#Investments — 03.05.2018

The Food Value Chain

Guillaume Duchesne

The Food Industry Versus Food Retailers: Which Industry Should Be Favoured?

The food industry, the market’s star performer during the financial crisis, is suffering from much investor disinterest. After two difficult years in the markets in 2016 and 2017, it continues to underperform both in the US (-13%) and in Europe (-7%). Often viewed as a bond proxy, this industry is the victim of a rotation into sectors that perform better during an economic recovery. Indeed, the relative attractiveness of the food industry is largely reliant on macroeconomic factors. Its defensive characteristics—good visibility on earnings and high dividends—have so far been an asset in an environment of modest economic growth and low interest rates. So in stock markets, the current economic cycle is not very favourable. The future performance of food industry stocks will partly depend on how long the bull cycle lasts. Any sign of a reversal may whet investor appetite once again.

However, apart from the cycle duration question, the industry is also suffering from stretched valuations. Despite its poor market performance, the food sector is still trading at 18 times earnings in Europe (compared with an average of 16.9x over the last ten years). In addition, earnings prospects may not be very positive in light of recent results. In the first quarter of 2018, sector sales were modest (about 3%) and profit margins came under pressure (in particular due to rising commodity prices). The capacity of large companies in the sector to lift sales prices also appears limited: price growth at many companies was practically non-existent in 1Q18, partly due to the pressure, downstream, from food retailers. In this environment, some stocks in the food industry might suffer from an additional “de-rating”. Therefore, we recommend keeping a cautious stance at this stage, particularly in the context of rising interest rates, which is central to our economic scenario.

We are slightly less pessimistic (neutral stance on food retailers). The sector, which has gained 5% in Europe year-to-date, is undergoing major structural change: digitalisation, new consumption trends and growing competition. These transformations have been extremely disruptive in recent years and have fuelled deflationary pressure on the sector for a very long time. However, the markets seem to have priced in this challenging context while the economic situation is improving (rising inflation) and the industry's historic players are in reorganisation mode (restructuring, mergers and acquisitions).

Therefore, the food sector is undergoing massive transformations across its whole value chain, including the traditionally more solid segments, such as the food industry. As a result, typical sector rotations, seen in previous cycles, might be affected. Remember that past performance does not guarantee future results, and this is especially relevant today!