THE BLOG

Riding a Growth Wave

06/25/2015 05:17 pm ET | Updated Jun 25, 2016

Organic food has gone from being a fashion fad twenty years ago to becoming a staple in the average American diet. Since the Organic Trade Association (OTA) started tracking the data in 1997, organic food sales have risen at a 15% compound annual growth rate and now make up around 5% of total food sales in the US compared to under 1% back in 1997. A recently released report from the OTA showed that the growth in organic food sales remains quite strong, jumping 11% in 2014 to $35.9 billion. This kind of growth is hard to find in any other sector of retail.

The impressive growth in organic food can be attributed to many factors, but at the core is the perception that organic food is healthier than foods grown or raised with the use of pesticides, hormones, antibiotics and genetic modification. While much of the data is inconclusive and widely disputed, consumers are increasingly displaying a "better-to-be-safe-than-sorry" attitude about what they put in their bodies. In part, their attitudes are being shaped by increased exposure to information about food from channels like social media. Indeed, a survey recently conducted by Fortune Magazine showed consumers are increasingly concerned about pesticides, hormones, antibiotics and genetic modification. This has resulted in the organic sector growing at a rate three times that of overall food sales, according to the U.S. Department of Agriculture and trade association data.

From an investment standpoint, the growth in the organic food sector cannot be ignored. In years past, the strong sector growth had the effect of "lifting all boats." More recently the stock performance among the various industry participants has been more disparate. In 2015, there has been a divergence in stock performance between the organic retailers/distributors and the organic food manufacturers. The manufactures of organic food continue to rally and trade well above their long-term price-to-earnings average, while organic food retailers/distributors shares have pulled back. Several factors account for this schism.

Sales growth at the organic food retailers/distributors disappointed in the most recent quarter. In our opinion, the sales growth deceleration is largely attributable to short-term transitory and macro factors, with the long-term attractiveness of the sector remaining intact. Indeed, the operating environment was difficult during the first half of 2015. Bad weather, the West coast port strike, and food deflation all had a hand in negatively affecting industry sales growth. The CEO of one organic food retailer recently commented that his company was dealing with 10% produce deflation in April, followed by 6% in May as a result of issues related to the port strike. Deflation acts as a headwind to a company's sales growth.

But the larger concern appears to be that natural and organic retailers are facing a more permanent increase in competition from conventional supermarkets and big box retailers. This is true to a certain extent. However, our research suggests that demand for natural and organic food will grow into the increased supply. At the same time, the number of purveyors may level off as new entrants fail to gain the critical mass needed to create the inventory turnover required to produce acceptable returns. In other words, it may not make economic sense for many old-school retailers to continue to ramp up their organic offerings.

Contrary to organic retailers, the organic producers are mostly trading near all-time highs as traditional packaged goods companies like Kraft and General Mills try and capture the high growth inherent to the organic food industry through acquisitions. At the end of 2014, General Mills brought Annies, the maker of natural and organic Mac and Cheese and other organic products, at a 40% premium to the listed share price. Natures Path, a privately held natural and organic producer said recently in the June edition of Fortune magazine that the company receives some 50 overtures a year from interested buyers. Yet, consumers continue to shift purchasing dollars away from the center aisles of the supermarkets and towards the perimeter where fresh foods are stocked. Therefore, those retailers offering a better selection of fresh produce are the most likely to gain share. And here, the entrenched have the advantage.

It is still early days for the American newfound interest in health and wellness, but as organics only make up 5% of total food sales I think the industry has a long runway of growth ahead. Growth won't be without volatility, but as always, I endeavor to look through the short-term noise and invest in companies with strong fundamentals, reasonable valuations and secular trends that provide a tailwind.