Monday, November 9, 2015

McCormick Spice - Almost Perfect

 What makes a perfect investment? First off, the business should be in an excellent sector, and ideally it should control a niche in that sector.

For sectors, I like how Don Yacktman looks for low cyclicality and low capex.

Getting more specific, let's check historical data - Consumer staples beats pretty much all sectors hands down. Which proves out Yacktman's most favored quadrant

Next drilling down from the sector and niche should have the ability to deliver excess returns over a very long period of time to let compounding do its work. Consumer staples is filled with lots of interesting companies and niches. But how many will continue to generate excellent returns decade over decade? The companies that sell products from older generations like Wal-Mart Coke, General Mills, and Pepsi are finding some headwinds with new generations of consumers. The consumer companies that are more on point with current norms like Whole Foods or Monster are pretty expensive. Of course, the old school brands will probably muddle through but its not always clear the profitability will be as robust as today, for example profit margins on Coke where Coke controls the brand versus profit margins on water where the barrier to entry is way lower.

But there are some areas where growth appears sustainable, for example spice. McCormick Spice is over 125 years old, and as the largest manufacturer, it dominates the spice niche. McCormick estimates the global spice market at $10B, McCormick has a 22% share of the market and is 4 times larger than the nearest competitor. If you add in the fact that McCormick produces many store brands, the combined set of brands is pretty much the whole spice aisle.
Better still, you see McCormick's brands everywhere, you see them in Walmart, regular grocery stores, and unlike most Coke/Pepsi/General Mills products you see their brands on the shelves of Whole Foods with brands like Thai Kitchen and organic lines. McCormick has pyramid of profit that lets it sell from low end to high end, not many companies can pull that off. McCormick has a B2B unit as well and customizes spices for larger companies like Frito-Lay.

How about durability of consumer demand? Well, the first IPO was a spice trading company. Don't let the IPO scare you off, gentle investor, the IPO was the Dutch East India company on September 9, 1606. The history of spice goes back to the origins of the stock market.

So McCormick operates in a sector with demand measured in centuries, dominates its niche in the favorable consumer staples sector.  Further, its got a safe balance sheet with a Debt/Equity ratio at 0.5. So why almost perfect not perfect? Well, by now you guessed it - price.

McCormick is a premium company and its priced accordingly (source- Morningstar). Its excellence is not subjective, but valuation is. its current P/E of 30 is too high for a low growth company, but at the same time even in 2008-09 McCormick still traded in the 16-17 range for P/E. There is downside protection in pepper, basil, and  mayo.

What if we use sustainable growth rate as a measure to approximate future returns? The Sustainable growth rate for McCormick can be estimated using its current 56.1% Dividend Payout ratio, and a 5 year average ROE of 24.1% which yields a Sustainable Growth rate of 10.6%. That projection dovetails pretty nice with McCormick's actual 10 year average dividend growth rate which is 10%. Assuming, McCormick can continue to deliver that dividend growth even with an expensive entry point it can work out fine for investors over long time frames. If you invested in McCormick in Nov 1, 1995 and held through to now, you earned 12.4% annualized return, and $1,000 turned into over $10,000. Run it yourself on LongRunData.

So that 1995 McCormick investor earned a tenbagger over 20 years. I would submit that investor did not take much risk at the time, no dotcom, no tech, just time. But here is an interesting side note, what do you suppose the 1995 investor paid? As we have discussed, McCormick is a stock that is never really cheap, and in 1995 the P/E was 33 which is 10% higher than today (source YCharts).

So while its difficult for a cheapskate like myself to work up much enthusiasm over a current P/E of 30, and a low current yield at 1.9%, the reality is that in the past McCormick has been able to deliver stellar long run returns even with high multiple. If long run consumer trends on spice and flavor seem durable, and if the Sustainable Growth Rate is close to what the company can deliver, then a low double digit return seems reasonably likely if you take the long view.

Personally, I would still hold out for a discount from today's price, but what is interesting to me in this analysis is that my gut reaction to a 30 P/E is to say well I guess I need to wait for a big 40% pullback or something. The history shows that instead a pretty small reduction could still potentially offer long run excellent returns. Note, this is not buy, sell or any other kind of guidance just a thought experiment on valuation and the impact of quality over the long run.

"Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result." – Charlie Munger


  1. Very interesting. McCormick's had not even been on my radar before. Thanks for highlighting it.

    Interesting to see just what an excellent company it is. Looking at their dividend history, they are easily a dividend aristocrat and looking at their reports saw pretty significant growth throughout the recession. Stunning.

    What I would say is that I think Morningstar has its data wrong. My calculations show that last years PE is around 24.7 and with consensus earnings this drops to 24.8 and 21.6 the next two years.

    I'd check the numbers separately as it may be that they are not badly priced for you at all! Certainly, they have jumped to the top of my watch list!

  2. @Dividend Drive - thank you. Morningstar has a 30 P/E TTM and a forward P/E of 22.

    I like P/CF better and here they have a 20 P/CF versus a 5 year average 19.2 P/CF.

    In any case, similar to a Unilever, this is not a company that ever gets really cheap at least as far back as I can see. Unlike Unilever (which is a great company in its own right), McCormick is smaller and more focused.

    I will be interested to hear what you think once you drill down

    1. My pleasure, Gunnar.

      It looks like the P/CF is a better reflection on the current relative price as it is certainly running a little ahead of its historical average.

      I must admit, I am sorely tempted to open a small "marker" position at the current price and wait until the price drops before opening a larger one. It is certainly not outrageously priced.

      As far as I can gather they have grown earnings every year since 1999. That seems almost too good to be true. I can't actually think of another company which can boast the same history.

      You're right, like Unilever, this does not seem to ever be "cheap". Although, Unilever has had a few dips of late thanks to the emerging market turmoil which has been good for some top-ups.

      I have run my little "fair value" sums through MKC and have got a price of $78.77 as a target. (I get this by taking the 5 year average PE and multiplying this by the average consensus EPS predictions for the next two years). That seems fair to me. Obviously running quite ahead of that at the moment. We will see if it drops down or not!

  3. @Dividend Drive - Speaking of Unilever, McCormick has some room to grow in emerging markets. Today they only derive 22% of their sales in emerging markets. Personally, I generally agree with your fair value, something in the mid 70s feels pretty fair to me.

    That's still an expensive price obviously, but based on my read as to the durability of people's neverending quest for spice, it seems more durable than just about any other consumer brand. So in my mind its really a quality/durability argument, and I am sure Marty McFly wished he bought in in 1985

  4. I've been following the company for most of this year but can't ever seem to get a chance to add shares. The value investor in me wants a better price because I feel that inevitably the P/E ratio is going to drop. M* has the 5 year average P/E ratio at 21, although the forward P/E is actually right at that level. I really want to buy shares cheaper but like you I have a feeling I'll probably just add some shares over the coming months knowing that I'm paying up for the quality just so I can get a starter position going.

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