(This is Part 2 of a four part series. Part 1, Part 3, Part 4.)

In our post last week we highlighted the risks associated with low growth stocks and made a passing reference to how we had allowed this risk to hurt us with our investment in Prestige Brands (PBH). So in this post, we’ll review what went wrong with our Prestige Brands investment and why we sold our position at a loss.

Before we dive in, we want to state clearly that we do not use a stock’s current free cash flow yield as the basis of our valuation analysis. As we explained in our last post if you assume that the growth rate of free cash flow is stable, then the free cash flow yield plus the rate of growth would indeed be the right way to approach valuation. You can see this in practice with treasury bonds, which have a known free cash flow yield (the interest rate) and a known growth rate (0%). These instruments should indeed be valued based on their current free cash flow yield and are done so in practice, not just in theory. So while the Gordon Growth Model of valuation we reviewed in our last post is not some abstract theory, it only describes the right way to value a financial instrument in the special case when growth rates are known and stable. This case study is focused around the specific issue of low growth and is not meant to be a comprehensive overview of our full company analysis process.

OK, with that out of the way, here’s a description of Prestige Brands that we wrote in January of 2018. You can read more here.

“Prestige Brands is a small company that owns big brands in small markets. The company sells over the counter consumer health products that typically do not have any kind of prescription competition. While their competitors include huge companies like Novartis, Johnson & Johnson, and Procter & Gamble, within the niche markets where they compete, their products generally hold #1 or #2 market position and often have market share of well over 50%. As a comparison, Coke holds 42% market share in carbonated soft drinks and so Prestige’s market share in their niche markets can be seen as more dominate than the hold Coke has on the soda market.

With no prescription competition, the company operates in markets where customers use brand as a key signal of quality and effectiveness. If you have a sore throat, itchy eyes, a wart, or your kids are car sick, you want to be sure that what you buy works and buying an established brand is the best way to make sure you get what you paid for. Whether you go to the drug store or order online to treat the conditions I just mentioned, you are very likely to buy products from Chloraseptic, Clear Eyes, Compound W, and Dramamine. All of these brands are made by Prestige and every one of them has the #1 market share position.”

At the time, it was clear to us that Prestige was not a high growth business. We wrote:

“Prestige operates in slow growth end markets. The number of people who have a sore throat or itchy eyes is not going to grow dramatically. But it also isn’t going to shrink. In order to be an attractive investment, the stocks of slow growth businesses must offer investors high levels of current free cash flow yield. With Prestige’s free cash flow yield hitting 10% in November, we added significantly to what had been a small position for us. We believe the stock offers the potential for steady, dependable returns over the long term that exceed the market.”

Below is a chart showing Prestige’s share price and the free cash flow yield over the past five years. The red arrow points to November 2017 when we added significantly to what had been a small position we had owned for some time. The purple arrow points to January 2018 when we wrote the comments above. The green arrow points to May 2018 when we completely exited our position.

Close readers will notice that we stated that the free cash flow yield in November 2017 was 10%, but it shows as just 7% on this chart. That’s because the chart shows the trailing 12-month free cash flow, which at that point included one quarter of abnormally low free cash flow. But the run rate free cash flow yield was about 10% as we stated.

When we bought Prestige Brands at a 10% free cash flow yield in November of 2017, we believed that the long term growth rate of free cash flow would be as high as 4%. As we described in our last post, the Gordon Growth Model demonstrates that assuming a stable level of growth, the return an investor can expect is the free cash flow yield, plus the growth rate. So an implied 14% rate of return for owning Prestige Brands looked pretty attractive to us.

Our 4% growth assumption simply assumed that the company could generate 2% growth in volumes (population growth plus a little bit of additional growth from expanding usage of certain products they sell) and 2% price increases. Since Prestige Brands dominates their product categories, we thought it was entirely reasonable to assume that they could raise prices at the rate of inflation.

After we added to our position in November 2017, the stock initially rallied, but then plummeted in early 2018 falling from $46 to $29. Bears on the stock and some adamant short sellers believed that organic growth was actually negative and that the company was hiding this weakness, which bears thought would become apparent when they reported their full fiscal year results in May 2018 and provided guidance for the upcoming year.

The bears were wrong. But so were we. In May, the company reported that their most recent quarterly organic growth rate was 2.4% but they guided to just 1% growth for the coming year. With the stock offering a free cash flow yield of 13% going into earnings, it was priced for significant negative growth. When that didn’t materialize, the stock rocketed higher, jumping 35% in just three days and pushing the free cash flow yield down to under 10%.

In theory, a 1% growth rate and a near 10% free cash flow yield means a solid 11% return potential for investors. But as we stressed at the beginning of this post, this math only works if you assume a growth rate is known and stable. Our confidence in our growth outlook was falling apart (not just because of the weak guidance, but in the interest of keeping this post relatively concise, we won’t expand on our comprehensive analysis of their long term growth potential and pricing power) and we used the rally to exit our position.

Here’s an excerpt from the actual internal note we wrote to our client advisors about our decision to exit the stock:

“While the quarter validated our view that growth is not declining, it also only further reduced our conviction that they can bring growth back to a more sustainable path. We do not demand high growth to own a stock, since in theory any cash flow stream, even one that is declining, can be valued. However, businesses that are unable to grow revenue at least as fast as GDP are effectively losing wallet share and risk hitting “stale speed” at which point their growth rate may deteriorate unexpectedly. We see this dynamic at work in many natural systems both in and out of finance. The world is rarely static and most things are either improving or going into decline.

If we knew that Prestige would grow revenue by some exact amount, even if that amount was low, we would be able to value the business. A treasury bond offers an example. Treasury bonds offer zero growth but a known cash flow stream and these are very valuable and secure financial instruments. But while it seems to us that Prestige is quite likely to continue to grow over time, the very low rate of growth that it seems they can achieve opens up the very real possibility that the business could unexpectedly go into decline over the medium to long term. This dynamic makes the value of the stock too uncertain to qualify for our portfolio. While most people think about the risks and volatility that comes along with high growth stocks, very low growth stocks exhibit a similar set of uncertainties because their ability to simply “ride the wave” of economic growth is in doubt. If you stick with a “riding the wave” analogy, you can see that so long as you keep up with the wave (GDP growth) you’re fine, but if you slip behind (stall speed), your ability to continue comes undone and you end up wiping out.”

In our last post, we showed this chart that illustrates the valuation justified based on various levels of sub 5% growth rates.

If you hold all else equal, a company whose assumed growth rate declines from 4% to 1% will see the value of the company decline by 37.5%. Worse yet, once a company’s growth rate slips behind the growth of the economy, the level of uncertainty about their long term growth rate usually spikes due to the “stall speed” issue that we mentioned in the excerpt above and discussed in more depth in our last post. While it is easy to dismiss as “irrational” the fact that Prestige Brands stock rocketed between prices under $30 to almost $60 over the course of 12 months, one key point we want to make is that those moves can be entirely justified by small changes in expectations about long term growth. That’s heart of the low growth risk. Small changes in growth can lead to big changes in uncertainty and share price volatility.

It is easy to look at a stock that blows up and exhibits slowing growth, and conclude that it must not be a very high quality company. But that’s not exactly right. Here’s some commentary about Prestige that we wrote in January of 2018 that is unlikely to change much at all:

“Owning these strong brands, in small niche markets, results in Prestige generating the highest profit margins in their industry. While Procter & Gamble and Johnson & Johnson might be a lot more well known, Prestige Brands turns every dollar of revenue into 34 cents of profits while P&G and J&J manage to squeeze our just 26 cents of profits.

It is important to recognize that Prestige is a brand management company more than a product producer. They outsource most of the capital-intensive production aspects of the business. This capital light, outsourcing approach means the company only employs 520 people, generating an amazing $1.7 million per employee. In comparison, most health care and consumer staple companies do closer to $500k per employee and Apple, which has the highest revenue per employee in the technology industry does only slightly more at $1.9 million. Until their acquisition of Fleet a year ago, Prestige had only 259 employees and was doing an amazing $3.1 million per employee.”

All investing is uncertain. The value of a stock is nothing more than the value of the future cash flows that the company will produce. When the growth rate of these cash flows is high, it is easy to see how volatile future cash flows might be and so the risk associated with that uncertainty is clear. But when the growth rate of a company’s cash flow is low, especially if the company otherwise exhibits strong signs of being a high quality, competitively advantaged business, it is easy for investors to be lulled into thinking they own a “safe stock”. This can be doubly true when the company in question pays out a significant dividend (which may be a sign that they don’t have much in the way of growth prospects in which to reinvest their cash flow).

Our goal with these posts is to demonstrate just how risky low growth businesses can be. Not because of big variations in near term grow rates (while we owned Prestige, the rate of organic growth never wavered by more than a percent or two), but because small variations in the long term growth rate has a surprisingly large impact on the value of the business.

As we’ve come to better appreciate this risk, we’ve placed much more weight in our analysis on trying to confirm that businesses we own can produce growth at least as fast as the broader economy for the foreseeable future. But temporary declines in a company’s growth rate can often be excellent times to buy a stock… unless of course it turns out not to be temporary. Because of the uncertainty that is intrinsic to the business of investing, we know we’ll make mistakes in the future. But we’ll try our best to make new and more interesting mistakes. And once we recognize and learn from them, we’ll do our best to share them with you here.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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