We Study Billionaires - The Investor’s Podcast Network - TIP659: Hermès Stock Deep Dive w/ Shree Viswanathan

Episode Date: September 13, 2024

On today’s episode, Clay is joined by Shree Viswanathan for a stock deep dive on Hermès. Hermès is a luxury goods manufacturer renowned for its high-quality craftsmanship. The brand is known for its iconic products, such as the Birkin and Kelly bags, silk scarves, and equestrian-inspired items. Since the IPO in 1993, shares of Hermès have compounded at 20.6% (excluding dividends), while the S&P 500 had a total return of just 10.4%.  Shree Viswanathan is the founder and portfolio manager of SVN Capital. IN THIS EPISODE YOU’LL LEARN: 00:00 - Intro 02:38 - A business overview of Hermès. 10:28 - Examples of Hermès thinking exceptionally long-term in their business strategy. 30:16 - The attempted takeover of Bernard Arnault. 37:59 - The strength of Hermès’ moat. 56:01 - The growth opportunities ahead for Hermès and the luxury industry more broadly. 01:03:22 - How Hermès approaches capital allocation. 01:14:15 - Shree’s thoughts on Hermès’ valuation. 01:29:51 - Risks that investors should monitor for Hermès. And so much more! Disclaimer: Slight discrepancies in the timestamps may occur due to podcast platform differences. BOOKS AND RESOURCES Join the exclusive TIP Mastermind Community to engage in meaningful stock investing discussions with Stig, Clay, Kyle, and the other community members. Shree’s fund: SVN Capital. Follow Shree on Twitter. Best Anchor Stocks write-ups on Hermès. Books mentioned: 100 Baggers, The Founder’s Mentality, The Luxury Strategy. Stewart Brand’s seminar on long-term thinking. Howard Marks’ podcast with Morgan House. Related Episode: WSB585: Concentrated Value Investing w/ Shree Viswanathan. Mentioned Episode: WSB645: The King of Luxury w/ Christian Billinger. Follow Clay on Twitter.  Check out all the books mentioned and discussed in our podcast episodes here. Enjoy ad-free episodes when you subscribe to our Premium Feed. NEW TO THE SHOW? Follow our official social media accounts: X (Twitter) | LinkedIn | Instagram | Facebook | TikTok. Check out our We Study Billionaires Starter Packs. Browse through all our episodes (complete with transcripts) here. Try our tool for picking stock winners and managing our portfolios: TIP Finance Tool. Enjoy exclusive perks from our favorite Apps and Services. Stay up-to-date on financial markets and investing strategies through our daily newsletter, We Study Markets. Learn how to better start, manage, and grow your business with the best business podcasts. SPONSORS Support our free podcast by supporting our sponsors: Bluehost Fintool PrizePicks Vanta Onramp SimpleMining Fundrise TurboTax HELP US OUT! Help us reach new listeners by leaving us a rating and review on Apple Podcasts! It takes less than 30 seconds, and really helps our show grow, which allows us to bring on even better guests for you all! Thank you – we really appreciate it! Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm Learn more about your ad choices. Visit megaphone.fm/adchoices Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm

You're listening to TIP. On today's episode, I'm joined by Sri Viswanathan for a stock deep dive on Hermes. Shri owns Hermes in his fund, Svian Capital, and he takes a long-term, concentrated, patient approach to investing in public equities. Armes is one of the most valuable luxury brands in the world, renowned for its high-quality craftsmanship and rich heritage. The brand is known for its iconic products such as the Birken and Kellybags, silk scarves, and horse-related items. Since the IPO in 1993, shares of Hermes have compounded at 20.6% excluding dividends, while the S&P 500 has had a total return of just 10.4% over the same period. Hermes was founded in 1837, and it's still managed by the founding family who owns 67% of the shares.

These shares are controlled by three branches of the founding family, and combined, the shares are worth roughly $155 billion, making them one of the wealthiest families in the world. During this episode, Shri and I give a business overview of Hermes. We share the story of the attempt to takeover of Bernard Arnault, we discuss the strength of Armez's moat, the growth opportunities that lie ahead, their approach to capital allocation, their very rich valuation, and the most important risks going forward. This was one of my favorite episodes I've recorded on the show, so I really hope you enjoyed as well, as Shri shares a ton of fascinating insights during our conversation. Whether you're interested in Hermes or not, I think there's a lot we can learn about such a company that can somehow

be implemented into our own business or own personal lives in some form or fashion. With that, I bring you today's episode discussing the luxury icon, Hermes. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Clay Fink. Welcome to the Investors Podcast. I'm your host, Clay Fink. And today I'm happy to welcome back my friend Sri Vismanoth. And Shri, it's great to have you back on the show. Clay, it's a pleasure to be back again. you for inviting me and your pronunciation of my last name is perfect. I like that.

We do our research here at the Investors Podcast. So I've really been looking forward to this conversation for quite some time. I actually just visited Austin with a friend back in June and I made it a point to visit an Hermes store because I knew I'd be having this conversation with you. And over the years, I've looked at a number of different companies from an investor point of view and just being a host here on the show and doing what I need to do through interviews and such. And every once in a while, I come across a company that, just for lack of a better phrase, I think is just cut from a different cloth, whether it be the business model or especially the management team in many cases and how they manage the business.

And this year, I started to dig into Hermes. And I felt that this was just another case where I really wanted to understand the business better. And I think there's some lessons that can be learned from studying such a company. I really hope the audience understands where Shri and I are coming from here and seeking to learn more about a company from an investor's point of view, because in some ways, I think it can be a bit awkward to talk about a luxury company like Hermes, because generally our audience is full of value investors, many of which are hardwired to look for bargains, whether it be in the stock market or when they're shopping or whatever they're purchasing.

So if you aren't familiar with this company, you might go to their website and see that They're selling very expensive watches, $1,000 belts, $10,000 bags. So I wanted to bring Sri on the show to help shed more light on the company for our investing audience. Yeah. No, thank you for thinking about me as it related to Hermes. Yeah, it is one of my portfolio companies. I've owned it for a few years.

And it's just, as you mentioned, it's a fabulous, it's a true definition of a quality business. We'll get into the details of how I define quality and why Hermes is still an interesting proposition for your followers and other investors. But yeah, nicely cut from a different cloth. I would just add cut from a different leather. That's right. Cut from a different leather. So how about we just start with a general overview of the company?

Vincent Churchill said the farther back you can look, the farther forward you're likely to see. Fortunately, Ermes gives us more than 187 years to look back, although we have a much shorter history of only 30 plus years to look back since it went public in 1993. In the past, Claven, I've talked to you, I've seen this book, Hunter Bagger by my friend Chris mayor right behind you. That's a fabulous book. In that book, he says that on average, it takes about 25 years for a company to become a hundred-bagger. He was right on the button. Hermes took 25 years since going public in 1993 to become a hundred-bagger in 2018. It's gone up more than 4x in the last six years since 2018 for a total return of more than 400 times since IPO.

I'm sure we'll get into some of the quantitative features of the business later. Let me get to the qualitative overview that you just asked. Hermes Paris is a prestigious luxury brand renowned for its exceptional craftsmanship and rich heritage. As I just mentioned, the name is Hermes Paris, not just Hermes, although outside of France in many of the stores, it just goes by Hermes. You know, the great Emerson in his essay title, The Self-Reliance, he says, an institution is the lengthened shadow of one man. Hermes is a very long shadow of theory Hermes, who founded it in 1837 as a hardest workshop. The company was selling high-quality saddles and other leather goods to Europeans and ended up being European nobility over time. Over the years, the company has evolved into what we now know as a global luxury powerhouse,

maintaining its reputation for exclusivity and quality. It's celebrated for its meticulous attention to detail and the artistry involved in its products. The brand emphasizes artisanal skills with many items handcrafted. The commitment to quality has positioned their mess as one of the most valuable luxury brands globally. consistently ranking high in brand valuation studies. A few weeks back or months back, maybe you talked to my friend Christian Bellinger about LVMH and Kaffer's book The Luxury Strategy, and I'm sure we'll get into those as well.

But luxury, this is probably a good time to kind of also define luxury as I'm defining the qualitative features of Hermes. luxury has always been morally condemned. In ancient Greece, it was the philosophers, and today it's more the moralists and politicians. Be that as it may, luxury is here to stay. We have a very large and rapidly growing sector with both public and private companies. But given this moral condemnation, it also is appropriate to highlight that luxury as a concept has been around in the old continent in Europe and to a certain extent in Asia. It's actually relatively new in the US. So what's luxury? And are there many, many definitions of this word luxury? But one that I really

liked was from Bernard Arnaud, the CEO of LVMH, said it's the ordinary of extraordinary people and the extraordinary of ordinary people essentially gets to the heart of luxury strategy. Let me come back to providing this qualitative overview. You know, Hermes as a company, has 16 meteors. It's a French word. It's essentially a specialized metiers, a specialized craft or area of expertise within the company. Each matier represents a distinct domain of craftsmanship and creativity. We'll come back to that details as to various different components of this.

But the products that Hermes now produces falls into four. four buckets essentially. Leather goods, which is the largest within the company, accounts for about 50% of sales, features the iconic brand names like the Birkin bag and the Kelly bags. Number two is the ready to wear. That's about 23% of sales. That includes clothing and accessories for both men and women. Number three is silk and textiles. That makes approximately 10% of sales. In the olden days, it was known for its luxurious scarves and ties and other silk products. But as leather has kind of become big within the company, within luxury in general, silk and textiles has come down to about 10%.

And then the final category, which is sort of all encompassing, is what's defined as watches, jewelry, and other home goods. And now that's the business end of it. What started off as a French company selling to the French, more than 187 years ago, has now ended up as a French company that exports almost 90% of its products. They still keep about 75% of the production within the country, and that's not by accident. That's a big part of the bigger strategy. Currently, they have 54 production sites across the country, within 11 regions, 23,000 employees.

7,000 of them are artisans, and they sell it through their controlled and distribute. mechanism, about 300 stores around 45 countries. Shri, as I've been involved in the podcasting space for coming up on three years, I've recognized this importance of the short-term versus long-term trade-off and trying to find the right balance between the two. And that balance is going to look different for each company. For the podcast, for example, we know that listeners do not like hearing ads. They're going to hear ads during this episode, and they'll likely continue to hear ads. But without ads, we wouldn't be able to have this conversation.

So inevitably, it's sort of a sacrifice we're simply willing to make in order to provide this content for free. Now, in the case of a luxury company, they might see a lot of a demand for a product, like a Birkin or a Kelly bag. And many management teams are going to be tempted to try and increase the level of production as much as they can to try and boost the earnings. But this can be harmful to a luxury brand if it ends up decreasing the perceived value. of the brand. And I think Hermes sort of epitomizes what it means to think long-term and not

really make these shorter-term sacrifices to boost short-term earnings. So I was curious if you could speak more to this. That's a wonderful question about long-term. Anytime this phrase long-term pops up, it piques my interest. Not to digress too much. I'm sure you've heard of Stuart Brand, the founder of Whole Earth Catalog. He created something called the Long Now Foundation. which is essentially seminars on long-term thinking. It's a wonderful platform to follow. You may already know this with some of your followers may be interested. Back to your question,

while there is no perfect count back in 2008, Bank of Korea found out that there were about 5,500 companies around the world that were more than 150 years old. At more than 187 years, there was already a part of a select group. long-term is in its DNA. For Irma, as long-term thinking is core part of its business philosophy and strategy. To support that long-term thinking, there are many factors that go into supporting that.

Let me just highlight a couple of them, and maybe we can address a few more as we go along. Quality is absolutely paramount to Hermes. One of the important features of this long-term thinking is the quality of the products. And again, allow me to digress a little bit. Walter Isaacson in the biography of Steve Jobs, he writes about how Steve Jobs was passionate about quality of the computers. Steve and his father were working in building a fence around their house in Mount Mayo, California.

When his father said, you know, you got to make the back of the fence that nobody will see just as good looking as the front of the fence. Even though nobody will see it, you will know it, and that will show that you are dedicated to making something perfect. This idea stuck with Jobs, and when he made the Macintosh, he had the engineer's names engraved inside each one of those computers. And he said, real artists signed their work.

No one would ever see them, but the members of the team knew that their signatures were inside. Why do I bring that Steve Jobs episode here? Because I sometimes wonder if this quality obsession of Hermes had an influence on Steve and how he thought about quality. While there is no direct evidence, similarities are striking, I think. When many of Hermes' competitors began using sewing machines, Hermes refined the 400-year-old saddle stitch so that connoisseurs could distinguish between their inevitable craftwork and mechanical sewing. A saddle's underside rivals its upside.

It's inside, outclasses it's outside. That's the classic stamp of a quality product. Therein lies that nobility. Irma's products are made to last a long time. Axel Dumas, the current CEO, and he says we want our products to look even more beautiful 10 years later. In these types of products, there is no planned obsolescence or forcing the customer to buy a new collection because the previous ones no longer make sense.

So that's the type of commitment, that's the type of quality that Ermes brings to its products. Another trade that lends to this long-term thinking is craftsmanship. Now, Ermes invests heavily in training its artisans and preserving traditional craftsmanship techniques. They take a patient approach to production, focusing on quality overspoken. speed. Let me tell you something about this lady Christine Nagle. She's the head of the perfume division of Vermez and is termed as the nose of Hermes within the company. Perfumes make up just a few percent of the total business, but I think what in a recent interview that I read, what she said about her work, her career, and Hermes's employer is very appropriate in terms

of defining this craftsmanship. She created this perfume called H-Termes. This is the first perfume for men in the last 15 plus years. Christine is the first female perfumer for Hermes. She has the gift of what's called as synesthesia. It's the merging of certain senses. She says, odors have a color for me. She has the unique ability to smell and taste color. Hermes, she says, is a playground for me,

and I'm happy to work for a house with a lot of stories and roots. My day-to-day life here inspires me because I don't have the limitation of time or price. And choosing a perfume is not a question of marketing, but if we like the perfume or not. I'm exercising the real job of a real perfumer. We like to go where no one else has or will go. What's remarkable about Hermes is the constant faith placed in creation and the creator. And that's a very, very important phrase to remember. all through this. Armus's commitment to the creation and the creator. I'll come back to that

and a few other places later. She says if I was chosen by the house, it was for this signature. This recognition is a source of delight every day because I'm living my dream of creating fragrances that uphold and embody all the values of this house. My only aim, therefore, is to create exceptional fragrances. That's a little bit about the craftsmanship that I mentioned. This is an integral part of how the company has put together this long-term success story. I think there's so many examples within the company we can think of where they truly think long-term. And one that certainly comes to mind that I'd like to mention is during the 1970s, they were going through some issues as a company.

And I believe they were speaking with some consultants. These wise consultants were like, hey, you need to start doing what all these other luxury names they're doing, you know, take production elsewhere, minimize costs, increase efficiencies, cut corners on product quality and such. Thankfully, they didn't go that route. And I believe they even adopted a corporate philosophy of no consultants. They just operate in a much different manner. Yeah, absolutely. As you correctly pointed out, this is a unique business and a unique management team in many regards. That's one of them. I told you that they have this commitment to the creation and the creator. There are many examples in that sense. For example, there was this

leather artisan from France who moved to Japan. Primarily, his responsibility in Japan was repair related work. And one day, Hermes got a request from the Empress of Japan, saying that she wanted one of the bags that she carried that had some sort of a strip, a leather strip. She wanted that to be removed. And this gentleman, this artisan, took a look at the bag and he suggested that they not remove it. If it was removed, it would change the complexion, the quality, and the true value of the bag. So he did the unthinkable, which is stand up to the impress of Japan. Obviously, this became a big issue. And the current CEO, Axel Dumas, father, Jean-Louis Dumas, was the CEO at that time. It got to him. He intervened. He listened to both.

sides, and he agreed with the artisan that cutting that strip out would essentially change the nature of the bag. And so he actually had a new bag without the strips, sent back to the impressive course. But it tells you a little bit about how the management team and the culture within the organization is all for the artisan and the creation. So Airmez is well known for being a family owned and family controlled business. They opened up shop in 1837. And as you mentioned, they've been operating in that manner for 187 years. I look at Air Meds and it just reminds me of one of those companies that doesn't seem like it should be public, just because it operates much differently than your typical public company.

So talk about the family ties and what even led them to being a public company. I mean, in answering your previous question, I listed just a couple of the features, quality and the craftsmanship. but the other important feature is this, a family ownership. This might be, in fact, slightly more important than many other features. Now, it's a classic family business. Company, as you said, that's more than 187 years old. There's a lot of history and some monumental decision points along the way. Axel Dumas, he's currently the sixth generation family member,

who's the head of the organization. And from the Dumas family branch is his country. cousin, Pierre, who is essentially signing off on every product that comes out of the company. So the top two spots are held within the Dumas branch of the family. I'll come back to that in a second. While there isn't a precise count of sixth generation family-run companies around the world, data suggests that such businesses are quite rare. Now, the odds of a sixth-generation family business is 500 to 1. Only 3% of the family business is 100 to 1. Only 3% of the family business is operated the fourth generation.

30% of businesses get to the second and only 12% get to the third. So Hermes is currently in ratified air, I would say. But why is that important? There is a wonderful book called The Founders Mentality by Chris Zuck and James Allen. They say that the founder's mentality constitutes a key source of competitive advantage

and it consists of three main traits. an insurgents mission, owner's mindset, and an obsession with a front line. They go on to show that the returns to the shareholders on these types of companies is three times higher than in other companies. Back to Hermes, it's actually controlled by three branches of the founding family. The Dumas family, which I mentioned, Axel Dumas, is part of that branch. There is the Gurran family, pardon my French, actually. As you can tell, I'm originally from India, spent a lot of my life here in the U.S. I have an accent that's neither European nor American. And so I may be mispronouncing some of these French names. But the second family is the Guiran family,

and the third one is the Pueck family. These three branches are descendants of Emil Maurice. He was the grandson of the founder of theory. Together, these three branches of the family, they currently control 67% of Hermes. And this combined, ownership is currently worth about 155 billion, making it the world's third wealthiest family. Al-Nahian family, the family that controls Abu Dhabi and Walton family from the Walmart wealth. Those are the only two that are ahead of this family group. At Ermas, the family itself is one of the secrets and principal assets of the brand's success. They're the keepers of the heritage and know how to make it evolve.

without a revolution. Created in 1837, the company has always been independent and has been passed down from sun to sun as it expanded over time, from harnesses to saddles to everything that they sell today. Theory was the founder and his son, Charles Emel, he took over the business in 1880. And here's an interesting stat.

He's the one who moved the company to 24 Fowberg, which is the headquarters even today. More than 150 years later, that is still the headquarters of the company. After Charles Emile, he retired, you know, his two sons, Adolf and Emil Morris, they took over. And watching the decline in sales of horse harnesses and saddles, Adolf, he left the business in 1919, letting Emil Morris be the sole owner. That was the glorious period when he introduced many products that are popular even today. For example, Saka-Depish, which is essentially the Kelly bag that we know today, silk scarves, leather jacket with a zipper. These were all introduced during that period in the 20s and 30s.

He had three daughters, and so Emil Morris groomed his sons-in-law in the business. In 1951, Robert Dumas, he took the helm. He was one of the sons-in-law, of course. He's credited with the success of the Kelly bags, even though they were. founded a couple of decades earlier. In 1978, his son, Jean-Louis Dumas, he took the helm, and he's credited with making the Birkin bag, which is even more expensive today. In 2003, for the first time, and the only time, Patrick Thomas, who was not a family member, he took over as the CEO. He ran the company, and he's the one who successfully defended

this hostile takeover attempt from Bernard Arnau of LVMH, and then he handed over the reins to Axel Dumas, who is currently the CEO. As to why Irmaz remains public today, Jean-Louis Dumas was the CEO in the early 90s when he took the company public. He had a few reasons, apart from providing capital to strengthen its financial position,

going public, now allowed some of the family members to liquidate their holdings. And John Louis said, you know, it helped lessen the family tensions by allowing members to sell some shares without disputes over valuation among themselves. Today, in addition to the family itself owning such a huge percentage, about 80% of the employees own some shares of Hermes. So it's also turned out to be a good compensation tool for the company as artisanship and culture within the organization is all important for the company. So that's a little bit about the history and why they went public and why they remain public. Let's take a quick break and hear from today's sponsors. All right.

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I think it's a good point to also mention another extremely wealthy billionaire who you just mentioned Bernard Reneau. Christian Billinger and I chatted about him and LVMH back on episode 645 for listeners that want to learn about that company. you mentioned the attempted takeover. With this being a family business and very high ownership within the family, that really didn't stop Bernard from that attempted takeover, which ended up being unsuccessful. So I was curious if you could just tell this story because it's just so fascinating.

It just points to sort of Bernard's character and who Hermes is in that, you know, their family company and they're not going to let a corporate raider come in and take it away from them. Yeah, this was a momentous episode in the momentous episode. long history of Hermes. Just a couple of hours before the world would find out on October 23rd, 2010, Patrick Thomas, as I mentioned, he was the CEO. He was the first and the only non-family member who was the CEO. He was cycling through rural France when he got a call from Bernard Arnaud.

He took the call standing on the side of the road. Arnault wanted him to know, you know, he was just alerting him that LVMH would be announcing that it had acquired 14.2% stake in Hermes. Hearing this, Patrick, who was enraged, had an immediate and colorful response. Unfortunately, I can't repeat it here, since it's not appropriate for a family-friendly show like this. But your listeners can go, Google, and find out what exactly was his response. And as the family's anger and protestation were gathering steam, within less than a week, LVMH announced that it had raised its stake to 17.1%. The big question in the minds of Fannley and Patrick and everybody was,

how did they build such a big stake? Here's what they were able to find out. Between 2001 and 2002, LVMH acquired 4.9% stake through a handful of subsidiaries. French law requires the acquirer to disclose the identity if you go past 5%. and if it reaches 10%, the acquirer has to disclose his or her intentions. That's the reason why LVMH stopped at 4.9. To hide its identity, LVMH had banks in Luxembourg and Panama purchased shares in Hermes on its behalf. The LVMH then paid these banks in cash in order to avoid any sort of a discovery.

Nothing happened for about five years. Then the action started again in 2000. 2007, when LVMH engaged in a string of complex cash-settled equity swaps through financial intermediaries and subsidiaries. However, in 2010, LVMH's stock swaps with its own subsidiaries brought its stake in their mass to an accumulated 14.2%, which is what triggered that call. In spite of strong protests from Pueck and Goran and, you know, Dumas families, LVMH maintained its stake and flatly denied that it was entertaining ambitions to slowly gain control and take over a mess.

While the French regulatory authority started an investigation into LVMH's investment, Patrick Thomas said, I'm not a fan of conflict, but I can fight from time to time if necessary. He quietly helped the family set up age 15. a private holding company with more than 50 family members who agreed to pool all their shares and to keep them in it for at least 20 years. H-51 was designed to have the first right of refusal should a family member decide to sell. LVMH, of course, then back down in spite of this investigation and all those responses from the family. In fact, in May 2011, it announced that its stake had gone up to 21%.

And this Ellison did further response from the family and Patrick. Patrick said this whole affair is ungentlemanly. Hermes' culture is fundamentally incompatible with that of a conglomerate such as LVMH. Bertrand Puet, the head of that

branch of the family, chairman of the company, said, you know, we are the target of inciscent attacks of the kind we have never seen in 174 years. Even though LVMH says its approach to us as friendly, I don't agree. With friends like this, who needs enemies? Every time MERS'H responded verbally, LVMH opted its stake. By the end of 2011, its stake had gone up to 22.6%. As you would have suspected by now, there were suits, counted suits, back and forth,

and the regulatory authorities were concluding their investigation. And when they did, they ordered LBMH to pay $10.4 million for serious and successive breaches of public disclosure requirements. LVMH said it would appeal the ruling and you guessed it increased its stake further. Now, to 23.1%. The two parties were unable to resolve their differences in court cases continued on for a number of years, for a few years after that. And finally, in 2013, Bernard and LBMH announced that they'll distribute the stake in their Hermes to its shareholders and institutional investors.

Even though he had been building up a stake for about nine years, he talked about Hermes for the first time in an earnings call in 2011. Now, Bernard said something very interesting. He said, I understand that they were a bit surprised that we came in, but we ourselves, we didn't expect to become shareholders of Hermes. And the circumstances meant that starting from a financial investment standpoint, for technical reasons, it was more or less imposed upon us. In the same call, Bernard acknowledged the question about the difference in culture between the two organizations. He said, I'm often told

that Hermes culture is different from that of Louis Vuitton. Well, that's true, but do you prefer Hermes or do you prefer Louis Vuitton? Do you prefer Proust or Stendor and the two great riders? I think we can prefer one or the other, but we are bound to recover. recognize that both are great talents. He said, Christian Dior's culture is different from that of Chanel's, which is different from that of Firmes, and that's different from that of Louis Vuittons. I find it rather pointless to oppose cultures. What I believe is that LVMH in today's world is best placed to preserve the crucially important

cultures for the future of these companies. And now that we are a significant shareholder of Firmis, we can guarantee the preservation of their culture in the long time. So that's all about how Bernard and LVMH came at this. But remembering this event and how they went through, the family finally put another fine touch on this ownership. In 2022, they took a further step to unify this family ownership by bringing eight families together under an investment vehicle called Creffeld Invest. Krafeld is where the founder, theory Hermes was born. So this will be a family ownership business for a long, long time. This was, as I said up front, a very colorful and a momentous episode in the long history of

Armes. What a wonderful story. Just to put some perspective on where shares were when Bernard started buying around 2001, shares of Hermes were trading around 50 euros then, and today shares are trading north of 2100. So that's a overall. over a 40 times increase, and of course he doesn't own that stake anymore today. But yeah, he saw the tremendous value in EMS certainly. I want to transition here to talk about their moat. I think it might sound ridiculous to some in the audience to think that a company that sells handbags has a strong moat. I had asked Christian Bellinger, what is it that makes a luxury product different than, say, a premium product or a high quality product? And he mentioned the importance of singularity.

So the product and the brand are really in a category of their own, and they simply can't be compared to other products in the minds of consumers. And in preparation for this episode, my friend Leandro, who writes the blog, Best Anchor Stocks, he did this wonderful five-part write-up on Hermes that I found to be quite helpful, which I'll be sure to get linked in the show notes. So when looking at Hermes' competition, one could argue that Hermes and some of the other luxury players are competing for a set amount of luxury dollars, let's call it. And the way Leandro puts it is that the typical luxury customer rarely has to choose between the product of one company

versus another. So if you're an Hermes customer and you see something that you like at Brunello Cuccinelli, for example, then you likely aren't going to delay the purchase of a Birkenbag to make that other purchase. And since Hermes is sort of at the top of the luxury industry, this dynamic, I think, plays more into their favor maybe than some of the other players, presumably because they are appealing to the higher-end customers. So let's cover the moat and what gives you confidence in the long-term sustainability of the moat. Clay, before I forget, with respect to this Bernard Arnaud question, I just want to make one more comment or maybe a couple of more comments. One is, Hermes was not the first one that he missed. He tried doing something similar with Gucci before it ended up in what is now known as caring. And the second comment I want to make is there is a similar effort going on at Richemont today. LVMH has a deep interest in Richmond as well and there's likely some change of management team coming up within that company and he finds many of those brands very attractive. I just wanted to mention that before I forgot.

your question about the mode of Hermazia. It's a wonderful question. Before talking about the mode, I think it's appropriate to again bring up Kaferr's book, The Luxury Strategy. I know you discuss that with Christian. Three very important takeaways from that book. One is the 24 anti-loss of marketing which you discussed. Second is that dream equation. Now he explains it very beautifully. He says a basic product corresponds to a need. If you're thirsty or you need to go to a hospital, the role of the basic product is to do this at the lowest cost. A branded product corresponds to a desire, a wish. Now, we are thirsty and we desire a high-quality beer, preferably on tap.

A luxury product, on the other hand, corresponds to a dream. They do not need to be satisfied. Sometimes their existence alone makes us happy. luxury brands must be, you know, sensitive to the difference between their level of awareness and their penetration. And he says, in this difference lies the dream. The product is known by all, but bought by a few. So I think that the dream equation is another major takeaway from that book. The third one is art and luxury share several characteristics. For example, art value grows over time. How can art achieve this feat?

It does so by being totally independent of function. Just as art has done, luxury must decarolate price and function, according to Kaffir. So those are, I think, key takeaways and are worth keeping in mind as we talk about the mode of quality business like Hermes. And I'm sure you've heard of this gentleman Francois Rochon, who runs Givani Capital out of Montreal, Canada. He wrote a fabulous newspaper article in 2014 titled Finding Durability Value is Tough, but is worth the effort. He says, you have to look for three important things in a prospective company. Competitive Edge, durability, and culture.

I don't think he had Hermes in mind when he wrote this, but all three are present in plentiful within Hermes. Competitive advantage can be a brand name, reputation for excellence, or a monopoly position. Irma's brand name has not just survived, but thrived over the last 180 plus years. And as for the Lindy effect, it's likely to last that long. Quality of a product,

which I talked about earlier, lends to that reputation. And while companies like LVMH and Chanel offer some similar products, Irma's doesn't look too much of the competition because they fear they might be influenced. Durability, at Hermes, the products are made.

to last for a really long time. Patrick Thomas, the former CEO, in a recent interview, he talked about an incident where, when he was the CEO of the company, he talked about an incident when a famous actress, he didn't name her, happened to be her friend, you know, who had a saddle in possession. And she had some issues with the saddle. So when she came in to meet him, brought the saddle and told him about some of the issues that she was facing.

He took her to the saddle shop near her. buy and the guy at the artisan at the saddle shop took a look and asked her and I went and where did she buy this and this is a very interesting side note at their mass they maintain a log of all the purchases made essentially a big book of all the purchases made details of the purchaser the amount the item purchased and if it was repaired when where things like that so this guy was able to go to the log and see if he could find this actress's name and the details. He couldn't find it. And she remembered, no, I got it from my mom. So he said, okay, let's go look for your mom's name. And they went and looked for it. They couldn't find it. And she thought, okay, maybe she got it

from her mom. And bingo, it was the grandmother who had purchased the saddle more than 70 years before she came into the office and had never been repaired. Now, that's durability. at its best. So that's the second feature that Francois O'Shaun, for example, writes about in that article and the culture. You can appreciate the culture within the organization, not just from the family standpoint, but from the 23,000 employees as well, particularly the artisans. As I mentioned, the commitment to the creator and the creation has developed a very unique culture within the organization. I already mentioned this diplomatic quandary that they found themselves in when And this gentleman, Francis Norbert, from France, he went to Japan and stood up to the Empress.

And all three factors are sustainable over a really long term. And these are the sort of features that combine to form what is called us the moat within the organization. There's a couple points I'd like to hit on there. So I pulled a quote from Axel Dumas from the 2022 AGM that ties in well with your comments. He said that, Performance is important, but resilience is of paramount importance. I wanted to also mention the Birkin and Kelly bags because the high desirability of these products are extremely important. And getting these bags is not easy. You and I just can't walk in and just pick one up off the shelves. It's a process, and I'll give you the opportunity to share a bit about that if you'd like. So to give the audience a sense

of the prices of these bags and sort of their history, the Kelly typically reads. details for somewhere around $7,000. And then the Birken bag, it's a bit more expensive at $10,000. And one thing I found just extremely fascinating with this, you're talking about the durability and the resilience of the brand. These two bags have had a compounded annual growth rate of 4% in their price over the past 50 years. What's also very interesting in pointing to the desirability of these bags is that oftentimes

customers can buy these from Hermes and they can sell them tomorrow in the off market for more than what they bought it for. It just like it goes completely counter to what we learned about business. And it just points to there's a lot of untapped pricing power with these bags. And that's likely to be sustained for a very long period of time. Who knows how long? It seems quite durable. Absolutely. Absolutely. Yeah. Those prices that you mentioned, And there are actually 17 different bags, at least that I am aware of, that the company makes. Birkin and Kelly are the two famous ones. Close to those two are the third brand, which is Constance.

There are many other brands of bags that they manufacture. The 10,000 for Birkin is at the lowest end. The price of the bag depends upon the complexity involved, the skin type, the quality of the leather. For example, the crocodile skin is one of the most expensive, and they have something called the Himalayan crocodile skin color. Himalayan is not necessarily to do with the mountain, but it's more the color white with a blend of gray in it. When you see it in picture, you'll see what I'm talking about. But those things go for hundreds of thousands of dollars. That's just retail. And you're right, these bags are not necessarily available

for us to walk into a store and buy it on the spot. Typically, this is, again, part of the culture within the organization, part of managing the brand, managing the supply, and everything associated with making sure they put out the best quality product that lasts for a long time. And so to begin with, these bags which are made by these artisans, it takes a long time. So, for example, an average mass market automobile can be put together within somewhere

between 18 to 35 hours. It takes about 40 hours to make just one bag, one Birken bag. It takes about 20 plus hours for Kelly, which is apparently a little less complicated, but still, it gives you some context. And the other interesting and an important feature here is, Irma has a requirement. that the artisan who makes the first cut on the leather gets to essentially complete the bag. So it's one artisan working on one bag.

That's the reason why it takes about 40 hours. And by the time the artisan gets to make the first cut of this very expensive leather, the artisan has gone through some serious training. The company hires about 200 artisans a year and they go through mandatory schooling for about a couple of years, and even after that, it takes about six years for them to work with a veteran and another couple of years after that before they can graduate to making

the first cut for a Birkin or Kelly. So it takes a really long time. In the meantime, as I described, the veteran who is well trained is also not necessarily focused on making the product every day because he or she is now having to spend time with these novices who are growing within the organization. So the culture and the commitment to quality comes from a variety of different angles. And so the margins on these products are immense. While they don't necessarily disclose what the cost is on a per bag basis, if you look at the gross margin of this business, you may think that it's more like a software company at 70%. consistently over time. It's partly because of the pricing that they're able to obtain on these

really high-quality products. Back to your point about pricing and the ability to walk into a store and buy these things, yeah, that's not possible because there is significant demand for these products and at the same time they have serious constraint in how many bags they can actually put out. unofficially, I've seen numbers, something like 12,000 Birkin bags a year. For a company that's about 240 billion in euros in market cap, 12,000 bags a year and each bag taking about 40 hours, that's partly self-constrained and at the same time that commitment. So that all translates into a really healthy margin,

and net margin, in fact, has continued to go up. Post-COVID, net margin has also gone up quite significantly. These bags are not readily available, even though the company has, in fact, the fastest growing segment within the company is online. You can buy many products within, you know, from the online stores, but you can't buy these two bags or a few other bags that they manufacture through the online option. As a result, you know, the company maintains sort of a wait list. It's an unofficial wait list. You are not required to put a deposit down. you're required to put your name and contact info down as in when that particular salesman or the

representative at the store finds it available and interesting enough picks up the phone and calls you and if you are ready you go by if not they go to the next guy on the wait list and these wait lists go from anywhere from one year to six years it moves around a little bit and that again lends to the stable top line over time. In fact, both Hermes and LVMH or the two companies that had positive revenue numbers even during the financial crisis. Now, the numbers did go down.

They were down about 7 plus percent in Hermes during COVID, partly because most of the stores around the world were shut down. But the fact that even during the great financial crisis, the company was able to put out positive revenue numbers tells you a little bit about how this wait list helps them remain committed to quality and continue to put out strong top line. One comment I have in relation to the Birken and Kelly bags, they almost require customers to spend something like three times the amount in the store on other items before they get

the call and say, hey, we have a Birken or Kelly ready for you and they don't even get to pick the color of the bag they're going to get. Something about it almost doesn't feel right. and it makes me think of the luxury strategy, the anti-law of marketing that mentioned to dominate the client. I mean, that's what dominating the client looks like. That brings a question of why aren't some of these customers just going out and purchasing the exact bag they want from just somebody else and not going directly to the store? I'm curious your thoughts on that. Yeah, I think that's a wonderful question.

In fact, there is actually a case going on. A couple of purchasers from California filed a suit alleging that there is something called this time. which is you get to buy the bag only if you buy a few other items. Not sure how this is going to settle, but it is a live case that you bring up at this point. It's tied to this question about why aren't customers willing to go buy other products? Well, that tells you a lot about the quality of something like a Birkin or a Kelly. There are no alternatives. There are really no alternatives for something like Birkin or Kelly. If, it was available, yes. Many of these buyers would gladly go by, you know, those alternatives.

Yeah, Chanel puts out good quality bags, but it's not a Birken. Louis Vuitton puts out good quality bags, but it's not a Berkin. So there is something about a qualitative feature of this name Berkin or the name Kelly that brings credibility to these bags that is absent in many of them. With some of the buyers, it may not matter, but many actually crave what actually wait for a few years to get their hands on these types of bags. Peter Bernstein in 1956, he wrote a very interesting article on Harvard Business Review. He talked about growth companies, provided essentially a checklist of growth companies, and he listed a number of items. A few of them are relevant to this point that you're raising. One of them is the ability to create

its own market is the strategic, dominating, and the single most distinguishing characteristic of a true growth company. The company's products have above-average profit margins. The products have little to no price competition. The company is constantly improving products, developing new products, or creating new markets for existing products which help insulate it from economic trends. It's a non-confirmist in economic society. It adapts the outside world to itself by creating something or a demand for something which did not exist before, instead of adapting itself to the changes in the outside vault. So he lists a number of these things. And I'm sure he did not have a mess or luxury for that matter in mind when he wrote this.

But this was 1956. And he answers your exact same question. So given that the mo is just so strong and that the family is so incredibly protective of the brand, they really have a lot of control on how fast they can grow to a large extent because they set their own prices. And it's also worth mentioning that, like, Axel Dumas mentioned that they're producing as many of these bags as they can and they're not purposely limiting supply like a lot of people would think with a lot of these luxury names, just artificially suppressing it. So I'm curious about their future growth. Obviously, they're a very large company today. Their market capitalization is 222 billion euros. So a very big company already today.

I'm curious your thoughts on what you're looking at for growth for say the next three or five years. And I think another important point of this company is just that untapped pricing power we discussed and that pricing power is going to be used and implemented for many, many years down the line. that's going to impact your terminal value when looking at this company, which, you know, it's a much different terminal value for a company like this than I think for a lot of other companies. So that's also an essential part. So maybe you could speak to that terminal value in the longer term growth.

Altagama is an Italian trade association that includes mostly Italian and some European brands. Altagama and Bain Capital, Bain Consulting rather, they released a report on the luxury market in I think it was 2022. And a couple of years prior to that, Deloitte had also released a similar study, and Sanford Bernstein's analyst Luca has released some studies on this luxury market. All of them point to a market that's about personal luxury product market is about 350 billion and is growing at a high single digit percentage. Luxury market consumer base is expected to grow from 400 million in 2022 to, to,

to 500 million by 2030, just about eight years. Already crossed a couple of years into that. The size of the market is expected to go from 350 billion euros to somewhere between 540 to 580 billion. That's about a 50% growth. Among these rising stars, one of the countries that they highlight is India. India stands out, its luxury market is currently approximately 50 billion euros,

is expected to hit 200 billion by 2030, and more than three times where it is today. If you look specifically at Hermes, as you would suspect, sales has grown at a much better rate than what the market has done so far. As I said, revenues did go down a little bit during COVID, but revenue growth over the last five years

has been approximately 19%. More than offsets the small decline in 2020. Revenue growth over the last 10 and 20 years being 14 and 13%. Now, it's a remarkably resilient business. And as I mentioned earlier, this is so one of the few businesses that actually had revenue

go up about 8.5% in 2008 during the crisis, during the financial crisis. As for the next few years, I expect a similar low 10% revenue growth. Your question, you mentioned that the company has the ability

to control its growth. I think that's a very unique feature in the retail business. In some manufacturing businesses, for example, and the customer puts down a deposit while placing an order, which then leads to a negative working capital situation, which is wonderful. But here, it's a retail business where the customer is scrambling to get on a wait list that runs anywhere from one to six years. Apart from being able to control its growth, another aspect to take into account is the considerable operating leverage. Now, given the business where the company controls, it's vertically integrated in a business model, its fixed costs are high, at least relative to many

other players in the ecosystem. In 2024, for example, they instituted an 8 to 9% price increase. That's at the company level. Individual geographies will have had different percentages. For example, Japan, whose currency has been depreciating at a rapid clip, notwithstanding what happened in early August, is expected to see a double-digit price increase. So that 8 to 9% for 2024 is at the company level. That is essentially remaining true to covering its production costs. Production costs have increased at approximately 6%. The price increase that they institute also goes towards pointing out the commitment to the employees. Axel Dumas, he said we wanted to cover the currency impact that's quite negative and that's an extra cost of about 300 million euros. This is in

2024. So the price increase that they institute takes into account, the increase in raw material cost, labor cost, and this foreign exchange in certain situations like Japan, all that is taken into account and they push through somewhere in the 5 to 10% consistently, but more recently, they've done 8 to 9%. Typically, when you push through that sort of a price increase regularly, you may feel push back from your customers. It's the exact opposite in a company like Hermes in many luxury companies as well, but particularly in Hermes. And that's likely to continue. That's likely to continue for a variety of reasons. The brand strength, the increasing demand from not just the existing marketplaces, but also countries like India and

southeastern Asia, African countries. And so in my estimation, I still expect a low 10% revenue growth after taking into account these types of price increases. Do you have any thoughts on terminal value, since that seems to just be such an important aspect of Hermes? Say 10 years down the line, you would expect the growth to be higher than, say, the GDP growth rate, for example. Absolutely. Yeah. Again, luxury as a business is one where it's grown at almost two times the GDP growth rate beginning in the mid-90s.

Of course, a big reason is the growth in China over the last 15, 20 years. But the business has continued to grow at a much better rate than GDP. As for your question about terminal value, yeah, that is. absolutely key. You know, if you extend it, say, over the next five years, your cash flow model based on, let's say, the next five years, irrespective of whatever timeline you use, anywhere from 85 to 90-some percent of the eventual value lies in this terminal value. That is based on the kind of margins, the kind of cash flow that the business generates, and the quality aspects that we have discussed all through the call today. So I've run a variety of scenarios in my analysis every single time

I arrive at a terminal value that's well north of mid-80%. That tells you a lot about the definition quality as it relates to a mess. Yeah, and just to make sure I'm understanding it correctly, so north of 80% lies in the terminal value, and that's relative to what you determine as your intrinsic value. Correct. Okay. So, I also want to discuss capital allocation and valuation. So Christian Billinger actually chatted with our TIP mastermind community. He talked through the financial statements and all these metrics on Hermes and LVMH. And one of the things he mentioned that just really blew my mind is he mentioned that

Armez's return on incremental invested capital is north of 100%. It's just an amazing metric and it helps further illustrate just the quality. of this business. So when they're renovating their stores or maybe building a new store or investing in R&D and such, they're getting a high, high return on that investment. But the problem is they can't reinvest 100% of their cash flows. So it's just a portion of it. So talk about how they approach capital allocation. You know, when you look at any business, when you go from the top of the income statement down as you hit the gross margin line item, you can tell by looking, at the gross margin, the consistency of the gross margin line item, you can tell what the quality

of the business is. To understand the quality of the management team, you can go from the bottom of the income statement up, and in both cases, in the case of Hermes, you can tell the quality of the business, and 70 plus percent gross margin, the healthy net margin tells you a lot about the quality of the management team as well. That all leads to this prodigious cash machine that we're discussing today, which is Zermas. On a free cash flow basis, on a per share basis, free cash flow per share in, for example, 2023 was about 34 euros per share, which is almost five times what it was 10 years ago. So that free cash flow is a number that continues to grow at a very healthy double-digit rate. And I expect, as I mentioned a few minutes ago, expect that to continue to

perform at a high level. What does the management team do with that? prodigious cash. In fact, Axel Dumas addressed this in 2018. In his prepared remarks, he said, we keep one-third of the cash for dividends. This is for the following year. And that includes special dividend. For example, in 2023, they just announced a special dividend of 10 euros per share on top of the regular. One-third for CAPEX for the following year. And another third for the future. And that, I think, he was referring to as CAPEX for the future. Unlike LDMH, Hermes doesn't do any acquisitions. They've done a few, very few in the past, but that's not the mojo here.

It's organic growth and reinvestment through what I call this atelier, these workshops. They've got 54 of them in France today, along with the year-end earnings announcement. They said they want to open up four more atleers. over the next four years, one each year. And so these things take up a lot of capital. And as I mentioned, Chicago's store, for example, was refurbished. A couple of years ago, I haven't been to the new store. So that sort of a refurbishment is an ongoing exercise across the world. They did one in Vegas. They've done one in Beijing, for example. And so that refurbishment. And of course, they open up new stores. So all these things take up capital over a long stretch of time. They also have.

a small buyback program in place. I think 10% is something that they can buy back. They have done a little bit of buyback, but that's not their primary capital return. As we discussed earlier, this is essentially a family-run business, almost 70%. 67 is in the hands of those family members. 50-plus family members are a part of this. As a part of keeping the group together, without a revolution, it's part of their strategy to pay a healthy dividend. So, like LVMH or maybe a few other even non-luxury businesses where we may see very efficient capital management, you can probably point out a few inefficiencies. Of course, the management team wouldn't accept them as inefficiencies. It's part of the strategy. It's part of their culture,

keeping their artisans together. In fact, they also have a free share compensation program to the artisans. In addition to these things, as a part of the culture of keeping the artisans happy, they get more than 12 pay checks per year. Depending upon the year, there is one extra paycheck for seniority, a few other paychecks for the company doing well over a stretch of time. So those all come into play as a part of what we may define as inefficient capital management, but that's part of the culture. Bringing it back, yeah, they currently sit on what appear to be a hefty cash balance, approximately nine and a half or close to 10 billion net cash on the balance sheet, but that's by design again.

They want to remain independent, be able to fund their growth internally through their own funds, keep the family unit, the group together without a revolution. And so that's how they've thought about capital management. It prioritizes the capital allocation strategy prioritizes long-term value creation and brand strengthening or short-term profitability or aggressive expansion. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform. So whether you're prepping for a SOC

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Back to the show. So Howard Marks and Morgan Housel recently recorded a podcast together. They discussed the impact of debt and the podcast was just phenomenal. One of the points that Howard made is when you go back and you look at bankruptcies during these various financial crises, excessive. debt is involved in every single one. Debt works well until the unimaginable happens. And when you're focused on maximizing the terminal value, it's not just critical to be able to withstand the average crisis. It's critical to withstand every crisis. So I think your typical investor

would look at 10 billion euros on the balance sheet. I mean, that's just insane. But it's not insane if you're Hermes because you're maximizing for the terminal value and you care about that durability and that terminal value. So add a note here that conventional wisdom tells us that a lot of this cash should be distributed through dividends or through share buybacks, but Hermes is anything but a conventional company. All right. So I'm sure a lot of people when they clicked play on this episode, they know Airmes is an amazing company, but it's probably too expensive in their eyes. So the PE multiple today sits around 50, and we're recording here on August 29th, 2020. 24, and the share price on the ticker RMS on the Paris Stock Exchange is around 2160 euros.

So I'll just throw it back over to you to talk about valuation. Ah, yes, the premium valuation of Hermes relative to the market or even to the luxury landscape. At the outset, one explanation for this valuation is the markets expect Hermes to continue to maintain its healthy profitability while growing at this fast pace. that's been the case for a long time. If you actually go back to the 1990, mid-90s, if you look at the P-Multable, average has been somewhere close to where it's trading today,

maybe slightly less, but not a whole lot different from where it's trading today. While that may not be satisfying for the valuation-minded investor, let me offer a couple of thought leaders who have helped me think about quality and long-term. One that I would bring to this point is, one, Mr. Barath Shah. He's the head of research at a firm called ASK funds in India.

He wrote a fabulous book, Long Time Back, called Off Long-Term Value and Welf Creation. As you know, I started investing in India. I was in India recently and met with him. He talks about quality and valuation associated with quality very elegantly. He didn't talk about Hermes, but I'm just highlighting his perspective on quality and how I view Hermes' valuation today. Typically, returns on stocks reflect the underlying businesses' earnings growth, right? When earnings have compounded at X percent, returns on the stock are generally around X.

When the stock returns X plus Y percent, that Y is the result of quality. Obviously, this should be evaluated over a long stretch of time. In the case of Hermes, earnings have gone up around five times over the last 10 years. The stock has gone up about seven times over that 10-year period. Over the last 20 years, earnings have gone up 21 times, and the stock has gone up almost 50 times. Back to Barat, you know, he says quality is more real than the numbers like growth or whatever else that we can compute.

Because it can be computed, it sounds mathematical. What is mathematical sounds precise, and what is precise sounds true. While all of that may have some merit, quality is simply because it's not so easy to compute or to define very pinpointed manner, it doesn't mean that it doesn't exist. It's just that we need to learn to better appreciate the market mechanism. And valuation mechanism really works in the market. That's essentially the essence of what Barat has taught me or what I have learned from him through his view of quality. and that's what I would bring to bear in the case of Vermerses's valuation today. Of course, we can't run around assigning, you know, super high multiple to all businesses

and claim that their quality. And that's where I would bring in, for example, Peter Bernstein's 1956 article in HBR to bear. When you bring all that to account, you know, you've got a business that is almost, that doesn't have any competition, has complete control over its growth. has control over its pricing power, has a strong brand loyalty. When you bring all that together and you bring Barat's view of quality

and how it translates into valuation, current valuation, I would say, is fair. It's probably not cheap, but I don't think it is supremely rich. It's just fair. And the historical performance tells you a lot about why one should at least take a view at what Barat is saying and what Peter Bernstein has written about.

That's how I view valuation today. And that's why it's part of my portfolio. Oftentimes the toughest part of some of these quality companies is figuring out the right valuation. I looked back over the past five years and there's been three scenarios where the market sold off this stock by 20% or more. I think that's one other thing about the company is the drawdowns, I think the volatility relative to the market tends to be lower based on what I've seen. I think the pricing power is also worth revisiting. You mentioned the recent price hikes that were above average, but I think over time, their price increases have actually been pretty modest.

So do you know what price increases look like, say over the next three to five years? Or does management give a sense on what that might look like? They don't talk about the future in those terms, but you can absolutely look back and see what they have done and why they have incorporated those price increases. That's how I arrive at this somewhere in the high single digit percentage as price increase. Of course, in the case of 2024, Axel Dumas and the earnings call did say they were instituting 8 to 9% price increase, but it's generally in the high single digit percent at the company level. and different geographies may have different price increases. That's been a consistent theme.

In fact, going back to the book about luxury by Capferr, one of the things he talks about is a luxury company must institute price increase, irrespective of what the underlying economy does. And in fact, do not have a price-based or a discount-based sale program. If you walk into a store and you end up buying, eventually buying, say, $30,000 worth of working bag, and for that exact same bag, I go in and buy a $20,000, how would you feel if I told you that? So in luxury, discount to pricing is never the right strategy. Most of them do not do it.

But instituting this price increase is somewhere in the, I would say, high single digit percent and that's been consistent. It's essentially, Axel Dumas, he talked about this. It was his mom in the 1980s who came up with this strategy of having this price increase at a percent higher than the cost. In this case, cost increase was around 6 percent, and they're pushing through a few percent more than the cost. That's how they end up in this high single-digit percent. So that's been consistent for a long time.

I expect them to continue to do that in the next three, five years. and far into the future. Yeah, and some other points on valuation, I think, are also worth noting is that the market tends to put a premium on certainty. So if there's a high level of certainty that free cash flows are going to continue to grow and revenues are going to continue to grow and it's a good inflation hedge, they can increase their prices in line, at least with inflation. And I believe you mentioned earlier that it was LVMH and Hermes that have been growing in China.

And I think on our previous call, you mentioned to me that Hermes is going to be. going to be able to grow in essentially any economic environment. One, due to the quality, but two, just due to the luxury market overall, the growth being quite strong globally. Yeah, so maybe there's more to add on China, because China's around half of Hermes' business. And I think it's really amazing to hear that Hermes is still growing in China and in Asia, despite these economic issues they're currently going through. Absolutely, absolutely. Before I forget, we brought up a very interesting point about inflation. I don't know who ran this study, but somebody did, and they actually compared the price of gold, the price of the S&P 500 index, and the price of

Berkin back. As you may guess, over a long stretch, I think about 25 years or so, S&P, of course, beat out gold, hands down, but the price of working actually beat out S&P itself. It's honestly unbelievable. Yeah. And so this person was S&P. essentially pointing out how Berkin could be a better inflation hedge than many things that we generally consider as inflation hedge. That's for you to chew on later. But back to your question about China, many luxury brands have benefited from this enormously benefited from this growth of China. I mentioned luxury as a sector has grown at two times the global GDP

since the mid-90s. Much of it is due to the growth of China. And today, both LVMH and Hermes, for example, have a little less than 50% of their business coming from Asia X Japan, which is essentially China. Japan, by the way, is another big market. Has been a big market for luxury for a long time. And as I mentioned, the gentleman Francois, he moved to Japan because the Japanese market was growing back in the 70s. The other interesting aspect, this is not just China, the other interesting aspect about Hermes is when they operate these stores, what they maintain in each store is essentially catering to the local clientele. There are many luxury companies that cater to the tourist community. Chinese are known to spend enormously when they travel, and so many luxury brands

and premium and super premium brands have geared up their businesses to cater to that touring Chinese community. But for example, in the case of Hermes, what you may find in an Hermes Beverly Hills store would be different from what you would see in Boston. And that's because the store manager, the director, is buying products from the company that cater to the local community. And that's another distinct feature I want to highlight here. twice a year every six months, the store director, approximately 300 stores, $295 to be precise, but 300 stores, all these directors go to Paris twice a year, and they buy products that they think, or they essentially get products from the headquarters that they think will sell well in

their store. And that's the reason why products in different stores may look different. Of course, there are going to be similarities like some of these handbags and a few other. products that they sell, but the scarves, for example, that you find in Beijing may be different from what you find in Bombay or Mumbai. So that's another distinct feature. Catering to the local community as opposed to the tourist community is an important feature that has helped the company come through different cycles. And today, in the most recent quarter, Irma has also announced that, along with many other luxury brands, that their sales in China was a little soft. Chinese buyers, have historically, this was Axel Dumas who mentioned this, he said,

Chinese buyers have historically relied on their local real estate and their stock market, which has been the support for their wealth to be able to spend on luxury products. As you very well know, both asset classes have been hurt badly in China. And that's one of the reasons why the luxury market has had this soft patch. Be that as it may, they still have a very robust presence in the market. China, 30-some stores, the second highest number of stores around the vault, you know, 40-something in the U.S., 30-something in China, and I think 22 or 23 in France. They still have a big presence there, and they expect the Chinese buyer to be able to come

back and, you know, buy their mess products over time. But in the meantime, they're not necessarily just waiting for the Chinese buyer to come back. Within Asia, for example, as I mentioned earlier, India is a big market for them. The Indian luxury market itself is expected to grow three times. In my most recent trip, for example, I was in Mumbai. I was going through, going in an Uber to one of my meetings, going through the largest slum in the world. This is the slum where part of the movie Slumdog Millionaire was shot. Going in the opposite direction to me was a Rolls-Royce. This is a very common scene in India. This is a country with contradictions galore. I come from a city down south, the city called Chennai, used to be called as Madras, supposedly a conservative city. Right close to the airport is a Rolls-Roy's dealership. I was very surprised.

This is to just highlight the fact that India has a luxury market maybe is at a very incipient stage, but is absolutely bound to grow. That's just one of the markets. Africa is growing through similar growth pattern. Much of Indonesia, Vietnam, a few other Southeast Asian countries are also growing at a reasonably good clip. And that's partly why I keep saying I have a growth expectation that's slightly better than inconsistent numbers relative to what they have done in the past, definitely better than many other luxury markets. So, yeah, China is a big market, is going through a relatively soft path. company and a few of its competitors do expect the Chinese market to come back. It may take a little longer than expected, but we'll come back. In the meantime, many other peripheral markets are opening up at a healthy pace. One more question on China and India.

So, 295 stores today globally. Do you have an idea of what the store accounts look like in India and China, and if they'll be pursuing opening new stores? in those markets in the coming years? Absolutely. So they currently have 36 stores, I think, in China, but only three in India. Only three. The third one was just opened recently.

But in both markets, they expect the number of stores to go up. I mentioned anecdotally from my own experience as to where I see luxury in India. And I left the country a long time ago. And it was an absolutely poor. It still is poor. but it was an absolutely poor and a socialist country, has come a long way, is positioned exceptionally well, is evident in many of the market dynamics that we are seeing today. That's just India. China, over the last 30 plus years, has had a phenomenal growth. No time in history have we seen

so many hundreds of millions of people get upgraded from penury and poverty to middle income and upper class. As I mentioned, they just expect this soft market to play out over the next few years, they're still growing their store base within the country. I'm not sure what the plans are in terms of specific numbers from both countries, and that's something that they don't disclose publicly. What they have disclosed is the Adeliers, the workshops. They are talking about just four workshops over the next four years. But the number of stores in both countries are expected to grow. I suspect the number of stores in India will be growing. The number of new stores in India will be more than number of new stores in China.

I think that's a reasonable conclusion to make. Wonderful. It's really fun to talk about all the good things in a company like Hermes, but I think I can come up with plenty of reasons why things might go wrong or things might not go as planned. Just to mention a couple here, let's say younger generations aren't as interested in high in luxury, or maybe the growth in India doesn't go as planned, or the Chinese economy continue on its downward trajectory or maybe takes a while to recover.

Yeah, I'm interested in hearing what you think are some of the biggest risks that you'd be monitoring as an investor in this company. Yeah. So in a company that is more than 180 years old, you would suspect that it's gone through some existential questions. And of course, it has. As I mentioned, Adolf, one of the brothers of Emil Morris, left the business in 1919 because there was a significant slowdown in the sales of horse harnesses and saddles,

because automobiles were sprouting up all over the country, all over the world. Of course, Emil Morris started supplying to both the automobile market and some of the nobility that existed at that time. That's just one example of how the company had an existential question raised, and it has come through very successfully. It's also had the factor of luck work in its favor. For example, even though the bag itself was released to the market in the 1920s, Kelly, as a bag, did not become as popular until Grace Kelly, the Princess of Monaco,

a Hollywood actress, essentially hid her pregnant belly using the bag. And Birkin bag itself was also an accident that turned out to be a big success. Jean-Louis Dumas, he was. sitting right next to this actress, Jane Birkin, and she spilled a whole bunch of things from her bag and complained about not having a good bag to keep all her things, including her kids things in a big enough bag. And that's how the Berkin was founded. So while the company has had existential questions raised, it's had some lucky breaks. It came through this Bernard Arnault assault successfully. And I'm sure it'll go through some existential question in the few.

future. I'm absolutely not discounting it. However, I am confident that having come through these tough situations, it has the experience, the expertise, the management team, and the financial wherewithal to withstand any kind of assault. One of the quirky things about this company is, there are many quirky things. One of the quirky things about this company is they put out an annual report that runs to almost 600 pages. 2020-annual report is about 592 or 93 pages. European companies generally cover many things, ESG related and all that,

which makes the annual report even longer than American ones. But this is one of the longest that I have come across. It is so long that they actually have a sort of bibliography or a sort of a cross-reference table in the end where you can search by words or phrases and go to the actual page number. But in any case, in the middle of the annual report, about 380 or 384, page number, they have a nice table about risk factors, certain risk factors that they view and the severity

of the risk factors on one axis and the variety of risk factors on the other. As you very nicely said, listening to Howard Marks's podcast, debt is a killer in many businesses. We don't have that problem here. It's a net cash balance sheet. It has been a net cash balance sheet for a long time. Ownership interest, it's held within this family, and now they have this other investment vehicle called Krefeld Invest, which makes it even more difficult to pry open the family ownership. Those things are not going to be a problem. But if you go back to this table, one factor that they list, and which I agree with, is the reputational risk.

Just a few years ago, 2020 or 21, there was a video circulated which showed in a crocodile farm in Australia, the treatment metered out of these crocodiles was very inhuman, it was very unfriendly. People immediately concluded that it was a mess-controlled crocodile form. Hermes, by the way, it controls its suppliers, crocodile skin being an important quality feature on a body. Berkin bag, they do control crocodile forms in Australia. But it was a video that was distributed and got wide attention. In fact, Jane Birkin, before she passed away, she actually announced that she may actually dissociate her name from the company because she was so perturbed by this mistreatment.

Later on, they found out that this whole footage was from a farm that somebody else had. It was not a Hermes form. but the damage was done. That sort of a reputational risk is what I worry about the most. By the way, to address this leather and various different skins, one of the areas where the company is spending capital on is something called mycelium. Mycelium is essentially roots of mushroom. Apparently, when you put a whole bunch of roots of the mushroom together,

it gets into a material that is close enough to leather. And so they're working on making their products even more eco-friendly. I'm not sure when they will come out with mushroom leather, but to avoid these types of reputational risks. I don't think they'll be able to avoid completely, but to at least address the need for these types of animal skins and other types of leather, they are working on certain alternatives. In fact, Patrick Thomas, the CEO who defended the company against Bernard,

he's now on the board of a company in California, which focuses on mycelia. So bringing it back to your question, I think that's sort of a reputational risk is what I worry about the most. I'll keep my fingers crossed as to when the next existential question arises. Yeah, that makes sense. It's pretty easy to tell you're very knowledgeable about this business. So before I give you the final handoff, I'm not sure if there's anything else that you'd like to cover, just to give you the opportunity. to share anything we might have missed during this discussion. No, your questions were very well thought out, detailed,

given that the company has such a long history, we could pick any one of those topics and go into just one question or maybe a couple of questions and make that a podcast by itself. But thank you for giving me the opportunity to talk about a very high-quality business. Whether I own it or not, you know, the business is business talks, quality and highlights its own strengths and establishes its presence in a very dynamic industry. So thanks for giving me the opportunity to talk about a wonderful business today. Well, Shri, this was definitely a very fun conversation.

And I'm really happy we could put this one together to learn more about just this amazing business. So please let the audience know how they can learn more about you to get in touch with you if they'd like to. Sure. I am, I run a fund called SVN Capital Fund LP. I'm on SVNCapital.com. That's the website to my fund. And I'm also on Twitter, handle is at SVN Capital. I would love to hear from some of your listeners if they're interested in learning more about or Ms. or just my fund. Wonderful. Well, Sri again, thank you so much. This was absolutely wonderful and I'm excited to deliver it to the audience. Thank you again. Appreciate this.

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