What a week! The richest genius, in his own orange-tinted head, was arrested and fingerprinted in a dingy 15th floor Manhattan courthouse. On the streets outside, his tiny MAGA support cult railed against leftist conspiracies, socialism and woke liberalism. Oh, the irony of it all. Their cult leader isn’t very rich, even in a New York context, but the most delicious bit is the revelation this week of who is the richest of them all. Straight from a Disney mirror Queens scene, American ‘freedom’ vanity has had to confront the stunning reality that the home to both the richest man and woman in the world is that over-taxed liberal socialist hellhole……France.
Yep, Bernard Arnault the owner of LVMH and its 75 luxury brands is now worth over $200 billion, and the richest woman, Francoise Bettencourt-Meyers, as heiress to another luxury brand, L’Oreal, is sitting on an $81 billion fortune. You’d almost believe France and luxury are the real places to be. The country view is up for debate and cultural subjectivity but this writer believes the superiority of luxury as a wealth builder is on far stronger ground. I’ve been giving some thought to the wealth creation characteristics of the luxury goods sector and can’t help feeling we’ve missed out on one of the great currencies of the last 30 years.
In the early ‘90s, as the Communist ‘Iron Curtain’ collapsed and opened up to global consumer markets, I used to watch with fascination Japanese housewives strolling around the glitzy streets of Ginza in Tokyo with their Harrods shopping bags. The concept of Tokyo ‘luxury’ in those days ranged from hundred dollar watermelons to million-dollar golf memberships but they didn’t survive the multi-decade decline of the Nikkei and real asset values. Interestingly, the Japanese currency, the Yen, did hold its value surprisingly well against all foreign currencies. However, as aging Japanese households moved into ‘savings’ mode, there was one other currency which retained its value – the Harrods bag. Well, not exactly. However, the luxury items bought on the streets of Ginza and carried with London-badged pride back to tiny homes reflected two key features of a currency. First, these luxury items were a store of value and also had exchange value as our previous article on Pachinko parlours demonstrated. And, secondly, there was an aspiration and a confidence/credibility embedded in these goods. Or should we say “tokens”?
The crypto bros might disagree but currencies from Bitcoin to Dogecoin to digital assets like NFTs are dependent on their store of value, confidence and exchange value in secondary markets. It could also be argued that there is a youthful aspiration to decentralize finance away from central banks and the implosion-prone banks they are supposed to regulate. Furthermore, it is striking to me that the most developed initiatives in the world of NFTs and digital assets tend to reside within fashion and luxury houses like Nike and Gucci. We can speculate as to how digital and physical luxury goods evolve and interact over the coming years but the structural foundations of luxury businesses are instructive. Here are a few of the standout features….
Brand: Luxury brands take decades to build and are protected fiercely. The confidence built on quality control, finite supply, image and limited access is critical to the premium pricing achieved by brand power.
Growth: Our anecdote plucked from Asia in the early ‘90s is not accidental. The opening up of former communist consumer markets of the last three decades has added billions of potential new customers. A standout statistic for me is that two thirds of the world’s middle class will be in Asia by 2030.
Asset-Lite: Given, the vast majority of the value of a company like LVMH, Rolex or Hermes is tied up in non-tangible assets like goodwill, brand etc the real asset bases of these companies are small. This can be helpful as brands in a portfolio like LVMH’s can drift in and out of fashion. In an asset-heavy business this cyclical shift can cause permanent exits from the market and the sunk costs of abandoned property, equipment, staff redundancies. Luxury brands can stay in the game for decades; think Balenciaga and YSL comebacks.
Returns: In the wonky world of finance we would know that returns(on capital) are a far better driver of share prices than earnings or profits. I won’t apologise for my evangelism of returns measures as the best way to manage a business and create wealth – it’s in my quantsy DNA and Quest for alpha. The metric to use is the ROIC(return on invested capital), not earnings growth, not sales growth or balance sheet growth(debt usually). Luxury goods businesses, thanks to small asset bases, deliver fantastic ROIC way above market averages in the FTSE, Nadsdaq or S&P 500 equity indices. As illustration, LVMH delivers ROIC levels around 15% year in, year out compared to the S&P average in 2022 of 10%.
Cost of Money: That 15% return on capital becomes very important in a rising interest rate environment like now. That extra buffer of returns for luxury goods companies means they are beating their cost of capital every year, not just the low interest rate years. That cost of capital “beat” translates into the miracle of compounding and wealth creation. For those wondering why some valuations fall further than others in times of turmoil, remember If you don’t beat your cost of capital you are actually destroying wealth. As a further aside, in an inflationary world there will be some savers who will escape the loss of purchasing power of their domestic currency and buy luxury goods to store their wealth. Just ask Turkey’s citizens suffering kamikaze Erdogan economics – just seven years ago 55,000 Turkish Lira would buy you a car, today you’d get a phone if you’re lucky.
That last point on valuation is worth considering in funding land these days. LVMH’s annual revenues are over $80 billion and that supports a franchise valuation 4.5x higher at $440 billion. In 2019 LVMH revenues were $53 billion which approximates tech-like 50% growth BUT with returns on capital (ROIC) maintained each year at 15% on that journey. That returns piece is important and should be instructive to SaaS and tech cheerleaders wondering why valuations at 4.5x revenues are no longer on the table with investors.
Returns are not a luxury. They are ultimately a business’s currency and an owner’s wealth compounder. Ask Bernard, not The Accused.