Today we are going to talk about:

• Our strategy at ROA for 2024

• Why Hermes International is the king of the luxury brands

ROA strategy

The new year is always a good time to change things up and we’re doing that here at the Rule of Acquisition.

To figure out this year’s strategy, I did a two day breakout session and analysed our activities using a Strategic Horizons framework.

I’m just kidding, that would be so MBA-ish. I actually just wrote a few bullet points and here they are:

• More stories

• More deep analyses

• Make it easy to understand

• More about what we’re doing at our company

Not sure how this will play out, let’s wing-it and see.

Onto the investing stuff…

Hermès International

Hermes is a French luxury goods manufacturer. They make many things but are renowned for their leather goods, such as their popular Birkin bag.

Amongst the luxury brands in the world, Hermes has often been ranked as the world’s most valuable luxury brand. 

What piqued my interest in Hermes was a graph I saw. It showed the 10-year returns for Hermes, Louis Vuitton, Burberry and Kering. These are all luxury companies, three are French companies, Burberry is British.

The graph was entitled “One of these is not like the other. Despite consistently holding a considerable premium on forward earnings, Hermes has outperformed luxury peers over the last decade.”

I had to know why Hermes was better. So it was time to break out the big guns. That’s right, it was time to crunch numbers in Microsoft Excel like a nerd on Valentine’s Day without a date.

Why do we crunch numbers?

We calculate about 5000 data points for each company (20k in total for this four way comparison) and we use them to understand everything we can about the company.

Some might say numbers are historical, investments are forward looking, what’s the point of analysing them?

Financial statements are a simulacrum, in other words they are a model (using numbers) that shows you how a business operates. Once you become proficient at looking at them, you start to see problems, successes, management actions, etc. In other words, they tell you the story of the company for each year.

If you look at the numbers for multiple years, you can start to see the how the market affected things or how management behaved in a year. Eventually, you get an idea of what normal could be for the business. Once you understand that, you can start to think about whether that will continue on into the future. That is how you decide whether to invest or not.

To be clear, you don’t have to predict the future. You look at normal and assess if that can continue. Most people think you need a crystal ball to be a good investor, you don’t, you just need crystal clear thinking.

The other advantage of looking at the numbers before listening to management (or other people’s opinions) is that it helps you to form your own opinion, before being swayed by a narrative. It is standard practice for companies to push their narrative when reporting. Sometimes, the wool will be pulled over your eyes with words. It is much harder to do that with numbers.

The analysis below looks at about 16 numbers, bear in mind those were selected from 20,000 numbers to help us answer one question “why is Hermes better?” You can use these numbers to analyse your own investments, but remember, there’s more to it. If you are answering other questions, you will need to look at other numbers and qualitative data.

Let’s dive in.

Gross profit

Let’s start with gross profit. Gross profit gives us an indication of pricing power. And all these companies have fabulous pricing power. Here’s the 10-year average gross profit margins:

• Hermes: 69.2%

• LVMH: 66.3%

• Kering: 70.6%

• Burberry: 69.7%

These are very high gross profit margins. Most companies are closer 40%. But as you can see, there’s barely anything in it. In fact, Hermes is in the bottom half. So that doesn’t explain much.

Growth

Let’s look at sales growth. Companies that grow faster are more valuable, maybe this explains it? Here’s the 10-year average sales growth.

• Hermes: 13.7%

• LVMH: 12.3%

• Kering: 9.0%

• Burberry: 4.9%

Now we’re getting somewhere. Hermes leads the pack on sales growth, but it’s nothing stellar like some of the tech stocks.

Valuation multiples

Looking at this graph of price-to-earnings ratios, we can see that Hermes (44.8x) is significantly more highly rated than second place Louis Vuitton (20.4x).

Hermes’ growth is good, but not enough to justify that premium by itself.

Return on capital

Let’s look at what returns on capital each of these companies is able to achieve:

• Hermes: 22.5%

• LVMH: 10.4%

• Kering: 9.2%

• Burberry: 21.1%

Burberry and Hermes are clear leaders here, with very high returns on capital. But these numbers kind of skew things a bit. It looks like LVMH and Kering have been left behind. This is not the case. Every single one of these companies creates value for their shareholders. But again on this measure Hermes leads the pack.

Free cash flow conversion

Lastly, let’s look at cash conversion. In other words, how much of every sale is converted into free cash flow for the company. Here’s the 10-year average:

• Hermes: 26%

• LVMH: 14%

• Kering: 13%

• Burberry: 16.7%

That is a significant difference! Hermes converts 10% more of their sales into free cash flow. And free cash flow is what drives valuation.

Putting it together

If you put these facts together, the picture starts to reveal itself. Hermes has strong sales growth and efficient operations. Because of that, they earn high returns on capital and convert sales into hefty free cash flows.

This kind of performance isn’t ordinary, it is extraordinary. When there are high returns and profits to be made, competitors will come in droves. They will try to take those profits away. The only thing that can save you is a strong competitive advantage.

Hermes’ source of competitive advantage is its 190 year old brand. Their brand stands for quality and luxury. A message they have been consistently delivering through their products for many generations. The brand has unquestionable pedigree.

If competitors had to come after them, they would have to develop an equally prestigious brand. How long would that take? Perhaps 190 years. That is an insurmountable hurdle.

In conclusion, the answer to the question “why is Hermes better” is:

Prestigious brand + Growth + High returns in cash = Premium Valuation

Hermes is not in our Extraordinary Companies portfolio yet. There is still more work to do before we would add it. But it is definitely on our watchlist.

Connect on social media.

You can also reply and send us suggestions on investment topics that you would find valuable.

If you found this enjoyable, feel free to share it.