Monday, Feb 25th 2019

Warren Buffett on Consumer Brands


"House brand and private label [goods] are getting stronger and going to keep getting better...we overpaid for Kraft."

One of Warren Buffett's biggest bets in recent years -- Kraft Heinz (KHC) -- fell more than -27% on Friday.

Kraft Heinz Fell -27%##

Last week, the global food company cut its dividend, announced a $15 billion write-down, and disclosed an SEC investigation into its accounting practices.

The main culprit, in our view: increasing competition from cheaper private label brands and many consumers "trading up" to healthier alternatives instead of Kraft's processed food products.

Buffett's History with Kraft##

The Berkshire Hathaway CEO teamed up with Brazilian private equity company 3G Capital in 2013 to acquire cash-flush, strong global brand Heinz. Buffett later worked with 3G to help finance Heinz's $49 billion merger with Kraft Foods Group in 2015.

Berkshire Hathaway is now one of Kraft Heinz's biggest shareholders, so KHC's write-down certainly took a toll on Berkshire's earnings. In an interview on CNBC, Buffett said he paid too much for Kraft, noting he might have misjudged certain aspects about the company. Here are some of his thoughts.

Buffett on Misjudging the Kraft Brand##

"I was wrong in a couple of ways about Kraft Heinz. Really strong brands can go toe-to-toe with Walmart, Costco, and Amazon, but weaker brands tend to lose out... *House brands and private label [goods] are getting stronger and going to keep getting better... We overpaid for Kraft."*

Why People Buy Brands##

Historically, many families purchased Kraft Heinz products -- from Oscar-Meyer to Jell-O and Velveeta -- not just for their taste, but for the low "search cost" they entail. For example, when families shop the grocery aisle, they know they'll consistently get the same quality if they buy Velveeta cheese (vs. a random private label brand).

Many would rather save time and effort, and just buy Velveeta, instead of searching for a little savings on a cheaper (but riskier) unknown cheese brand. These low search costs can create strong brands. Tide detergent and Charmin toilet paper are other good examples.

What's Changed?##

In the past, many consumers were willing to pay higher prices for a more consistent, low search-cost brand. We think that was a big part of Buffett's thesis for investing in Kraft Heinz.

Today, however, more stores are launching private label brands (for example, Amazon's 365 brand at Whole Foods, or Costco's Kirkland brand) at cheaper prices. Consumer preferences are also shifting toward healthier foods -- and let's be honest, Oscar-Meyer Lunchables aren't exactly healthy.

These secular pressures are reducing the pricing power that many consumer brands had in the past. It seems Kraft Heinz can no longer get away with charging such higher prices vs. the competition.

At some point, consumers won't pay up for consistency, especially if it's super unhealthy.

Tying It to Constellation Brands##

In the Titan portfolio, Constellation Brands (STZ) is our primary exposure to the branded food & beverage space. STZ has famous brands like Corona and Modelo beer which are growing at a healthy clip.

In contrast to Kraft Heinz, we think STZ is on the right side of shifting consumer preferences. Volumes are growing, not shrinking, because STZ is acquiring brands that appeal to the growing imported & craft beer movement.

Also, alcoholic beverages tend to be a vice that most consumers acknowledge isn't the healthier leisure activity. While some will search for low-carb beers and "skinny" vodka, beverage industry data suggests to us that taste & search costs are still the main drivers of purchasing behavior.

We remain positive on the brand value of Constellation's beverage portfolio, but will be keeping a close eye on how it evolves with consumer preferences over time.

As of this writing, STZ was a portfolio holding of Titan. This security may cease to be a portfolio holding at some point in the future.
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