Last time I wrote one of these “Lessons On Investing” posts, the chosen stock was a HUGE success. It was one of those successes that everyone dreams about investing in. The kind that make you rich. I still criticize myself for not investing in the company 20 years ago. That company was Apple, Inc.
Investing successes are great of course, but we can also learn from investing failures. Some people even say you learn more from failures than you do from successes.
I do know this for certain — Investments that fail to produce an adequate monetary return can still have significant value if you learn from your mistakes. Failing to learn and then apply those learnings is the most expensive outcome possible… because you’re bound to repeat the same mistake again.
Learning from other’s mistakes is a better way to go — So this time around we’re going to look at a recent stock disaster someone else made (and it’s a doozy). Even though I researched it last year, I personally chose NOT to invest in this stock.
The company is Kraft Heinz (Stock symbol: KHC).
The Kraft Heinz Disaster
Even though I chose not to invest in Kraft-Heinz a year ago, some of the world’s greatest investors did. Warren Buffet owns about 26.7% of the shares outstanding, and 3G Capital owns about 23.9%. (If you’re not familiar with 3G Capital, there’s a great book written about them).
These two super-investors effectively control Kraft-Heinz by owning slightly more than 50% of voting shares outstanding.
The control of Kraft happened through a merger of Heinz (which Buffet and 3G Capital 100% owned) and Kraft Food Group. All this happened back in 2015. Kraft shareholders got 1 share in the merged company for every share of Kraft Foods they owned AND a $16.50/share special dividend. Buffet and 3G got control of the merged company.
Fast forward four years later, and it’s been a disaster — Last week KHC reported a loss of $10.34 per share (mostly because of a $15.4B goodwill write-down), and slashed its dividend by 36%. They also announced a SEC investigation into their accounting.
One week later and shares have fallen 32%. Since KHC shares first started trading back in 2015, the stock has fallen 63%.
Ouch! What the heck happened?
Lesson 1: Brands Under Attack
To begin, let’s rewind things a few decades — people used to pay a premium for Kraft cheese, and Heinz ketchup. They were the food brands people grew up with and trusted. A big brand like Heinz meant good quality and good flavor.
Investors used to do pretty well investing in these kinds of packaged food companies too — profit margins were healthy enough to fuel global growth, share buybacks, and large dividends.
These days, the big packaged food brands don’t hold nearly the brand power they used to. Today, many private-label brands like Costsco’s Kirkland brand, or Kroger’s Private Selection, have supplanted those trusted brands. Customers know those private label store brands are just as good and cheaper. You really can’t tell the difference in flavor.
Opening up my own refrigerator I can see just how true this is — Only one Kraft Heinz product, but about half a dozen generic brand packaged goods that taste just as good as the more expensive Kraft versions.
Today, people expect quality and good flavor from a store brand (and aren’t willing pay a premium for it). Organic products, non-gmo products, paleo, no sugar, fair trade, gluten-free, vegan, and other “unique value propositions” are what people are willing to pay a premium for these days.
If you don’t care about those “unique value propositions”, then you probably just buy cheaper store-brands.
Just take a look at KHC’s stable of brands:
I wouldn’t willingly feed most of that “food” to my kids. I think this says something really important about Kraft-Heinz’s competitive position today.
Kraft-Heinz brands are no longer products people are willing pay a premium for. Those brands represent the outdated chemical laden products of our parents (or grandparents) — NOT the healthy foodstuffs we can trust to feed our family with.
All this competition has been eating into Kraft-Heinz’s margins for years — even before Buffett and 3G got involved. Buffett probably knew all of this when he invested in Kraft… but he did it anyway.
My guess is, 3G Capital had a reputation for cutting costs and maintaining the strength of tired brands. Buffett probably trusted his partner. When I looked at KHC last year, I pointed out that I thought the company was “still broken”. 3G hadn’t turned it around yet.
That still seems to be the case today. 3G may have cut costs, but overall profitability of the company has declined due to a loss in overall pricing power.
The big lesson here for investors is that being a well-known brand is no longer the durable competitive advantage that it used to be. Companies like Costco or Kroger can quickly create their own private brand and develop consumer trust in a relatively small amount of time.
The internet has also made it a lot easier for smaller brands to enter into people’s homes. I can quickly search Amazon for “ketchup” and find dozens of little-known brands that aren’t carried at my local stores.
The dominance of the big consumer brands is definitely under attack, and the competition won’t be going away anytime soon.
Lesson 2: Overpaying For Quality
In a recent interview on CNBC, Buffett admitted he’d overpaid for Kraft. Historically speaking, Kraft-Heinz used to be able to generate about 6 billion in pre-tax operating profit. Those days appear to be long behind it.
Back when Buffett and 3G invested in 2015, Kraft-Heinz had an enterprise value of about 104 billion and it generated around $6 billion in pretax operating profit. I call this an “optimistic” price to pay for a company with little-to-no growth.
To put this in-terms of a PE ratio, that’s like paying a PE of 30 for Kraft (EPS in 2016 was 2.81 and share price was around 88) That’s pretty expensive by most standards.
To be fair, Buffett has long extolled the virtues of paying-up for quality companies. This strategy of paying-up for quality has mostly worked-out well for Buffett — Buying quality companies (like See’s Candies) really paid-off for him, generating billions over the years.
In general, it works because higher quality companies earn better returns on capital. (This concept is well covered in Joel Greenblatt’s book) Kraft use to score pretty well on that front too.
Kraft looked like a decent company if you go back pre-2015. It earned decent returns on invested capital, but 3G probably though they could improve upon this by cutting corporate waste.
Today, the enterprise value of KHC sits a lot closer to $70 billion and the company is likely to make somewhere around $5 billion in pre-tax operating profit. Returns on invested capital appear to be in the single digits.
If we back-out all the non-cash goodwill write-downs from Q4 2018, Kraft earned EPS of 0.84/share. At today’s price of $32.40/share I still feel that’s a premium to pay for a set of brands under attack. It’s NOT the kind of company I’d want to pay a premium for. The margin of safety just isn’t there.
The big lesson for investors here is NOT to overpay for quality. You could very well be miss-assessing the quality of that investment.
In the past, I’ve written how every investor should invest considering multiple potential outcomes. This rings very true in the Kraft-Heinz case.
Buffett and 3G might have fallen in love with the ‘bull’ case, but the ‘bear’ case is what actually manifested into reality.
Investing is never a sure thing… even for the world’s greatest investors. Some investors like to follow big investors into stock investments like this… and occasionally it even works out.
In this case, you could have followed Buffett into Kraft-Heinz and done terrible. Despite their incredible record, the future is anything but certain.
Kraft-Heinz was also a large dividend payer — Being a high return on capital business, KHC needed very little in additional funds to maintain the business. It paid out much of that cash to shareholders. At it’s height, KHC paid out $2.52/share annually. Yet those dividends did very little to compensate investors last week after all the bad news was announced. It’ll take more than a decade of dividends to make up for last week’s fall.
Dividends and high returns on capital are not a cure-all if the business itself is ‘sick’.
This is why I frequently repeat the mantra “don’t chase high-dividend yields”. Yield is not an indicator of quality or longevity. Even long-time dividend aristocrats can run into trouble when the world changes.
Investors who bought into Kraft-Heinz should learn theses lesson well. The rest of us should pay attention too. Even with the combined might of Warren Buffet and 3G Capital, Kraft Heinz took quite a beating when the world changed.
Big brands selling packaged food no longer have the same mojo that they once did.
Indeed, it was Buffett himself that once said, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And, if you have to hold a prayer session before raising prices by 10%, then you’ve got a terrible business.”
It’s a pity he didn’t follow his own advice.
[Image Credit: Flickr]