small cap, owner-managed companies have outperformed the S&P/ASX 200 Accumulation Index over each period: 10 years, 15 years, and the full history of our test over 22 years (since 2000).
• This outperformance includes notable blow-ups ABC Learning, Babcock & Brown et al associated with the GFC meltdown.
• Small-cap owner-managed companies are the place to be - over the years think ARB Corporation, Mineral Resources, and Premier Investments. Companies that have compounded at more than 20% p.a. for years. More recently (past five years) companies such as AfterPay have made the owner-managed universe.

Performance of owner-managed companies versus the market

Source: Macquarie Equities, Airlie

Further refinement

We have further refined the notional index by applying Airlie's investment filters that favour financial strength, business quality and management capability. We believe that not all owner-managers are created equal. We feel some look after minority shareholders better than others and/or their businesses fail our quality test. As mentioned, ABC Learning and Babcock & Brown were two high-profile situations where shareholders lost all their money. Both companies failed Airlie's test on financial strength. Further, we have excluded some business models (notably the buy-now-pay-later space) where we feel there is a question mark around sustainable profits. Note that the exclusion of AfterPay penalises our notional index performance.

So, taking our investment process filters and looking 10 years over the performance of owner�'managed businesses versus the broad market:

Source: Macquarie Equities, Airlie

So, 10 years ago $10,000 invested in Airlie's notional owner-managed index (purple line) is worth $60,000 while $10,000 invested in the market is worth about $30,000. Of the 70 owner-managed companies that make up this notional index, the strong performers include: Fortescue, ResMed, Goodman Group, Mineral Resources, and Northern Star. To be clear, we have not owned all of these companies in our funds over the years. Although it is pretty evident to us now that our performance would have been enhanced if we had! The poorer performers include: Monadelphous, Nufarm, Freedom Foods, and Oroton. We have not held any of those companies in the fund.

The small-cap effect is evident when we split our notional index into two market cap groupings. So, the bigger companies (purple) versus the smaller ones (green):

Source: Macquarie Equities, Airlie

The conclusion we draw is that the owner-managed model is immensely powerful in a small company, where the success factors of owner-managers can be leveraged into truly remarkable results. Examples in our fund include ARB Corporation, Premier Investments, Nick Scali, PWR Holdings and of, course, Reece. So going back to years ago when I was allocated Reece to analyse, the market capitalisation was less than $250 million. With a market cap of nearly $9 billion today, Reece remains the poster child for the power of backing the right owner.

Author: Matt Williams, Portfolio Manager

Funds operated by this manager:

Airlie Australian Share Fund

Important Information: Units in the fund(s) referred to herein are issued by Magellan Asset Management Limited (ABN 31 120 593 946, AFS Licence No. 304 301) trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation. This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Airlie makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Airlie. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any third party trademarks contained herein are the property of their respective owners and Airlie claims no ownership in, nor any affiliation with, such trademarks. Any third party trademarks that appear in this material are used for information purposes and only to identify the company names or brands of their respective owners. No affiliation, sponsorship or endorsement should be inferred from the use of these trademarks.. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Airlie.