LUXURY AND THE PRETENDERS

Within the luxury sector, there are degrees of desirability Ferrari, for example, will always make Aston Martin look like a carthorse, writes

In May 2023, the luxury sector was all over the headlines. Before the media went mad over AI, Bernard Arnault — the founder, chair and CEO of LVMH — was on the covers of countless magazines. LVMH was the most exciting stock in the world, with a classic case of “nothing can go wrong” baked into the valuation, fuelled by the media articles and the hype that plays out in the market over and over again.

The rollercoaster in that share price over the past year has been breathtaking. The 52-week high was nearly €905 and 52-week low was €644. That’s a drawdown of 29%, which is the kind of drop we typically see in a proper market crash. As a sign of the wild volatility, the share price has subsequently clawed back some of that drop, now trading at €800.

The lesson is that no sector is immune to hype — even one that represents “old money” and heritage in its purest form. The markets will always be a function of human emotions. Humans love the next big thing and momentum in the markets is a force that shouldn’t be ignored.

Still, the 10-year compound annual growth rate (CAGR) for LVMH is more than 20% — and that’s in euros! These are exceptional returns. But if you can believe it, that’s still not the best performance in the sector. Hermès has products that are even more exclusive (read: expensive) than LVMH and has returned a 10-year CAGR of more than 25%. As the market has chased luxury stocks, the purest luxury plays have seen their earnings multiples go into the stratosphere.

One of the ways to assess the “hotness” of a sector is to consider the source of returns over a given period. When a share price performance has been far ahead of earnings per share (EPS) growth, then you know the market has pumped up the stock to the point where investors are willing to pay far more per unit of earnings than before. Hermès achieved a 10-year EPS CAGR of about 18.5%. With share price performance over 25%, it’s clear that multiple expansion has been a major

There can be no doubt that buying the best luxury stocks in the world over the past decade was a clever strategy

driver. Sure enough, over 10 years, the p:e has expanded from the low 30s to the high 50s — a significant move indeed.

This has played out in other sectors as well. Over 10 years, Apple’s p:e doubled from 13 to 26. At the height of the pandemic mayhem, that multiple went as high as 44. Now, it’s not the end of the world if a high multiple unwinds, provided the underlying growth is still there to result in a net positive move for the share price. For growth stocks, it’s normal for the p:e to unwind over time as growth expectations cool. The danger zone for investors is when the multiple unwinds too fast relative to earnings growth (a typical outcome when growth is below expectations), leading to a disappointing outcome despite having bought “one of the best

companies in the world ”— but at the wrong valuation.

There can be no doubt that buying the best luxury stocks in the world over the past decade was a clever strategy. History isn’t the best predictor of future performance though, particularly when a decent chunk of the return was from multiple expansion. There is a practical limit to what people are willing to pay per unit of earnings, so at some point the likely share price return will be in line with earnings growth as a best-case scenario. This is because there’s plenty of potential for the performance to lag earnings growth if the multiple unwinds.

As always, a deeper fundamental approach is needed in assessing these stocks. The hype around the sector has largely died down, so at least that noise seems to be out of the numbers. Until LVMH announces some kind of AI-inspired handbag, we probably won’t see luxury getting as much media airtime as tech companies. Investors should see that as a positive.

In assessing the business models and valuations in this sector, it’s important to understand why the luxury model is so appealing to investors. There are fundamental elements of these businesses that are hard to find elsewhere. In a world where far too many companies have commoditised offerings in a race to the bottom, the best luxury companies in the world stand apart as having exceptional supply-demand dynamics.

Top executives at Ferrari (which trades under the excellent ticker $RACE) have often been quoted as saying that they will build one car fewer than the market demands. In practice, they build even fewer than that, but you get the picture. Avoid using the words “always” and “never” in markets (and in life), but it really does seem likely that Ferrari will never be in a situation where there is oversupply. The order book is full to the end of 2025 and this gives the company a wonderful combination of revenue visibility and pricing power.

The other benefit of this supply-demand dynamic is that if the new cars are hard to get, values of used Ferraris stay strong. This improves the total cost of ownership for buyers in a way that a company such as Aston Martin (and several other exotic car manufacturers) can only dream of.

Even for the very rich, the cost of ownership matters. How do you think these people got so rich in the first place? They care about owning exclusive items but they are also conscious of not throwing money down the toilet. This isn’t just the case for cars. There are many examples across luxury timepieces, handbags and other items of high value that can almost be seen as an investment. As the price of new items keeps increasing and availability remains scarce, the value of used items is well supported.

This means that pricing power has an incredible

flywheel effect for these companies. If they can’t keep pushing prices higher, there will be a negative effect in the second-hand market that will completely change the ownership economics for those who previously bought the products. Those consumers will think twice about buying again. Conversely, if pricing power is strong and the new items get more expensive over time, the ownership economics are more appealing and in turn this drives demand — a selffulfilling prophecy that results in delicious returns for investors.

This is why there is a huge gap in reality between true luxury (Ferrari) and pretenders to the throne (Aston Martin). In apparel, Kering Group (the owner of Gucci and many other brands) has only returned a 10-year share price CAGR of 9%. It has been blown away by LVMH and Hermès, as “pretend luxury” just isn’t good enough. The truth is that there are only a handful of true luxury brands in the world. The rest are affluent consumer at best.

If we look at the valuations in the market, it’s clear that the more luxurious the brands, the higher the p:e. Perhaps one could also argue that true luxury tends to drive higher earnings growth as well, which in turn supports a higher multiple. Growth aside, it seems plausible that the higher multiples are justified by the market mainly based on the defensive nature of selling products to the richest people on earth. Luxury products are the beneficiaries of the old saying: “The rich keep getting richer.”

Though LVMH is spoken of as the standard bearer for the luxury sector on public markets, the real story is that the group is more of a mixture of luxury and affluent consumer. Sephora, the cosmetics retailer owned by LVMH, certainly isn’t luxury. It’s also very difficult to argue that Hennessy Cognac is true luxury. Ditto for Moët & Chandon and Veuve Clicquot. These names might be difficult to pronounce, but the products are available at most upmarket restaurants and bars. In stark contrast, most people have never even seen a Hermès handbag. Spotting a current-model Ferrari on the road is also a rarity. When you read of the jewellery maisons at Richemont with names you’ve never even heard of, you’re in the presence of true luxury.

Scarcity and rarity are the best measures of luxury. Most higher-income consumers can splurge on expensive champagne for a birthday or buy costly cosmetics at Sephora. There are very few who can buy true luxury items. Within LVMH, we find genuine luxury in Louis Vuitton, which also happens to be the best business in the group. This is why LVMH’s p:e tends to be a blend of true luxury and affluent consumer comparatives. This is risky stuff for investors, as a meaningful slowdown on the affluent side can lead to messy outcomes for the share price.

One of the most interesting trends in the past five years in this sector has been the divergence in earnings multiples across the biggest names. Roll back the clock to April 2019 and we find Hermès at a p:e of 47, well ahead of LVMH and Ferrari at about 27. Today, LVMH is trading at a similar multiple to five years ago. In stark contrast, Ferrari has jumped to 55, which is similar to Hermès at 58. The market now sees Ferrari as being on par with the best luxury stock in the business.

Is that a fair assessment? Operating margins seem to suggest otherwise. Hermès runs at a 43% operating margin, with Ferrari and LVMH both running at 26%27%. Richemont sits just below them at 25%. Ferrari has margins that the rest of the automotive sector can only dream of. Hermès has margins that the rest of the world can only dream of.

The best-performing share price in this sector over the past 12 months has been Ferrari by miles. With an operating margin well below that of Hermès and all the uncertainty around electric vehicles, the market may have fallen too deeply in love with the red metal. As we saw when LVMH’s share price got too hot, be careful of an overcooked share price in the luxury game. Based purely on numbers rather than emotions, the sector can still be described as Hermès and the pretenders.

If we look at the valuations in the market, it’s clear that the more luxurious the brands, the higher the p:e