Campbell Harvey is perhaps best known for his work on the yield-curve inversion being a recession indicator. This happens when interest rates of long-term bonds fall below that of short-term ones. As the authority on predicting economic downturns, Harvey now proclaims that a recession looks imminent even though he previously floated the possibility of staving off a recession earlier this year.
Despite the mixed view with some such as the World Bank even raising the 2023 outlook, there are signs of an ominous downturn ahead. One would expect consumers to dial back spending when faced with uncertain times but luxury brands throttle ahead ever more strongly. We attempt to unpackage their unassailable march upwards and examine if this is indeed a safe haven shelter during tumultuous times.
Luxury never goes out of fashion
Luxury options seem to know no bounds: Various modes of transport from supercars to yachts, gastronomical gourmet, fine arts, high-end goods, etc. The list seems endless. Regardless of whichever subsegment one chooses to spoil oneself in, the growth is unquestionable. Together, the various pockets of lavishness pushed the overall market upwards at a compound annual growth rate (CAGR) of approximately 8% to 10% between 2019 to 2022.
Leading the charge is personal goods, which, following a V-shaped Covid comeback, ballooned in excess of 20% over the past three years. This is mindbogglingly outrageous since the period between 2010 to 2019 only posted a far more muted CAGR of 6%. Other areas of indulgence such as experience-based goods and experiences were left in the dust still trying to catch up to their pre-Covid growth rates.
Consequently, the blistering growth of personal goods translated to immense fortunes for the companies behind these widely acclaimed brands. There are easily over four to five hundred listed constituents in the apparel, accessories and luxury goods segment. They range from some of the largest names including LVMH Moët Hennessy Louis Vuitton, or LVMH (ENXTPA: MC), to midcap companies such as Ralph Lauren Corporation (NYSE: RL). As of June 2023, the segment registered one- and two-year revenue growths of 9.7% and 15.8%, respectively. By way of comparison, the S&P500 recorded a year-on-year revenue growth rate of 4% in the first quarter of 2023.
Mere top-line growth means little unless it translates to higher profits. By focusing on exclusivity through artificially limiting the quantity of opulent pieces or duration of availability, luxury brands create a perception of scarcity that drives up demand. Basic economics thus suggest a higher pricing power which drives corporate margins up. The numbers sing a similar tune. In 2019, the five hundred odd constituents average a gross margin of 24.4% versus 24.7% as of June 2023. This 0.3% hike may seem inconsequential, but when we take a look at earnings before interest, tax, depreciation and amortisation (EBITDA) margin, the difference swells six times to 1.8%.
From another perspective, the two-year CAGR for EBITDA margin during pre-Covid times, i.e. from 2017 to 2019, was 8.0%. The two-year CAGR for EBITDA margin during post-Covid times, i.e. from 2020 to 2022, was 38.6%. Covid-19 was undoubtedly a watershed moment for humanity but surely it could not have been the sole factor that spurred this yawning difference. So what else is at play?
Revenge spending
One reason is the pent-up demand and excess savings from the pandemic. Granted, it has been some time since Covid-19 restrictions were lifted so consumers had more time to spend their higher net wealth accrued from elevated savings rates. Yet years after the reopening of most economies, households continue to hold onto significant amounts of excess savings. For instance, even though the U.S. ranks below the global average in terms of savings as a percentage of their gross domestic product, U.S. consumers still own almost US$1 trillion of excess savings in June 2023. The U.S. is a noteworthy market to highlight as they continue to occupy the largest share of the global personal luxury goods market, both before and after the pandemic.
Another market worth mentioning is China which lags the world in relaxing its restrictive policies. This means that the impact of unleashing its population’s excess savings of US$2.6 trillion (which the country ranks fourth globally in savings rate) will be more recent and pronounced. China also has other characteristics that make it a vital contributor to the luxury market. It has the third largest share in personal luxury goods. Furthermore, its burgeoning middle class conservatively estimated at 350 million individuals exceeds the entire population of the US. Their rapid rise is projected to solidify the country to become the largest luxury market in the world. As such, market leaders such as LVMH have tailored their offerings to target this swelling audience. Based on its stellar record thus far, bets on Chinese consumers seem to have paid off.
The price of luxury
As a buyer and therefore investor, valuation (often determined by multiples) is important. 2019 was debatably a normalised year as markets had been following their upward trajectory for over 10 years after the Great Recession. During then, revenue (EV/Revenue) and EBITDA (EV/EBITDA) multiples came in at 2.1 times and 10.2 times, respectively. On an earnings basis (P/E), the apparel, accessories and luxury goods segment was valued at 22.7 times. Given that revenue and profitability margins trended higher between 2019 until now, the denominator of these multiples ought to have increased. Accordingly, registering a loftier multiple must require market capitalisation to increase more than proportionately. Growth rates and risk potential of businesses affect multiples. Therefore, this must mean that participants priced in higher growth rates and/or lower risks.
However, contrarians argue that the luxury market will experience more subdued growth in the face of uncertainties. Pundits indicate a slowdown among certain consumer groups such as the U.S. middle-class and the wariness of Chinese consumers to spend on larger ticket items due to weaker-than-expected recovery. All these factors allude to higher risks which should put a lid on what constitutes a fair valuation.
The fifth perspective
Over a longer horizon of five to ten years, the outlook for the luxury segment looks sanguine. In the nearer term, the picture is bleaker. Rather than talk in broad strokes, it is helpful to segregate the market into various strata by regions, size, and brand equity.
Winning marques such as Christian Dior SE (ENXTPA: CDI) and Kering SA (ENXTPA: KER) are better positioned to trudge on fiercely while weaker brands may be forced to contend with less ideal prospects of middle market consumers. Investors should not approach the selection of companies like how consumers evaluate the worthiness of extravagant shopping. Maintaining a value-seeking mindset may allow one to steer clear of exorbitantly priced companies.
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