One theory that truly held up during the crash is that the consumer-staples sector is more defensive than most others. Between September 11, 2008 and March 9, 2009, the S&P 500 fell 42%, while the S&P 500 Consumer Staples Index dropped 33%. Most other sector indexes also fell harder than staples.
Consumer-staples companies are inherently defensive because they sell goods people need regardless of the economic climate, says Kevin Prins, vice-president at BMO ETFs.
Food, hygienic products, soft drinks and even tobacco and alcohol all do better during a downturn. So companies like Walmart, McDonalds and Procter & Gamble are more recession-resistant. Still, the staples sector’s recent strong performance is surprising many investment experts. Typically, when markets recover, people sell off defensive assets and buy growth-oriented stocks. That’s not the case this time. Since January, the S&P’s consumer staples index climbed by nearly 17%, while the S&P 500 is up about 15.4%.
“It’s unusual for this sector to outperform in a bullish [U.S. equity] market,” says Brian Madden, portfolio manager with AGF Investments. “It should be lagging.”
Staples have done well because, despite rising U.S. markets, people are still nervous about the future. They want to stick with old reliables in case of another setback. Many consumer-staples providers are multi-nationals: they sell brand-name products and their earnings and cash flows are steady and predictable.
A healthy number are cash cows with little debt, so they pay attractive dividends—crucial in today’s low-interest-rate environment. The big names also have greater exposure to emerging markets, which helps boost growth.
But this unexpected outperformance also means many parts of the market are overvalued. The sector as a whole is trading at around 15 times earnings, in line with the S&P 500. Sukyong Yang, portfolio manager with Cumberland
Private Wealth, hasn’t bought a staples stock in at least six months, saying it’s getting harder to find attractive buys.
“These are good quality companies, but I still have to be cognizant of valuations,” she says.
What’s on the shelf
To find opportunities in this sector, advisors need to look for buys on a company-by-company basis. Start outside Canada because consumer staples make up just 2.8% of the domestic market; and while there are big names—Shoppers Drug Mart and Loblaw Companies Ltd., for example—the tight field has made many homegrown options expensive.
Madden suggests avoiding Canadian grocers as increasing competition from Walmart, Target and others will put pressure on margins. “I expect Canadian grocers’ EBITDA margins, which are currently at about 7%, will drift slowly closer toward the 4% level that prevails in the U.S.”
Beverages are another subsector to approach with caution, says Naveed Rahman, institutional portfolio manager with Fidelity Management & Research Company. Many companies in the sector are close to fully valued.
Coca-Cola and Anheuser-Busch InBev, for instance, were both trading at 19 times predicted earnings in June 2013. “They’re not screamingly cheap,” he says, but since this sub-industry is a big part of staples, you want to own some drink stocks.
The most attractive buys have international exposure, says Matt Quinlan, portfolio manager with Franklin Equity Group.
“Staples are typically much more global businesses than retailers,” he says. “North American sales usually grow by low-to-mid single digits, while emerging market-generated sales tend to expand by high single digits. The growth of the middle class and rising income levels in emerging markets is a positive demand driver for many consumer staple products.”
That’s why Madden likes the tobacco sector. Although fewer people smoke in North America, it’s still considered a staple since few people quit to save money. Tobacco demand is also growing in emerging markets and many people want brand-name sticks.
British American Tobacco is attractive to Rahman because it generates about 70% of its profits from developing nations. So it can be a good money maker, even though North Americans generally view it as a sector in decline.
Consumer staples’ close cousin
For advisors looking to buy growing but stable companies, consider staples’ cousin sector: consumer discretionary. It covers staples-like companies such as Dollarama and Tim Hortons, along with more growth-oriented plays like Toyota and Nike. Staples provide goods people need; discretionary taps into consumer wants.
Consumer discretionary often leads other sectors during a recovery. And, since March 2009, the S&P 500 Consumer Discretionary Index has climbed by an incredible 257%. “It’s the more bullish of the consumer sectors,” says Kevin Prins, vice-president with BMO ETFs. “It benefits when people start to spend more money more often.”
Like staples, this sector’s valuations have skyrocketed, trading at about 17 times earnings, and making it harder to find opportunities. Still, there are long-term buys available. Rahman is positive about the U.S. housing sector, though he admits many housing stocks have been run up over the last two years.
He’s more interested in stocks with an indirect housing connection, such as cable TV and payroll processors. Comcast is well positioned because, as more people purchase homes, more cable will need to be installed, he says. Paychex is a payroll and human resources provider, which often performs well in a recovering economy with a rising job market and rising interest rates.
The Fidelity U.S. Dividend Fund has a 9.6% allocation to discretionary, which overweights its benchmark, the Russell 3000 Value Index.
“Many discretionary stocks have sustained earnings growth,” he says. “If you can complement that with healthy dividend growth, then you’ve found a good buy.”
Sukyong Yang, portfolio manager with Cumberland Private Wealth, is keen on Hyundai Motor, which has better growth rates and valuations than its North American and Japanese peers.
Bryan Borzykowski is a Toronto-based financial writer.