Investor Compass September 2022

INVESTOR COMPASS
September, 2022
Concentrated value investing

Eldred Rock Investor Compass September 2022
THE OTHER SIDE OF VALUE
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
Warren E. Buffett
M
any clients know that the partners at Eldred Rock are fiscally conservative. As a matter of fact, we
never want to overpay for anything, especially not for our clients. However, some clients may have
noticed that certain companies in their portfolios are more expensive than the average stocks as
measured by common value proxies, such as the price-to-earnings (PE) ratio. The short explanation is that
they are great businesses with exceptional qualities.
Many of us have gone through the painful process of buying a used car before, and we cannot tell if it is a
good deal to pay $10,000 for a used car without knowing the brand, reliability, and engine power etc.;
often paying a low-price means buying a lemon. Similarly, a low valuation does not tell investors the
context of an investment, namely the business model, industry competition, management’s capital
allocation ability etc. At Eldred Rock, we always look at stock price in the context of business quality, and
we believe that one of the most important factors by which to measure quality is Return on Invested
Capital (ROIC), namely the profit a company can earn on the money that has been invested in the
business.
“The higher the return on capital, generally speaking, the better the business.,” says Warren Buffett. Let’s
compare two handbag makers, each of which invests $100 in capital to buy the required materials and
tools. The first, sells lower quality bags sourced from factories in China and earns $10 per year (i.e., a 10%
ROIC). The second handbag maker sells expensive bags handmade by experienced craftsmen in Europe
and earns $20 (i.e., a 20% ROIC). Which business would we rather own? The more profitable second
business seems logical, but only if that profitability has staying power and we don’t overpay for the higher
quality. Our clients might recognize LVMH from their portfolios, the parent company of Louis Vuitton, as the
second handbag maker. The first handbag maker is Coach, owned by the parent company Tapestry.
1
Louis Vuitton commands enormous pricing power over consumers because of its strong brand which drives
its high returns on capital. To illustrate its pricing power, Exhibit 1 shows that Louis Vuitton has been able to
increase the price of its Speedy 301 handbag by over five percent per year since the 1970s, and today the
small handbag is selling for over fifteen hundred dollars, 10 times of the price in 1979. Meanwhile, the prices
of similar handbags by Coach have remained below $300 today.
Exhibit 1: Louis Vuitton Speedy 30 price history ($)

1,550
1,600
1,400
1,160
1,200 1,100
950 1,000
1,000
800
595
600 495
430
325 350
400
150 195
200
0
1979 1986 1994 1995 2002 2004 2006 2017 2018 2020 2021 2022
Source: Luxe Front, Eldred Rock
A part of Louis Vuitton’s brand strategy is to always sell fewer bags than consumers demand, the
successfully managed scarcity effectively creates both pricing power and enduring demand and allows
the business to perform well in all economic environments. The robust business model is reflected in the high
ROIC of the parent company LVMH even during the pandemic. Over the last five years, LVMH has been
able to deliver a positive ROIC and a much higher ROIC than Coach’s parent company, Tapestry (Exhibit
2) and therefore earn the label of a higher quality business.
Exhibit 2: Return on invested capital (%)
LVMH Tapestry (Coach)

16%
14%
15% 13% 13%
10%
7% 6%
5%
1% 2%
0%
-1%
-5% -4%
2018 2019 2020 2021 2022
Source: Bloomberg, Eldred Rock
1 The Speedy bag is Louis Vuitton’s iconic compact handbag first introduced in 1930; It was originally a 30cm in size.
2
But does business quality matter? And are above average valuations warranted for high quality businesses
with above average returns (ROIC). It seems that it does: according to research2, more than 50% of the
valuation of the S&P 500 stocks can be explained by ROIC. To illustrate using our example companies,
since 2018, LVMH’s PE ratio mostly stayed above 25 times while that of Tapestry stayed mostly below 20
times (Exhibit 3). Moreover, despite the consistent valuation premium, LVMH shares delivered a positive
138% return (in U.S. dollar terms) to its shareholders while Tapestry shares lost 13% in the same period.
Exhibit 3: Valuation (PE)
45x
40x
35x
30x LVMH
25x Tapestry
20x (Coach)
15x
10x
Source: Bloomberg, Eldred Rock, as of August 2022.
As you can see, paying a low price is not everything. Instead of only buying cheap stocks regardless of
business quality, the partners at Eldred Rock prefer to buy high quality companies on sale. Every day, we
patiently monitor a list of great businesses that we understand well, and we will invest aggressively for our
clients at the rare moments when these companies are priced well below their intrinsic values.
2 Michael J. Mauboussin and Dan Callahan, “Calculating Return on Invested Capital: How to Determine ROIC and
Address Common Issues,” Credit Suisse Global Financial Strategies, June 4, 2014. Also, based on our research, ROIC
even has more explanation power for the non-financials.

Investor Compass September 2022

Uploaded by

Copyright:

Available Formats

Investor Compass September 2022

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Investor Compass September 2022

Uploaded by

Copyright:

Available Formats

INVESTOR COMPASS

Concentrated value investing

THE OTHER SIDE OF VALUE

Exhibit 1: Louis Vuitton Speedy 30 price history ($)

Source: Luxe Front, Eldred Rock

Exhibit 2: Return on invested capital (%)

LVMH Tapestry (Coach)

Source: Bloomberg, Eldred Rock

Exhibit 3: Valuation (PE)

Source: Bloomberg, Eldred Rock, as of August 2022.

You might also like