The High-Quality Case for Investing in Global Luxury Goods

The High-Quality Case for Investing in Global Luxury Goods

Josh Rubin: Welcome back to the Thornburg Investment Insights podcast. I’m your host, Josh Rubin, the client portfolio manager for Thornburg. In this episode we begin our on the road to this episode. We begin our From the Road series, where we interview portfolio managers and analysts about their most recent research trips. Today we’re joined by portfolio manager Sean Sun, who oversees international equity strategies for Thornburg. One of the key strengths of active management is its emphasis on fundamental research. Portfolio managers and analysts traveled the globe to engage directly with corporate executives, with industry experts, to fully understand how companies operate. Engage market dynamics. Sean just returned from an intensive research trip to Italy, including attending the highly anticipated Ferrari Capital Markets Day and a private meeting with Brunello Cuccinelli, as well as a variety of other meetings with industry. Sean, thanks for joining us.

Sean Sun: Yeah. Thanks for having me, Josh.

Josh Rubin:  Maybe let’s start first with just the basics. What makes the luxury space worth investigating, what makes luxury stocks appealing for a quality-focused international growth mandate?

Sean Sun: Great question. I think it is important to take a step back and kind of frame the opportunity here. So today the global luxury market is enormous. Depending on how you define it. It’s roughly 1.5 to 1.7 trillion in annual sales across personal luxury goods, experiences, cars and high-end travel. And then within the core personal luxury goods segment, things like apparel, leather goods, watches and jewelry, that is about $450 billion today and historically has grown at about a mid-single digit to high single digit, rate of annual rate over the past decade.

You know, people tend to split luxury into two categories. They’re soft luxury things like handbags, clothing, ready to wear. And then you have hard luxury, which is like watches, jewelry, things like that. So, we’re going to focus more on that part of the luxury market today. But what makes it attractive is like when you, when you look at luxury, stories over time, they’ve consistently outperformed the broader just consumer discretionary spending environment because the spending from these consumers are less tied to income cycles and more tied to wealth creation, as well as a long term brand equity of many of these, like luxury brands.

Josh Rubin: So, I guess, you know, if I were to step back, I might say global luxury, call it one and a half to 2% of global GDP. You know, global GDP is a little over $100 trillion. And secondly, a little over a decade ago, the French economist Thomas Piketty introduced the Piketty principle, which was the kind of the proof point that capital tends to grow faster than incomes.

And so, if we have the owners of capital around the world both compounding that capital faster than the overall economy, they’re also able to spend it on luxury goods. They’re in that income bracket. So maybe than if we say, okay, luxury is only 2% of global GDP, but we think about the opportunities for investing in international consumption or just sort of general international indices. How important are luxury stocks to investing outside the U.S.?

Sean Sun: Yeah. So, like as you mentioned, what’s great about luxury stocks is that they offer this resilience during downturns because of the very affluent customer base you mentioned, which makes it kind of less sensitive to economic cycles than, than the average consumer would be. So from an investment perspective and why we care, I call out like three main reasons why luxury fits so well with into our quality growth approach.

First of all, it’s the large scale and steady resilient growth I mentioned earlier. Secondly, it’s the strong brand equity that many of the top luxury houses, such as, Louis Vuitton, Hermes, Ferrari, Richemont or like Bruno Cucinelli possess. It allows them to have this like incredible pricing power and really strong margin profile. When you look at 60% plus gross margins and oftentimes over 30% operating margins, that’s something that would be rare in most other industries or sectors but is much more common in the luxury segment.

And then these luxury companies achieve these margins and returns in a very capital light manner. And finally, the third reason why I think it’s interesting is like it’s how these brands manage their aspiration and scarcity. These top luxury brands do a really good job of constraining supply and managing desirability, and as a result, they’re often able to raise prices well above inflation without impacting demand. You know, it’s a generally inelastic consumer good, which is positive. And when you think about the most desirable luxury goods out there, like a Hermes Birkin bag, a Patek Philippe watch or the upcoming Ferrari F80 hypercar, you know, these products are not about function or utility or getting from point A to point B, they’re really about showing that you’ve made it and that it’s also an expression of like, you know, taste and culture coupled with like this really high quality craftsmanship. So, the buyers of luxury, these high-net-worth individuals are like I mentioned earlier, they’re seeing their wealth expand rapidly, especially in emerging markets. And given that they’re generally more economically resilient to than other types of consumers, that makes this, you know, an attractive part of the market to invest against.

Josh Rubin: Okay. So yeah, I guess maybe a different way to summarize it could be luxury spending might be one and a half or 2% of global GDP, but the margins of these companies allow them to probably be 4 or 5% of global earnings. And low capital intensity allows these companies to be even a larger part of kind of total global cash flow. And so, from an investment standpoint, that makes them punch above their weight, that you might just see from a revenue standpoint.

Sean Sun: Yeah. That’s correct. I mean, these are fantastic businesses. You look at all the various quality metrics that we might track, margins, return on capital. The fact that much of the equity is coming from these intangible assets, which are again, capital light, and it kind of lines up together. And then obviously, obviously looking at historically and how they’ve compounded a lot of wealth and value and earnings power over a long period of time.

These luxury stocks kind of fit this broader framework that we look for around resilience and optionality. So, we want we want companies are really resilient. You know, not very macro sensitive which luxury companies are. And they we want this optionality, this optionality around like, you know, addressing more consumers across the globe, maybe new product lines. Maybe you know, like a recovery in China, things like that. So, it’s a nice combination of resilience plus long-term optionality.

Josh Rubin: Okay.  One last question. Just on luxury in general, why is it that luxury houses are generally headquartered in Europe? So, some of these companies have been around for several hundred years, longer than the United States has been around, but plenty of companies haven’t. Why did luxury really emerge in Europe, and why hasn’t there been the emergence of U.S. luxury?

Sean Sun: Yeah, that’s a good question. I think part of the appeal of luxury is this long-term brand heritage. And a lot of that originated in Europe. You look at some of the top major luxury houses. Many are headquartered in Europe, countries like France, Italy and Switzerland, and some of the many, many luxury brands are over 100 years old.

It’s hard to replicate that type of long-term brand heritage in a long-term brand building over short periods of time. But you know, while these brands were originally founded in Europe, they appeal to consumers globally. You know, and their growth engines today are no longer just Europe, but they’re in the entire globe, especially emerging markets. Historically, China has been a huge growth engine for these companies. And the US is also a very important market for many of these luxury brands. To put some numbers around it. Chinese consumers, for instance, today represent about 30% of all luxury spending. That’s both within China as well as Chinese citizens traveling abroad to Europe and other places. And then the US is the most important part of luxury spending, representing roughly a third of all luxury spending.

Josh Rubin: Okay. In a minute, I want to move to some of the thoughts you had after your travels to Europe. But maybe two more questions on luxury right now, just sort of holistically. Number one, you talked about scarcity of supply. And maybe if you can talk a little more about when consumers slow down their purchasing behavior or they change their purchasing behavior, what are the ways that luxury companies adapt?

You know, do they actually stop making more handbags or making less champagne? Do they stockpile them? You know, for a little bit longer, but just what does it mean to maintain scarce supply even as demand slows down like it has over the last couple years?

Sean Sun: Yeah, it really depends on what part of the luxury pyramid, Your positioned. I think those companies are the very top kind of persistently have a supply demand mismatch where they there’s a massive amount of demand for their product and they are intentionally restraining supply and creating these waiting lists like it takes. You have to wait two years to buy a Ferrari, multiple years to buy a Birkin bag.

So that that is kind of like a perpetual feature of the most desirable luxury brands when you’re talking about more of the accessible luxury brands or kind of like the middle market luxury brands, you could say they’re they are trying to limit supply to some extent, but they don’t. They’re not able to kind of pull the same levers as many of the other top luxury brands.

And in some cases, they don’t do a great job of that. They actually hurt their exclusivity by trying to grow too fast. I think the case study of that, of what? Not to do in luxury is what, Gucci, which is owned by Kering, kind of went through a bit post-Covid where they had some hot products, 3 or 4 really hot products, and instead of intentionally constraining supply and maybe, extending the duration of the growth of those kind of like products, they instead went for as much growth as possible in the short term and sacrificed, you know, long term brand equity.

Josh Rubin: Okay. And that that ties in well to my final question on the space, which is sort of the way that, early, or I should say, less wealthy consumers access luxury and that there’s part of it, which is I can buy a luxury wallet for several hundred dollars if I don’t have several thousand dollars to buy a larger piece from a particular, you know, fashion house.

Then there’s this other angle, which seems to be a little more in vogue. Maybe it’s a generational thing of dupes or of kind of lower cost luxury, where people say, I would just buy something that looks great, doesn’t have a brand on it, but it’s a lot cheaper. Are those things disruptive or those things more cyclical? I know they’re two different things, but how do you see that those risks at the lower priced areas of luxury right now?

Sean Sun: I’d say the risk of duplicates is it’s probably not all that cannibalizing because those consumers are unlikely to purchase the real thing anyway. But you know what? I’ll give you a good case study of how a luxury brand captures a consumer early in their life, and then kind of moves them up the pyramid and the kind of ASP structure over time.

So, Hermes is really good at this. So, Hermes, they have entry level products like a lipstick for a very affordable price. And their goal by having that entry level lipstick, for instance, is to capture a luxury consumer. Let’s say, she your, she just received a promotion at work. She wants to reward herself. So she’s going to buy herself a lipstick or, you know, a bracelet or something kind of really small or a kind of entry level luxury item.

And Hermes is like, strategy is like, look, I’ve got you now. You’ve bought this lipstick today. Maybe in a few more years, you get another promotion, you buy something a little more expensive, and all of a sudden, 30 or 40 years down into your career or your life, you’re now ready to buy yourself a Birkin bag, and you’ve captured, like, this great lifetime value of the consumer.   You could say over time, because you had that entry level, accessible luxury product, to get them early in their 20s. Now different brands have different approaches to this, like a Brunello, Cuccinelli doesn’t believe in any accessible entry level price points. But other brands are very successful, offering excess accessible luxury, price points. You know, what we’ve seen over post-Covid is we’ve seen one of the issues with luxury, post-Covid is that for the most part, many brands have raised prices quite a bit, on average, about 35% globally.

And this is well above the typical rate of luxury price increases of about 5% a year. And while this strategy really inflated profits and preserve margins during this inflationary period, what it ended up doing is it priced out the aspirational buyer, this entry level luxury consumer, who can now no longer afford that entry level, you know, Louis Vuitton speedy bag or something or some other tote.

And what has happened is about 50 million consumers have exited the market because the price points have gone about out of, out of their reach. And what this has actually done is it’s actually created some winners. One, one area that has benefited from this, this, pricing out of the accessible luxury buyer or more accessible luxury brands like a Ralph Lauren or Coach. And you actually see it in their recent performance and numbers. Some consumers are actually trading down, and Ralph Lauren and Coach are at these accessible price points where they’re actually capturing a good number of those 50 million consumers who have been priced out.

Josh Rubin: Sean, thanks for setting the table with some of these foundational elements about the global luxury space. Next episode, we’ll talk about how global trade, the economy in China, some other moving pieces of global luxury buyers are impacting the opportunity set for these luxury companies.

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