Article / 20 January 2014 at 13:16 GMT

Quant Corner: European food sector's EM premium hit by taper

Head of Equity Strategy / Saxo Bank

• Emerging markets' focus bolsters European food sector growth
• Fed taper policy undermines emerging markets, hits sector
• Nestle, Danone and Unilever unattractive currently

By Peter Garnry

The European food sector has historically produced world beaters with the likes of Nestlé, Unilever and Danone. The last decade's intense focus on penetrating emerging markets has produced higher growth rates for European food producers and investors have rewarded them with a valuation premium. However, 2013 marked a change in perception and recently the industry has underperformed equities in general.

The Fed policy hit

The Bloomberg Europe 500 Food Index is up 10.7 percent annualised, including the reinvestment of dividends since January 2003. That is three percentage points higher than European equities overall (see chart) underscoring the industry's alpha generation over a decade. Money managers with an overweight towards European food producers have done well.

Bloomberg Europe 500 Food Index relative to Bloomberg Europe 500 Index

Bloomberg European 500 Food Index

Source: Bloomberg

One of the main drivers has been the increase in emerging market sales with Unilever currently getting 57 percent of its total revenue from emerging market countries. The strategic focus deployed over 10 years ago by the European food industry has been wise. Growth and profitability have been above competitors in the US and Asia leading to a valuation premium of almost 25 percent on EV/EBITDA (see chart below).

Bloomberg Europe 500 Food Index premium over Bloomberg World Food Index

European Food EV/EBITDA premium

Source: Bloomberg

However, the industry's success is now a drag on stock performance as the Bloomberg Europe 500 Food Index has underperformed the Bloomberg Europe 500 Index by around 12 percent since March 2013. The main driver has been the Fed's signal, and later action, to change its monetary policy by reducing its quantitative easing programme. This new course of action has put pressure on many emerging market countries with negative capital flows as a result. Thailand is the latest example where negative capital flows are beginning to hurt the country. Emerging markets have gone from being the positive story to being perceived as unstable and having an unsustainable business model.

Quant Corner remains negative

The three largest components in the Bloomberg Europe 500 Food Index are Nestlé, Unilever and Danone, and all stocks currently have a negative view from our quant model. Nestlé is overvalued but is still enjoying a rising stock price, while the two other stocks are fairly valued but are experiencing headwinds from negative price action.

Danone especially has been lagging in performance due to two factors. Milk prices have been rising in Europe increasing the cost pressure and the baby food scandal in China last year will impact profitability going forward as its Chinese Baby Nutrition segment is losing market share in China.

While valuation is not attractive on a relative basis, the European food industry still expects higher growth rates than other industries in general. The negative impact from the financial turmoil in emerging markets also seems to be a bit exaggerated as emerging markets may be slowing down but the growth rates are still attractive and the middle class is growing fast. It is definitely an interesting industry that offers fantastic exposure to unique parts of the global economy but everything has a price and our model believes investors should stay on the sidelines for now.


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