When the love disappears

A week or so ago, Tracey and I circumnavigated the entire M25 for the first time. I had never seen the Dartford Crossing before; I was in awe. I was living a sort of low-rent Michael Palin travelogue.

We stopped off at Brentwood High Street for something to eat…yes, I know now that was an interesting call. Anyway, we ended up in Pizza Express. If it’s good enough for royalty...but my goodness the premises were shabby! And the service was sloppy – literally, as my coffee slid down the side of the cup. Sadly, the food was average when compared to the Pizza Express I remember from 20 years ago.

But at least it’s cheap, right? Oh no, and apart from free dough balls (hmmm), no specials or discounts. Only four tables being used on a Saturday lunchtime. Why? Perhaps there aren’t too many households in suburban London who can pay £16 to £18 for a pizza. It’s clear to me that this business no longer provides value for money and the owners and staff know it. You could feel the desperation and you could see a business limping to a finish, kinda Debenhams like. If your partner suggests Pizza Express for Valentine’s night, time to Google search ‘singles holidays’.

As we know, staff and energy costs for these businesses have risen dramatically and I sniff falling profit margins and decay.

Costs spiral

Is this just a Pizza Express issue? Unfortunately, I don’t think so. It’s indicative of businesses based around low-cost capital, low wages and high volume. It only works when the customer sees value, sometimes at the expense of others, and the owners can keep prices as low as possible.

Inflation, much higher interest rates on a mountain of debt, and higher staff costs are the kiss of death for these types of businesses. Inflation increases both fixed and variable input costs (ex-labour), higher competition for workers sends wages higher but also increases turnover and therefore training costs balloon. Meanwhile, as interest rates rise, more and more cash has to go to servicing debt, delaying refurbishments and other investments that could help turn things around.

For months now, Ryanair boss Michael O’Leary has warned that plane ticket prices will have to rise in 2023. Looking at airlines’ indirect revenues (the cost of a fried sandwich or a miniature bottle of prosecco on the way to Malaga) they have increased significantly – price rises via the back door. For once O’Leary is probably speaking the truth rather than creating brand awareness. Flybe is the latest airline to fail (again). And if it wasn’t for subsidies, how many trains would still be running?

The cost-of-living crisis and its impact on consumer-facing companies’ revenues (as their customers have less to spend) has been the anthem of the past 18 months. I do think this is important and we have talked about trading down before. However, I think there is a much bigger phenomenon playing out: value for money.

When times are good we don’t mind paying up, but does £45 to go to the cinema and then paying extortionate prices for nibbles look good when you can watch a movie for free at home on your 55-inch screen? What about popping down the pub each week for a family bar meal, when you can cook something better at home for a fraction of the price? What about flying to Vegas for your mate’s stag/hen night for £1,500 when there are plenty of fun hotspots in Newcastle or New Quay when you can get a Megabus for £10 (obviously the trains would never be value for money).

Avoiding the creamy middles

So, what does this mean for the consumer stock in our multi-asset portfolios? It’s all about the top and the bottom. We like luxury/premium goods businesses, best epitomised by fancy brand conglomerate LVMH. In our latest The Sharpe End podcast, Love Satchually, we discuss some of the staggering prices its goods sell for and how it seems only to further fuel people’s desire.

Other quality consumer brands include premium shoemaker Nike and high-end smartphone and gadget developer Apple. But we also hold retailers that focus on bang for your buck, such as bulk-seller Costco and UK business Next, which found itself one of the few still standing on the high street and has been buying up failed competitors. There’s also US cosmetics, fragrances and skincare retail chain Ulta Beauty, which has continued to draw the punters both online and in store.

In essence, we’re avoiding the stretched middle market, like pubs and restaurants, and we’re wary of discounters in sectors like airlines, travel agencies and fashion. As always, pricing power and nimble execution are key.

Value for money is also important in business-to-business models. We’re very nervous of backing volume suppliers of commoditised equipment into manufacturing businesses, in any sector from autos to smartphones. To keep customers happy, some suppliers are putting off price rises to maintain long-term relationships, willing to accept margin cuts in the short term. This is a classic unbalanced power relationship. As unfair as is it may seem, you want to invest on the powerful side, not the weaker part of the business partnership. Will these suppliers ever recover their margins? Maybe, but I wouldn’t hold my breath.

It’s worth remembering that the key determinants of value are scarcity and quality, and only then price (ultra-cheap unknown quantities tend to raise alarm bells). On this rule of thumb we would rather own computer graphics processor developer Nvidia, the world’s largest computer chip manufacturer TSMC and ASML, which designs the high-tech printers that make computer chips. Meanwhile, we don’t want to hold their cheaper competitors. Low price has never meant value. This mantra should be repeated daily by all investment professionals before bedtime.

Alas, it’s no more Pizza Express for me. It ticks neither the quality nor scarcity boxes anymore. My local pub (the excellent Red Lion) does better gluten-free pizzas. They’re cheaper and they are all named after RAF planes (my favourite is the ‘Tornado’, a chicken tikka with mint yoghurt). Now that’s value.

So, if you want to emulate a duke on Valentine’s Day, you should probably do it this year as you might not have a chance in 2024!

Tune in to The Sharpe End — a multi-asset investing podcast from Rathbones. You can listen here or wherever you get your podcasts. New episodes monthly.