There’s Good News and Bad News

Just 18 days after the Fundsmith Equity Fund opened, the first takeover approach for a stock in the portfolio occurred with the news that KKR is in talks to buy Del Monte Foods.

On one level this is good news. The price of our Del Monte stock has risen and will rise further if or when the takeover is completed. This will boost short term performance of the Fund.

But on the other hand it will mean that we will lose a stock which we wanted to own. We purchased Del Monte on a free cash flow yield of about 10%. This is an unusually high yield free cash flow yield for a good company. We think we were able to buy Del Monte at this attractive free cash flow yield because not many people understood what it does.

Most people still think of Del Monte as a producer of canned fruit (those cling peaches will be in the memory of everyone of a certain age). In fact 45% of Del Monte's sales revenues and about 60% of its profits were from pet foods, where it owns brands such as Meow Mix, Kibbles "Bits, Pup-Peroni, Snausages, Milk-Bone, 9Lives, and Nature's Recipe. It is in fact the fifth largest pet food company in the world. Its speciality is pet snacks and 'humanising' pet food. Our particular favourite is Snausages, which are made to look like bacon and eggs, for dogs' breakfasts. We keep a pack in the Fundsmith office to remind ourselves what we are investing in. Although if times get hard it may have other uses.

The superior profitability of Del Monte's pet food business is shown by the fact that its profit contribution significantly outweighed its sales percentage. As the fastest growing US pet food company, it was able to reinvest some of its good cash flow in compounding returns for investors.

We like the pet food sector. It is a classic small ticket, consumer, non durable of the sort we seek to invest in. In these products consumers are often brand loyal, they have no opportunity to negotiate on price and when they have consumed the product, they have to buy more. They cannot defer repeat purchases as they often can with durable goods. Pet food is a particularly good product category. Research shows that consumers will cut down their expenditure on feeding their children before they will cut down on feeding their pets.

Ask any vet which is the more lucrative areas to work in. Large animal vets which are dominated by farming, where the owners have to be ruthlessly commercial; or small animal vets where owners often treat their pets like full member of their families, or even as child substitutes, and will pay many times the cost of a pet to treat it. That is not commercially logical on the part of the owners, but it makes them a great segment to sell to.

So just as we have warned investors not to become dismayed by short term mark to market falls in the value of our portfolio when they occur, we are not going to become too elated about an early takeover success are we?

The Fundsmith team will now be in search of the next great business that we can buy at a favourable price. Now who can name the four pet food companies which are larger than Del Monte? (Clue: we can't invest in the largest one although we wish we could as it also has some great confectionery brands.)