A Luxury Affair

During periods of strong economic growth, people feel freer to spend money on the finer things in life. This is a global phenomenon. Think Prada, LVMH, or Rolls Royce, just to name a few luxury brands. With such an increase in demand for high quality products, a number of funds that invest in the luxury and lifestyle sector globally have emerged.

A HNWI is defined as an individual with liquid financial assets in excess of $1 million. The table above illustrates the growth of the HNWI (High Net Worth Individuals) from 2005 and 2006. Regions including Africa, Middle East and Latin America have seen their HNWI population grow by at least 10%. These same regions have also enjoyed strong economic growth the past two years, particularly Latin America and the Middle East. Both regions have benefited from the recent spike in commodity prices.

The next table shows the breakdown of the countries that have experienced the highest growth in HNWI. Singapore is at the top of the list, with the highest growth in the HNWI population. Coming in a close second is India.

What does the strong growth in HNWI mean for the luxury sector? It means that luxury goods are becoming more accessible to individuals from the middle-income class as they join the ranks of the HNWI. The young premium market is set to boom. The Worldwide Insights Report from MasterCard revealed this market will be worth over $1 billion by 2016.

Defining Luxury

Formally defined, there are four components in the luxury universe – perfumes & cosmetics, designer & ready-to-wear clothing, watches & jewellery, and leather goods & accessories. However, if funds were to only invest in luxury-related companies that fall into these four sub-sectors, the investment universe would be limited.

Hence, a broader definition is usually used – it covers all goods and services that stand out by virtue of their superior quality or brand image. In other words, companies under the theme would be those that share characteristics such as high entry barriers, price-insensitive demand, and good growth visibility.

Companies that fall into this segment include luxury and lifestyle brands such as LVMH, BMW, Las Vegas Sands, Nike, Porsche AG. These are just some examples of companies that we are more familiar with and which are typically included in the universe of companies that fund managers of luxury and lifestyle funds tend to invest into.

Potential Risks

One of the more obvious risks that are faced by companies in the luxury and lifestyle business is that they typically experience cyclical demand. As mentioned earlier on, luxury products tend to be income-elastic, which means that when income levels go up, the demand for more expensive goods also experiences an upturn. On the flip side, if economic growth slows down or a global recession occurs, income levels may decline, and there may be a corresponding slowdown in demand for luxury and lifestyle goods and services. Companies in sectors that follow closely the boom and bust economic cycles are often known as cyclical companies.

Cyclical sectors include those related to hospitality and tourism, and automobile manufacturers, just to name a few. For example, automobile manufacturers such as Toyota, Honda and General Motors tend to experience cyclical demand for their products. If income levels go down or stay at relatively flat levels, consumers are less inclined to purchase new vehicles or upgrade to a more expensive car.

Thematic Thoughts

The luxury sector’s earnings growth is expected to be at reasonable levels of 12.8% and 14.9% for 2007 and 2008 respectively. However, it is important to note that the valuations for the luxury sector, relative to those of global equities, usually command a higher premium. Investors also need to bear in mind that these funds may not perform well during periods of recession and investments should be made with a longer-term time horizon in mind.

Send us your questions and comments to us at fundaffair@cnbc.com.