Editor’s Note: In our final “Best Of” installment for 2019, we look back at the Kraft Heinz share price meltdown and the way it illustrates how value investing has changed. If Amazon is the poster child for dominance in the “disrupters versus disrupted” thesis, Kraft Heinz is the cautionary tale — and value investing in general has entered a world forever changed.
The Kraft Heinz share price meltdown in February 2019 showed how a popular version of value investing — as practiced by the most celebrated value investor of all time, Warren Buffett — has changed forever.
On Thursday, Feb. 22, 2019, the Kraft Heinz company (Nasdaq: KHC) reported historically bad earnings. The announcement was a nightmare. Not only did the company miss Wall Street estimates and issue weak guidance for the coming year, it slashed its dividend by more than a third and took a $15.4 billion writedown on the value of its brands. To add insult to injury, it announced an SEC investigation (minor, but embarrassing) into an accounting discrepancy.
Investors reacted with horror to the Kraft Heinz report. The company’s share price, which was already at a multi-year low, fell nearly 30% on a gigantic volume spike.
Kraft Heinz was supposed to be the ultimate value stock.
Warren Buffett’s Berkshire Hathaway teamed up with 3G, a Brazilian private equity firm, to jointly buy Heinz, a consumer foods company, in 2013. Then they merged Heinz with Kraft in 2015, in a deal that valued Kraft at $62.6 billion.
“This is my kind of transaction,” said Buffett at the time of the merger, “uniting two world-class organizations and delivering shareholder value.” The Kraft Heinz entity went public with a market cap of $89 billion. Today it is worth less than half that. Berkshire Hathaway owns 27% of KHC.
“We overpaid for Kraft,” Buffett told CNBC’s Becky Quick on Feb. 25. “Anything, almost anything at a price can be good. But everything at a certain price can be bad. If you pay too much, you pay too much and that doesn’t change.”
When Kraft Heinz announced its terrible earnings reports, multiple other consumer goods companies fell in sympathy. That is partly because the problems faced by Kraft Heinz are hitting the entire industry.
For at least the past few years, if not the past decade or more, consumer goods companies have seen a relentless focus on cost-cutting. The idea was to ramp up the profit margins of popular household brands with a ruthless focus on efficiency, slashing expenses to the bone.
This trend was embraced by activist hedge fund managers and led by 3G, the Brazilian investment firm that Berkshire teamed up with on the Kraft Heinz deal.
The main tool that 3G and others used was something called Zero Base Budgeting, or ZBB for short. The idea behind ZBB is to examine every single cost, with the goal of trimming every conceivable ounce of fat. If a cost can’t be justified when it comes up for annual review, the budget item is cut.
This hyper-emphasis on costs increases profit margins. Or at least it is supposed to. The problem that Kraft Heinz and other consumer goods companies ran into was that, after a while, their cost-cutting efforts made them so lean they were almost anorexic.
And then consumer tastes changed, away from traditional comfort foods and more towards healthy foods, with more natural ingredients. The brand value of Kraft and other household names started to shrink, and the trouble was made worse by the rise of private label brands.
For example: Kirkland, the in-house private brand of the giant retailer Costco, does more volume than all the Kraft brands put together. And Amazon Prime consumers are increasingly willing to go with whatever brand is the lowest cost, especially if the site labels it “Amazon’s choice.” With online shopping, trust is being transferred from the brand to the platform.
“[3G and Berkshire] both misjudged the retail-versus-brand fight as to who would be gaining ground on the other,” Buffett told Becky Quick. “With Amazon and Walmart fighting, it’s a bit like the elephants fighting. The mice get trampled.”
This is about more than just food companies. A whole style of value investing, with an emphasis on milking the power of big brands through a combination of efficiency and inertia, is going away.
One of the co-founders of 3G, Jorge Paulo Lemann, admitted this straight out at a Milken Institute investment conference in 2018. “I’m a terrified dinosaur,” he said. “I’ve been living in this cozy world of old brands [and] big volumes. You could just focus on being very efficient and you’d be OK. All of a sudden, we are being disrupted in all ways.”
In the Berkshire Hathaway annual letter for the year 2007, Buffett explained this style of value investing — a style he has used for decades — as follows:
A truly great business must have an enduring “moat” that protects excellent returns on invested capital… Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere.
The trouble today is that “stable industry” is becoming an oxymoron. We are in a period of such rapid technological change, nearly all industries are ripe for disruption — including some whose core functions haven’t changed for decades.
In short, the safe and stable are becoming the hunted and disrupted. Big, pedigreed companies with a trophy case of household brands no longer have defensible moats. They are under assault from flying drones.
The new moats are different than the old moats. They are rooted in technology and innovation rather than customer loyalty or brand pedigree. And the new moats typically require smart investment in new technology or new products, rather than preserving the status quo.
A positive example of new moat thinking can be found in Walmart, a brick-and-mortar giant that has held up under Amazon’s onslaught.
In its latest earnings report, Walmart reported impressive results thanks to big strides in online grocery delivery. Thought it is far behind Amazon in e-commerce overall, 90% of Americans live within 10 miles of a Walmart store. That has created opportunity in the grocery space.
Walmart has expanded online grocery pickup services to more than 2,100 stores, the Wall Street Journal recently reported, and offers online grocery delivery in more than 800 stores.
The key thing is that, to protect its franchise, Walmart is investing and innovating in areas of natural advantage. It isn’t hanging back. This is what the new moats are all about.
Whereas the old moats were all about benefiting from inertia and wielding a large marketing budget, Kraft Heinz shows why that doesn’t work anymore. The new moats are based in the ability to pivot and innovate at scale.
This shift has real implications for investors, particularly value investors. It is no longer clear what constitutes a “safe” stock and what does not. Many longtime household names, like Kraft Heinz, will become the disrupted and turn into value traps.
This makes it all the more important to think about the “why” behind the cheapness of a value stock. Is the company cheap for cyclical reasons that will show a turnaround? Or is it one of the disrupted and facing the chopping block?
TradeSmith Research Team