When we think of Switzerland, a few things instantly come to mind – chocolates, watches, the Alps, and Swiss Banks among other things. One thing that doesn’t is surprises, and that is exactly what we got last week. The Swiss National Bank (SNB) decided to abruptly end more than a three-year peg with the Euro. The peg was initiated in 2011 with the big Swiss exporters in mind but maintaining the peg in the face of likely game changing monetary policy initiatives by the European Central Bank probably seemed too risky.
Unfortunately, markets are often not prepared for surprises of this magnitude so soon after a 14% rise in the Swiss Franc that day, there were some casualties. Those that made the headlines include losses to the tune of hundreds of millions of dollars at multinational banks such as Citi, Deutsche Bank, Barclays etc. and the near bankruptcy of forex brokers such as FCNX and Global Brokers NZ. While these were the first to hit the news feeds, they certainly won't be the last.
For the patient investor, however, opportunities can arise from such events. A casualty of the SNB decision was the Swiss stock market itself, down about 14% over the following 2 days. Investors took down individual stocks based on how much foreign (revenue) exposure they had. If we look at heavy weights in the Zurich market, names like Nestle, Roche, Novartis come to mind and for these companies there is clearly a mismatch between largely foreign revenues (in $, €, £ etc) and largely local costs (in Francs).
Here is a hypothetical effect on a typical exporter. The 15% increase in the Swiss Franc means a corresponding 15% decline in other foreign currencies. This would mean an immediate 15% decline in foreign revenues (upon converting to Francs) which would reduce profit margins if costs remain largely fixed in Francs. One way to deal with this would be to increase prices by 15% to make up for the decline in foreign revenues – but that would make the company uncompetitive in the global market. Could Nescafe really increase prices 15% in a competitive market without customers switching to other coffee brands, especially if the others don’t increase prices?
Difficult situation, right? Unless your only other real competitor is also a Swiss company. And you have strong pricing power associated with your product… Think high-end Swiss watches. In the current turmoil, we initiated a position in Richemont SA – a global leader in luxury Swiss watches and jewelry. The company owns enviable brands such as Cartier, Montblanc, Van Cleefs, Jaeger-LeCoultre, IWC, Piaget, Dunhill, Vacheron Constantin, among others. If there are some luxury watch brands I missed, they are mostly owned by Swatch Group, another Swiss watchmaker.
Being Swiss companies, both competitors are equally disadvantaged by the move in the Franc and there is no other credible competitor in this category (hard luxury goods). The target market for these products happens to be a demographic that continues to build wealth and is willing to spend on such luxuries. So price increases should be possible, as they have been in the past. Yes, the current end markets are going through a period of downward adjustment because of the crackdown in China, Occupy Central in Hong Kong, and the unstable situation in Russia and the Middle East because of oil – but these issues are largely transitory. I believe this is more than offset by Richemont’s qualities such as a strong balance sheet (10% of the market capitalization is in net cash), high profitability, and return on investment, a brand portfolio impossible to replicate, and solid dividend growth. With these qualities, the one thing that kept us from investing in Richemont in the past was a full valuation based on our models, and the 21% decline in the stock price over Jan 14 & 15 just took care of that.