The recent UK consumer squeeze shouldn’t deter investors from taking a look at consumer-facing stocks, according to EdenTree’s Phil Harris, who said many businesses selling traditionally discretionary items could paradoxically do well as inflation overtakes earnings growth.
The manager, who runs the EdenTree UK Equity Growth fund alongside Ketan Patel, argued that smaller items once seen as luxuries could become necessities as UK consumers sacrifice large-ticket purchases and feel the need to ‘treat themselves’.
This is despite the fact UK inflation has risen five-fold over the last year, with the Consumer Price Index having risen from 0.5 per cent in June 2016 to 2.6 per cent one year later. This has outpaced wage growth - which is now negative in real terms - and has sparked concerns that UK consumers could feel the pinch and cease spending money on such items.
Performance of CPI over 1yr
Source: FE Analytics
“The consumer as a whole is being squeezed slightly and you have to be a little careful,” Harris (pictured) said. “I suspect that people don’t stop spending, all they do is shift their spending. 
“Do I buy a car now or do I wait six months? I wait six months. Am I going to stop going to Patisserie Valerie to buy my cake and coffee? No, because you just shift things around a little bit.”
The manager said firms that sell large-ticket items will see some softness as many of these are purely discretionary purchases.
He used retail company DFS Furniture as a prime example, which – as covered in an FE Trustnet article last week – issued a profit warning last month and has experienced significant levels of volatility so far this year.
From the start of 2017, for instance, it has a maximum drawdown (which measures the most money lost if bought and sold at the worst possible times) of 21.31 per cent compared to the FTSE All Share index’s drawdown of 2.47 per cent.
“If your sofa isn’t great, you’ll still hold onto it for six months if you can. Do I still want my foreign holiday? Yes. Do I still want my coffee? Yes. If I have a pound, I am going to devote most of that towards leisure rather than big-ticket purchases,” Harris reasoned.
“It’s what they used to call the ‘lipstick effect’. During previous depressions in times gone by, lipstick sales soared. It’s because when there’s no money around, your little treat to yourself was to buy lipstick.
“A lot of these things are slightly counter-intuitive but people don’t want to give them up. What was perceived as a luxury is now a necessity, so there’s a hierarchy. If I’m short on money I won’t buy the car and I won’t do the garden, but I want my coffee, I want my Sky TV and I want to go on holiday. What you would have perceived to be a luxury or a necessity in the 1990s has totally changed.”
If history is anything to go by, the manager said the initial reaction of higher inflation against wage rates is for people to save their money. Not long after this, however, he argued that it is only a matter of time before people choose how they are going to spend their money and which discretionary items they will prioritise.
“If it continues into a year or so’s time and you can’t save anymore, you’ve done everything else, then you might see a different effect,” he admitted.
“But, at the moment, people - quite logically in some ways – are reacting to a temporary squeeze in income by not saving as much and re-allocating their money.”
One such stock Harris currently owns is the aforementioned café chain Patisserie Valerie, which floated in 2014 and is a constituent of the FTSE AIM index.
Since its IPO, the £351m stock has outperformed the FTSE AIM All Share by 61.75 percentage points with gains of 87.23 per cent.
Performance of stock vs index since IPO
Source: FE Analytics
The manager’s largest individual holding is producer of premium drink mixers Fever-Tree, which has outperformed the FTSE AIM All Share more than 24 times over since its IPO in 2014 with a return of 969.16 per cent.
“Both of those are treats. Fever-Tree is really seen as something where, if you’re having a nice drink, spending 50p or £1 more on tonic is still seen as feasible in the current climate,” he explained.
“They are a couple of classic examples where there is strong underlying growth potential which is almost irrelevant to consumer expenditure unless there’s a serious economic downturn. But anything other than that, they’re going to continue to perform incredibly well.”
Elsewhere in the portfolio, Harris has a very small holding in Domino’s Pizza, which he has actively been researching with an eye to increase the position. Following the release of its results today, the manager said the window of opportunity has now arrived.
“It’s a company that was almost a super-growth stock and has now entered greater maturity and the market is churning around trying to decide how to value it,” he reasoned.
“Drilling down into the results, they look robust. Like-for-like are slowing but against strong comparators. The shop opening programme is accelerating and more buybacks can be expected.
“Expansion may be slowing from historic levels, but I still see strong business growth and excellent cash flow prospects. The stock has been materially de-rated by over 30 per cent since March, which looks overdone. I believe the company is now attractively valued for the first time in several years.”
Another example of a stock the manager owns which has shifted from a luxury to a necessity over the years is car breakdown cover provider AA. As cars have become more complex, he said people are less able to fix them themselves and have little choice but to pay for the service regardless of a squeeze in spending power.
One discretionary area he is avoiding at all costs, however, is the pub and restaurant sub-sector.
“We have no exposure there,” Harris said. “The problem with the pub and restaurant trade is the maths, which are really quite simple.
“For the average pub company to break even, you need to grow your like-for-likes at around 3 per cent – it’s not an exact science because this depends on lots of variables. But these companies tend to generate between 1 and 2 per cent maximum per annum.
“They have to generate that 3 per cent to cover rent increases, higher inflation, input costs, the National Living Wage and apprenticeship levies among other things. In real terms, none of them are really going to do that.
“That’s why a lot of the pub companies and big restaurant groups have been struggling.”
EdenTree UK Equity Growth is in the top quartile for its total returns relative to its average peer over one, three and five years as well as over the last six months. However, investors should note that the £168m fund fell into the bottom quartile last year with a calendar-year return of 2.43 per cent.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
EdenTree UK Equity Growth has a clean ongoing charges figure (OCF) of 0.79 per cent.