Just doing it with a spoonful of quality
  • Vector Insights

    Just doing it with a spoonful of quality

    Brad Livingstone-Foggo, Head of Marketing - Australia
    04 October 2019
     


    A tale of two companies

    In 1964 Phil Knight and Bill Bowerman founded Blue Ribbon Sports. Bowerman was a track and field coach and Knight was a runner enrolled in Bowerman’s program. The two were obsessed with improving shoe technology to increase speed and comfort. They opened their first retail outlet in 1966. The company was a small business run out of Beaverton, Oregon.

    At around the same time, down the west coast of America in Orange Country, Disney was celebrating the success of its most recent hit Mary Poppins. Disney had a growing library of family friendly films and its theme park which opened 11 years earlier was a massive success. Warren Buffett had spotted this and he invested in 1966. At the time Disney had a strong balance sheet and stable earnings, two attributes that are commonly referred to as ‘quality factors’. In 1966 Disney was a quality company. Blue Ribbon Sports was not, given it wasn’t yet generating any return on equity, nor stable earnings. That’s not to say it didn’t have potential.

    Buffett sold his 5% stake in Disney in 1967 having made US$2 million profit in a little over a year.

    Morning forward into the 1990’s and 2000’s, Blue Ribbon Sports had long-become Nike and as an investment it was exhibiting the attributes that had made Buffett want to invest in Disney all those years before. Nike was fast becoming the biggest sports brand in the world and it had been experiencing consistent, stable earnings growth, and its balance sheet was robust. After initiating interest in the company in 1997, by 2005 Berkshire Hathaway owned almost eight million shares in Nike.

    At the same time things had changed at Disney and the characteristics that had made it an appealing investment in 1966 were no longer evident despite its growth.   By the late 1990s Disney was riding high on the back of a strong decade built on the rejuvenation of animated films that began with The Little Mermaid. The problem was, from an investor’s perspective, Disney was no longer a quality company. It had high debt and its earnings were suffering. Investments in EuroDisney floundered and its acquisition of television network ABC proved disastrous as various TV shows flopped. The then CEO Michael Eisner was eventually ousted. As a part of the ABC transaction Berkshire Hathaway acquired Disney shares, but because the company’s investment characteristics were not as appealing as in 1966, the firm sold them almost immediately.

    Fast forward and Disney has been revitalised. With its unrivalled catalogue of films both new and old and a thriving parks and resorts business, Disney seems immune from competition. Had Warren Buffett kept the Disney shares he owned in 1966 they would be worth over US$12 billion today (over US$20 billion, if we take into account the ABC transaction)1. His admission that selling those shares way back in 1967 as one of his worst investment decisions was in the early 90s’, he may feel the same way now.

    Buffett often mentions the importance of a business having “barriers to entry” to prevent competition by using an analogy of a moat surrounding a castle. The moat Disney has been building around its Cinderella castle is impressive. Its theme parks and tourism services continues to grow. Also, augmenting its own stable of movies, Disney has bought Pixar Animation (2006), Marvel Entertainment (2009) and Lucasfilm (2012). The Pixar, LucasFilms and Marvel acquisitions have resulted in some of the biggest box office successes of all time. This year alone, Disney has released five of the six films that have exceeded worldwide box office grosses of US$1 billion (Avengers: Endgame, The Lion King, Captain Marvel, Toy Story 4 and Aladdin) and its Marvel Studios had a hand in the other one: Spider-man: Far From Home.

    Meanwhile in retail, Nike is also riding high. Nike’s recent earnings announcement beat analysts’ estimates. The results have been boosted by product innovation like a new Joyride running shoe, investment in e-commerce and Nike’s best ever back-to-school season. Berkshire Hathaway had divested from Nike in 2010, so it has missed out on much of the company’s recent growth. Nike, like Disney has built significant “barriers to entry” around its intangible brand asset which is known and recognised worldwide. Nike is the largest athletic apparel company in the world and it actively protects is brand with endorsements, sponsorships and innovation. Evidence of Nike’s enduring popularity is the market for its older and limited edition shoes. Nike’s “Moon Shoe” sold for $US437,500 in July this year.  

    Looking at the numbers, many of the reasons Buffett invested in Disney in 1966 and the reason Berkshire Hathaway invested in Nike in 2005 are the same reasons that Disney and Nike are included by MSCI in its MSCI World ex Australia Quality Index (QUAL Index) today: they possess 3 key quality characteristics:

    1. High return on equity;
    2. Stable earnings growth; and
    3. Low financial leverage.

    The table below shows Disney and Nike’s earnings per share growth. Further, their return on equity (ROE) has been strong and neither company has significant debt indicating balance sheet strength.

    Table 1: Nike and Disney’s quality characteristics

     

    Nike

    Disney

    Diluted EPS 3 year historic compound annual growth rate

    4.9%

    12.9%

    3 year historic average return on equity

    31.5%

    23.5%

    3 year historic average debt to capital

    26%

    33%

    Source: Morningstar Equity Research. Nike updated 30 September 2019, Walt Disney updated 12 April 2019.

    Many seasoned investors cite these as the attributes of companies that they seek for long term outperformance especially in the current, low growth, low rate environment. The companies that demonstrate these quality attributes have historically been able to navigate volatile markets over the long term.

    The VanEck Vectors MSCI World ex Australia Quality ETF with the ASX trading code: QUAL, replicates MSCI’s QUAL Index which currently includes Disney and Nike and other quality companies such as Apple, Roche, Microsoft, Inditex.

    QUAL provides the potential to outperform broader international equity markets, at a lower cost than comparable actively managed funds.

    Using QUAL you can now own Nike and Disney shares and thus share in the potential upside of Nike’s innovation and the next phase of Avengers movies, the upcoming Star Wars sequel, Frozen 2, and Disney +.

    Disney and Nike are used by way of example only and this does not constitute a recommendation to invest in Disney and or Nike.

     

    IMPORTANT NOTICE: This information is issued by VanEck Investments Limited ABN 22 146 596 116 AFSL 416755 (‘VanEck’) as responsible entity and issuer of the VanEck Vectors MSCI World ex Australia Quality ETF and VanEck Vectors MSCI World ex Australia Quality (Hedged) ETF. This is general information about financial products only and not personal financial advice. It does not take into account any person’s individual objectives, financial situation or needs. Before making an investment decision in relation to an ETF, you should read the PDS and with the assistance of a financial adviser consider if it is appropriate for your circumstances. The PDS is available at www.vaneck.com.au or by calling 1300 68 38 37. The funds are subject to investment risk, including possible loss of capital invested. Past performance is not a reliable indicator of future performance. No member of the VanEck group of companies gives any guarantee or assurance as to the repayment of capital, the payment of income, the performance, or any particular rate of return from any ETF.

    QUAL and QHAL invest in international markets. An investment in QUAL or QHAL has specific and heightened risks that are in addition to the typical risks associated with investing in the Australian market. These include currency risks from foreign exchange fluctuations, ASX trading time differences and changes in foreign laws and regulations including taxation.

    QUAL and QHAL are indexed to a MSCI index. The ETFs are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to QUAL or QHAL or the MSCI Index. The PDSs contain a more detailed description of the limited relationship MSCI has with VanEck and the ETFs.

     


    1https://markets.businessinsider.com/news/stocks/warren-buffett-made-20-billion-mistake-by-selling-disney-twice-2019-8-1028484967