Trend Investing: Do More than Just Follow the Herd

Recently a reporter asked for my thoughts on what investors should consider when investing in spirits and alcohol, an industry that has shown great growth numbers in the past several years.

The Distilled Spirits Council counted 750 micro-distilleries in the United States in 2015, compared with just 92 in 2010. And the U.S. craft spirits market showed a compound annual growth rate of 27.4% in volume and 27.9% in value between 2010 and 2015, according to the American Craft Spirits Association, a non-profit trade group representing the industry.

Time to Invest? Not so fast. Sure, micro-distilleries have seen a huge boom in popularity. It seems a new micro-distillery pops up every day in my neck of the woods in San Diego. Witness, too, Constellation Brands’ $1 billion acquisition of the well-known micro-brewery Ballast Point in 2015.

3 Considerations Before You Buy into the Micro-Brew Trend

Here’s my caveat, which I offer as a way to help you see how I weigh such investment decisions as an investment adviser (full disclosure, neither I nor my firm have a stake or financial interest in Constellation Brands). Though the trends appear positive, there are other factors investors must consider before buying into micro-breweries, or any hot trend, industry or company for that matter. You may love drinking Ballast Point beer, but you still may want to look more closely at investing in the micro-brewery industry through Constellation Brands, for three reasons:

• Amped-up competition. The field is getting crowded. 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.
• Cost of materials. If the demand for malt, barley, rice, rye and corn continues to rise, a supply shortage could develop and prices could increase. This would have a direct effect on the profit margin for alcohol-producing companies.
• Individual corporate strength. The final consideration investors must think about is the company they are buying. Just because micro-breweries are hot doesn’t make an investment in a distilled spirits company a sure thing.

Measuring Financial Fundamentals

Let’s take a closer look at the fundamentals for Constellation Brands (Ticker: STZ). It was trading at around $182 earlier this summer, with a 52-week range of $144.00 - $186.05. The company produces such well-known brands as Robert Mondavi wines, Svedka vodka and Corona, Pacifico and Modelo beers, along with the previously mentioned Ballast Point brand, with its Manta Ray Double IPA and Pineapple Sculpin ale. Constellation Brands’ sales have grown by 11.96% in the 12-month period ending Feb. 28, 2017, and EPS has risen 53.21% during the same time frame.

So far, so good. But 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 stood at 25.71 at the end of May 2017, which is above the spirits industry average of 9.8. This is a negative, as I like to see valuation ratios lower because it shows we are getting a good value for that particular measure.

The price to sales ratio at that time was 4.86, once again above the industry average of 2.66. Price/cash flow was 19.42, which is also above the industry average of 16.53. Like the P/E ratio, these valuation ratios all appear to be expensive when comparing to the industry average.

I have other concerns with the balance sheet. Two ratios that show the company’s ability to cover its debts include the current ratio (which considers the current total assets of a company — both liquid and illiquid — relative to its current total liabilities) and the so-called “quick ratio,” which looks at the company’s ability to meet its short-term obligations with its most liquid assets. Constellation Brands’ current ratio of 1.20 looked OK. I begin to worry if a company’s current ratio falls below 1. But the quick ratio of 0.47 made me pause. The quick ratio gives a better idea of the short-term liquidity for a company as it excludes inventory from the calculation. I would like to see this company build a stronger base of liquid assets on the balance sheet.

Total debt/equity was also high at 134.06%. In real estate, this is the equivalent of owning a million-dollar home, but owing over $1.3 million on that home. It is concerning to me the company has been increasing its debt load without repurchasing stock.

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 last quarter, goodwill was $7.9 billion and net intangibles were $3.4 billion. Much of this was due to Constellation Brands acquiring new companies.

It is important to understand what the costs to acquire these companies were and how much goodwill (which includes such things as the value of a company’s brand name and customer base, along with any patents or proprietary technology) 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 — which is exactly what Constellation Brands did in late June, when it recorded an $87 billion non-cash “impairment charge.” This could send total equity lower, and debt/equity would then be higher.

Looking forward to February 2019, estimated EPS on a GAAP basis is $8.74. Based on a forward multiple of 16.5, I get a target sell price of $144.21. I use a forward multiple of 16.5, because it is the 40-year average for the forward P/E. These numbers don’t appear to support an investment in Constellation Brands, in my judgment.

The Downside to Buying into a Trend

Trend investing can be very fun and exciting, but it can result in a herd mentality. As an industry’s growth increases, so does the number of investors bidding up share prices to overvalued 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. Many 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 1990s.

Looking at trends may be a good starting point to conduct 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.