I have owned or followed many of our top holdings for over 20 years. Most are trading at steep discounts to their average valuations over the past ten years. We particularly like far reaching distribution arms that tap into aspiring populations in emerging markets. We seek energetic management that is on a mission to create a great product or service, as opposed to using financial engineering to generate returns. Most of our businesses are self-funding. They typically have high free cash flow yields, high returns on invested capital, strong balance sheets and the ability to grow dividends. Despite all these strengths, opportunities for material misappraisals still abound in these times of crisis when the future is unclear and the consensus is, “this is no time to invest.”
Netherlands–based Unilever (UN) provides many of the investment attributes that we like to buy in market panics. Some bullet points:
· Founded in 1930. Roots go back 140 years. Strong, enduring franchise. UN is an appropriate investment in a slow growing economy facing austerity and deleveraging headwinds.
· Powerful distribution into 180 countries and a global population approaching seven billion. Another billion expected over the next 15 years.
· 2010 sales of $59 billion, with 55% in faster growing emerging markets. Cash flow is 8% of sales. EBIT margin is 13%-14%.
· Leading global supplier of branded, low-ticket necessities in hygiene, personal care, and nutrition.
· Food is 51% of sales and 53% of operating profits in 2010...Dressings, savory spreads, ice cream and beverages. Brands include Lipton, Ben & Jerry’s, Breyer’s, Hellmann’s, Popsicle, Klondike.
· Home and personal care are 49% of sales and 47% of operating profits in 2010. Brands: Vaseline, Noxzema, Lux, Dove, Ponds, Suave, Snuggle, Lifebuoy and Alberto Culver.
· Leader in laundry products in developing and emerging markets. · Some 400 operating companies provide opportunities for spinoffs that could enhance shareholder value.
· Solid leadership under Paul Polman, who had successful stints at both Procter & Gamble and Nestle. Polman has the focus and energy to build brands while aiming to increase operating margins from the 13-14% lately to 16% over the next few years. He typifies the Peter Lynch example of an inspired manager in an uninspiring business. Dull and steady win the compounding game.
· For the first half of 2011, high commodity inputs contributed to a 2.3 percentage point hit to gross margins. Commodity cost pressures should abate helping margins over the next couple years as global economies slow in response to monetary tightening (especially in China and India).
· Second quarter sales were up 7.1%; volume up 1.9%; and prices up 5.1%. Emerging economies of Africa, Eastern Europe and Asia showed gains of 9.2% in sales, 3.3% in volume and 5.7% in prices. For the first half, double-digit growth was achieved in Argentina, Mexico, India, China, Indonesia, Turkey and South Africa. · Both Unilever and Nestle enjoyed similar pricing power this past quarter.
· Low-ticket, necessity products do well in an economic slowdown. There is a trend toward eating better while eating at home. Powerful brands help during inflationary times as well. The business has a free cash flow yield in excess of 6%, a dividend of $1.27 or over 4%, and a strong balance sheet, with debt only 33% of capital.
· Earnings should grow from $2.10 in 2011 to $2.34 in 2012. Operating earnings were up 10% in the first half of 2011.
· Buy limit of $29, with a target 17 P/E ratio over the next 18 months, equates to a potential return of 37% (including the dividend). In the steep 2002 market correction, UN managed to trade over 25 times earnings. The stock has rarely traded below 13 times earnings over the past 10 years. Management is materially better today. The business is far more innovative, streamlined and competitive. In time, it should command a higher valuation as execution is rewarded.
· Europe’s financial crisis provides an opportunity to invest in Euro-based companies that derive most of their revenues outside the region, yet are undervalued due to the negative macro news surrounding the EU’s debt crisis.
Here’s our time-tested recipe for earning above-average returns in all kinds of economic climates. First, the price you pay is a major determinant in the long-term return you can expect from an asset. Second, bargains must also be high-quality investments that generate growing cash flows and are managed by inspired, ethical leaders. When considering an investment in the Fund, think about comparing it not only to the S&P 500, but also to historic outperformers like Warren Buffett’s Berkshire Hathaway (BRK.A), especially during stressful market conditions. We never lose sight of the stewardship aspect of our job and how important it is to keep compounding with a constant eye on the downside.
Your trust and support is appreciated.
There can be no guarantee of success with any technique, strategy, or investment. All investing involves risk, including the loss of principal. The S&P 500 Index is a broad-based, unmanaged measurement of changes in stock market conditions based on 500 widely held common stocks. One cannot invest directly in an index. The views in this shareholder letter were those of the Fund Manager as of the letter’s publication date and may not reflect his views on the date this letter is first distributed or anytime thereafter. These views are intended to assist readers in understanding the Fund’s investment methodology and do not constitute investment advice.