Why are so many prejudiced against luxury businesses?

Three years of austerity have been good for the luxury good sector. Who would have thought that Burberry’s shares would react to the consumer squeeze with a five-fold gain?

Even larger European luxury goods groups, like LVMH, have tripled. And, though seen by many as cyclical, these companies came through the previous market sell-off quite well. The sector seems misunderstood by many investors and analysts. Criticisms range from too expensive to cyclical. Why are so many prejudiced against luxury businesses?

In contrast to capital intensive cyclical sectors, most of the luxury businesses have scalable businesses that consume less capital. That kept them out of trouble in the credit crunch, when many industrials needed to deleverage and refinance. Credit may remain tight for some years, and growth businesses that can avoid equity issues or distress bank finance merit a premium. Superficially, these stocks typically have high price/earnings ratios and are not clearly cheap. So, just how much of a premium do they deserve? Arguably, investors should focus more on the stability of free cash flow and the robustness of these business models.

The surprise in recent years has been the emergence of the travelling luxury consumer, often tourists buying in London or New York. This reflects currency differences or lower availability of the top brands in markets like China, Brazil and Japan. The global footprint of these businesses extends beyond their store locations. And, the successful luxury businesses have been good at brand positioning and development. Their heritage can give them entrenched positions in their core product categories, but with a lot of potential to extend brands into adjacent areas. It is a sector where the strong can get stronger, and is wrongly viewed as simply a matter of betting on China’s growth. Most developing markets have an emerging middle class with aspirations for high quality products.

Bids and deals have been a feature of the sector too. Last year, LVMH acquired Bulgari at 28 times EBITDA (earnings before interest, tax, depreciation and amortisation). This highlights the value in the sector and potential synergies. British businesses now feature in the sector; Burberry and Mulberry are some of very few global luxury businesses that are independent. And, the luxury boom also extends to other strong global brands, such as those in the portfolio of drinks group, Diageo. Investors need to take a longer-term view of businesses like these.

The concept of luxury brands is not confined to a single sector, but ranges from retailing to beverages. In each sector, they are mixed up with businesses with quite different customer profiles, strategies and margins. The relatively small size of luxury brands in terms of market capitalisation, and the fact that that is spread across a number of sectors, reduces research and investor interest. And, creating a sustainable luxury brand is not as simple as Burberry and Mulberry make it look. The disappointments at Supergroup and Pandora highlight that. Investors need to understand luxury business models in detail.

The luxury sector has further growth potential, and may be less dependent on China and Brazil than the market thinks. It may also show defensive qualities in any material global slowdown, such as the strength of cash generation. In contrast with premium brands, austerity puts pressure on commodity businesses and those without margin protection or any uniqueness in their retail proposition. Luxury should continue its strong growth and has a role in long-term portfolios.

Margaret Lawson is fund manager on the SVM UK Growth fund.