FOOL ON THE HILL
An Investment Opinion
What's Down with Food Stocks? Warren Gump (TMF Gump)
August 17, 1999
Most investors have enjoyed the stock market over the past three years, as the Standard & Poor's 500 index has surged over 20% each year. While that headline return number is quite important to investors who have their money invested in index funds, it does not necessarily give an accurate indication of what is happening to all of the industries in the market. During this time period, some market segments like technology and telephony have significantly outperformed S&P 500. On the other side of the spectrum, plenty have also underperformed the market.
One area that has been notably weak is food companies, the makers of cereal, cookies, crackers, meats, soups, and chocolate that keep our cupboards and stomachs full. Yup, I'm talking about the General Mills (NYSE: GIS), Keebler Foods (NYSE: KBL), Nabisco Holdings (NYSE: NA), Sara Lee (NYSE: SLE), Campbell Soup (NYSE: CPB), Bestfoods (NYSE: BFO), and Hershey Foods NYSE: HSY) of the world.
Before trying to figure out what's going on in this industry, I should warn you that I probably have a positive subconscious bias towards most of these companies. Having come of investing age during the 1980s, these were the stocks to own. Investors were enamored with the companies' steady double-digit earnings gains resulting from price increases and new product introductions. At the time, investors anticipated that these gains would continue uninterrupted as far as the eyes could see. Based on recent results and current market perceptions, that vision may not have been superb. (Do you think one of those eye lasers would help?)
Of the companies mentioned, only General Mills and Keebler are projected to have double-digit earnings per share growth this year. Keebler's net is projected to be up 25%, but that is all based on a surge during the first half of the year. For the last six months of the year, the company is expected to only increase earnings per share (EPS) by 6%. Estimates for Bestfoods and Nabisco are expected to approach the double-digit threshold, with an estimated 9% rise. Hershey seems to be treading water, as earnings projections call for a 1% increase this year after a meager 4% improvement in 1998. Earnings for Campbell Soup are actually expected to fall 9% this year.
One of the biggest challenges facing these companies is pricing pressure. In the 1980s, when inflation was higher, these companies would annually increase their prices several percent a year. Some of this increase would cover higher costs, but a portion flowed straight down to the bottom line. Inflation has slowed down to just a trickle over the past few years. This has made it more difficult to raise prices, which in turn has hampered profit growth.
Grocery store consolidation has also taken its toll on the food manufacturers. As existing chains become larger, they are able to exert more influence over their suppliers and request more substantial volume discounts. In addition to forcing lower overall pricing, the smaller number of distribution points makes it tougher to introduce new products. Key distribution venues like Wal*Mart (NYSE: WMT) or Kroger (NYSE: KR), which now includes the Fred Meyer chain, hold more sway over whether a product will reach consumers and be successfully launched.
Food manufacturers also have faced tough competition from different sources. In the store, many retailers have begun offering a wide variety of private label, or store brand, products. To reach today's more discriminating consumer, many of these products are actually positioned as being high quality rather than bargain-priced. While a yellow-wrappered can with the words "Chicken Soup" might not sell well, a glass jar of a store-brand "Select" chicken soup with all white meat sells better. Stores push these products because they tend to have much higher margins than branded goods, while consumers appreciate the modest savings over branded competitors.
Another factor having an impact on food companies is the slowdown in food prepared at home. The increasingly harried lifestyle of Americans, proliferation of casual dining restaurants, and better availability of "heat and eat" meals from restaurants and grocery stores have combined to reduce the amount of food cooked at home. For many Americans, bagels have replaced cereal, a burger or sandwich shop whips together lunch, and a Boston Chicken-like eatery makes dinner. The need for a kitchen and supplies to fill it seem to have diminished noticeably over the past decade.
Despite all of the challenges facing the food companies, there is some optimism that they will pull through and continue growing their earnings and cash flow streams. History is probably one of the most persuasive reasons to believe that these companies will adapt and prosper. Through decades of changes, these companies have been able to experience their historical prosperity. While firms that don't move with the times risk being remembered through bric-a-brac on the walls of restaurants, those companies that embrace the opportunities provided by societal shifts should survive and possibly thrive.
While the earnings picture for these companies may not currently seem too bright, remember that some of the greatest stock market gains are earned by people who correctly see a future that is different from what the market expects. The price/earnings multiples on the food stocks I've mentioned in this article range from 16x-29x current year estimates compared to a 27x multiple for the S&P 500 at large. Assuming that their earnings growth reverts to more historical double-digit levels, their potential for price appreciation could exceed many other stocks in the index.
Investors who haphazardly rush into a downtrodden industry or stock just because it's cheap are rarely rewarded with outsized gains. The more successful turnaround investors expend the effort to get to know their companies well enough to understand why they could have a more prosperous future than generally expected. Some reasons for such a rebound are new product launches, shifting industry trends, or structural changes that increase a company's competitiveness.
Another thing to consider is a company's business model and financial position. Those firms with strong balance sheets or excellent business models should be much less susceptible to a negative industry environment than competitors. Yet, for some reason, the market often lumps all of the companies in the same industry together. If you have the time to research some of the food industry's outcast players, you might find some hidden gems that will lead to some huge investment gains over the next few years.