One Untrue Thing

Coca-cola. Gillette. Disney. McDonald’s. Procter & Gamble. Until about two months ago, these were the belles of the ball that was the bull market. You couldn’t go wrong owning these stocks. “Buy and hold” doesn’t quite express the certainty with which these stocks were bought. It was more like “Buy and sleep like a baby forever.” In a creepy, classic example of killing the thing you love, though, investors have used the recent market sell-off as an excuse to take these companies out behind the barn and shoot them. And while the entire stock market did need to have a sense of reality knocked into it, the hits these companies have taken are a clear case of unjustified homicide.

What we’re witnessing here is a backlash against what had become the prevailing wisdom about these consumer giants, namely that they’re no longer cyclical companies. Cyclical companies are those whose fortunes rise and fall with the state of the economy, the way those of steelmakers, airlines, and auto manufacturers do. In boom times, these companies make money hand over fist. But in recessions, businesses stop the kind of capital spending that requires girders and cut back on air travel, and consumers decide they can drive the beat-up Chevette for another year, so these companies end up on the street corner selling pencils. Noncyclicals are those that keep generating profits even when the economy is shrinking, either because they make a product that people always want or because they’re so efficient that they’re able to remain profitable as sales slow. Not surprisingly, the stock market likes noncyclicals much better.

Now, it’s always been hard to figure out which category companies like McDonald’s, Coke, Disney, and Gillette fit into. Over the years, the market has gone back and forth on this question. But in the nineties, it had one answer: These companies are noncyclicals, and you should pay any price for them. After all, people don’t stop eating and drinking or going to movies or shaving when a recession hits.

The new noncyclical paradigm went something like this: American-style capitalism is sweeping the globe, accompanied by an unprecedented surge in the cultural influence of the United States. Coke, Disney, and the rest are the perfect avatars of Americanization, and already have well-established brand
names. More important, they’re exceptionally efficient users of capital with a keen sense of what the globalization of operations requires. Disney, for example, generates revenue from so many different sources today – TV, film, merchandising, theme parks – that it’s cushioned from a blow in any one area. And the noncyclicals make products that are always priced
to move.

That argument was backed up by the fact that these companies delivered solid earnings growth throughout this decade. Coke’s revenues doubled between 1989 and 1997, and its return on invested capital just last year was a remarkable 39 percent. Gillette turned in double-digit quarterly profit-growth rates for eight straight years. McDonald’s and Disney and Procter & Gamble were similarly stellar performers. The stock prices of all these companies responded accordingly.

Actually, the stock prices of these companies responded a little too well. The combination of the discovery that these companies seemed business-cycle-proof with the dramatic rise of index funds meant that money poured into these stocks as if buying Gillette was as much of a sure thing as betting against the Bills in the Super Bowl. This year alone, Coke rose from the low sixties to a high of 88 (it’s now back at 64), Procter & Gamble flirted with 100 (it’s now down to 77), and Gillette rose as high as 62 (now it’s at 40). Investors remained convinced that nothing could go wrong.

The dazzling thing, in retrospect, is how abruptly this Era of Good Feeling dissipated. As soon as these companies started to warn – late this summer – that in fact they were not impervious to the global meltdown, investors became the proverbial rats on the sinking ship. Now the new new paradigm is that these companies are in fact cyclicals in disguise. The world doesn’t want to buy itself a Coke, and doesn’t really need a Mach 3 shave. More than that, critics are now casting doubt on the whole idea that it’s a good thing to be a standard-bearer in the glorious battle to win foreign countries over to the virtues of American pop culture. Maybe, the argument goes, what we’re seeing is a reaction against Americanization. Coke’s earnings are going to be flat this quarter, Gillette’s are going to decline slightly, and P&G is having trouble everywhere. Isn’t this a sign that Brazilians want to eat at Brazilian restaurants and shave with Brazilian razors?

Don’t bet on it. The truth is that the prevailing wisdom about these companies was right. It just got a little out of whack, and the companies’ stock prices just got ahead of themselves – like everything else in our late, great bull market. When you say that a company like Coke is a noncyclical, after all, what you mean is that even if the economy slows down, people will still buy Coke about as much as they did before. What you don’t mean is that if huge chunks of the global economy are flung into depression, people will still buy Coke about as much as they did before. Only the most hopelessly deluded optimist could have believed that Coke, which gets 76 percent of its profit from international markets, could ride out this storm without a scratch.

On top of the simple reality that people in Asia and Russia just have much less money with which to buy Cokes, there’s also the impact of the currency devaluations that have swept the globe. Many Asian currencies are 50 to 70 percent weaker against the dollar today than they were a year ago. To make the same profit as it did a year ago, then, a U.S. company has to sell much more product, and do so at a time when everything’s falling apart. Companies hedge against foreign currencies, but there’s no real hedge against the kinds of enormous drops we’ve seen this year (as Long-Term Capital discovered).

Of course, these consumer giants have reaped all the benefits of globalization for years now, so it’s only fitting that they would be bitten by the hand that’s fed them. And the point isn’t to dismiss the slowdown in earnings growth at these companies as unimportant so much as to say that it reflects not some fundamental change in the companies themselves, or in the prism we should use to understand them, but rather a change in the world economy. That change is incredibly significant, and its effects will be with us for years to come. But unless you think the world economy is permanently, mortally wounded, and the very idea of free-market economics is down for the count, then it’s a mistake to believe that Coke and Gillette and Disney are riskier long-term investments today than they were six months ago.

The thing about these companies is that they are truly global. They can’t rely on the U.S. to prop up their profits if the rest of the world implodes. The risk of that kind of implosion should obviously have been factored into the stock prices of these companies. But so too should the enormous upside potential that exists once Asia and Latin America turn themselves back around. It’s possible, of course, that it’ll be decades before they do, though I doubt it. But if that’s the case, we’ll probably have other things to worry about than the value of our Coke stock.

If too much has been made of the implications of the current economic slowdown for the noncyclicals, though, there is an important lesson in there for the would-be heirs to Coke and McDonald’s. A company like Starbucks, for instance, is modeling itself on these consumer giants, boasting of the strength of its brand, and its stock, even now, has a price-to-earnings ratio of better than 49 as a result. But the similarity between Starbucks and these companies is only skin-deep, or rather brand-deep.

Coke, McDonald’s, Gillette – these companies have always had a remarkably high return on equity and on invested capital. Their global distribution networks are unparalleled. Their products are either technologically superior (in the case of Gillette) or offer a clear taste difference (in the case of Coke and McDonald’s). Their brands are immensely powerful. Starbucks, by contrast, is a relatively inefficient user of capital, makes a product that is largely indistinguishable from its competitors’ and that is unusually subject to the vagaries of the commodities markets, and runs stores in which the service is so slow you could slip into a coma while on line. This doesn’t mean Starbucks is going to stop being profitable. But what’s happened this year shows that not even the strongest brands are invulnerable, and we should look closely at that before anointing Starbucks the next Coke. If skepticism is to reign, it should reign over all the pretenders and not those who still sit on the throne.


One Untrue Thing