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Trend Investing; Only a Part of the Process

Tuesday, January 17th, 2017

Recently we were asked our thoughts on what investors should consider when investing in spirits and alcohol by a national report group.

The reporter brought up the great growth numbers in the micro-distillery industry.

Malt, barley and rice were up about 3.5 percent to 1.8 billion pounds, while rye was up about 26 percent to 208 million pounds. Corn was up about 14 percent to nearly 98 billion pounds, and there are now 750 micro-distilleries in the United States, compared to 92 in 2010. Some believe that we’re at the year five mark of a 25 to 40-year cycle that could see continued growth in consumer demand for spirits.

Micro-distilleries have seen a huge boom in popularity over the past several years. Especially here in San Diego, it seems a new micro-distillery pops up every day. The demand for these micro-distilleries is apparent after witnessing Constellation Brands $1 billion acquisition of the well-known micro-brewery, Ballast Point. Though the demand continues to rise, there are considerations investors must look at before blindly investing in the spirits and alcohol industry. Although you may love drinking Ballast Point, you may still want to avoid investing in Constellation Brands.

The first consideration investors should keep in mind is the threat of new entrants and the risk of competition. With a 715% increase in micro-distilleries since 2010 and the possibility of that number continuing to rise, there is potential for lost market share which could have an adverse effect on sales for other companies.

 The second consideration should be the potential increase in the cost of materials for producing spirits and alcohol. If the demand for malt, barley, rice, rye, and corn continues to rise, but supply for these products slips there would be a shortage and price for the materials would increase. This would have a direct effect on the profit margin for alcohol producing companies.

The final consideration one must think about is the company they are buying. Just because the spirits and alcohol industry may be strong moving forward, companies may do poorly if they have too much debt or if they cannot produce sales and profits.

With that said, let’s take a closer look at the fundamentals for Constellation Brands (STZ).

The current price for STZ is $154.82 and the 52-week range is $130.23 - $173.55.

The company produces well-known brands such as Robert Mondavi, Svedka, Corona, Pacifico, Modelo, and the previously mentioned Ballast Point brand.

The growth rates for Constellation Brands are impressive as sales have grown by 13.9% over the last 12 months and EPS has risen by 35.9% during the same time frame.

While sales and EPS are growing at nice rates it is always important to see what you are paying for various aspects of the business by analyzing the valuation ratios.

Price/Earnings for the last 12 months currently stands at 24.25, which is below the industry average of 33.11. While this is a positive, both P/E ratios are more expensive than we traditionally like.

Price/Sales is 4.04 once again below the industry average of 4.73. Price/Cash Flow is 18.71, which is also below the industry average of 21.35. Like the P/E ratio, these valuation ratios all appear to be attractive when comparing the industry average. The concern is the alcoholic beverages industry on average seems to be overpriced.

Other concerns lie within the balance sheet.

The current ratio of 1.31 looks okay, but when looking at a quick ratio of 0.50 we begin to feel somewhat concerned about the liquidity for this company. The quick ratio gives a better idea of the short-term liquidity for a company as it excludes inventory from the calculation. We would like to see this company build a stronger base of liquid assets on the balance sheet.

Total Debt/Equity is higher than we like to see at 122.99%. This is the equivalent of owning a million-dollar home, but owing over $1.2 million on that home. It is especially worrisome as the company has been increasing its debt load without repurchasing stock.

Price/Tangible Book value is currently not material. This means if you take away all the intangible assets on the balance sheet, the company is left with no equity. Constellation Brands has seen a major increase in total intangible assets in recent years. In 2013, goodwill was measured at $2.7 billion and net intangibles stood at $857.5 million. Looking at the most recent quarter, goodwill is now $7.5 billion and net intangibles are $3.5 billion. Much of this is due to Constellation Brands acquiring new companies.

It is important to understand what the cost to acquire these companies were and how much goodwill was incurred from the transactions. If the newly acquired companies do not perform as expected the company must write down the goodwill on the balance sheet. This will send total equity lower and debt/equity will then be higher.

Looking forward to February 2018 estimated EPS on a GAAP basis is $7.34. Based on a forward multiple of 16.5, we get a target sell price of $121.11.

Although there is good supporting information behind this trend, the numbers do not support an investment in Constellation Brands.

Trend investing can be very fun and exciting, but it is the result of a herd mentality. Often it is no secret that the trend is growing, so people pile into those very companies and bid prices up to unreasonable levels. Once the trend begins to dissipate or investors begin to realize the companies are overpriced, the stock price either falls out or goes nowhere for many years.

The tech boom and bust is the quintessential example of trend investing. Investors lost a lot of money during this time due to overpaying for hot tech stocks that were a part of the trend in the late 1990’s.

Looking at trends may be a good starting point to your research, but it should never be the final step. You want to make sure you are buying a company that has a good product or service, has room for growth, and that you are not overpaying for that company.   

Do you have a question or a company you'd like us  to take a look at?
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