Weekly Digest

Fast-moving consumer stocks

Andrew Hardy, CFA

21 May 2018

As the oil price soared higher last week, with Brent crude briefly breaking through $80 per barrel, I spotted a Bloomberg headline which read “What happens if oil hits $100?”. Remarkable when you consider it was just over two years ago that oil troughed at around $30 with commentators predicting a further one third decline! The pendulum has swung a long way; investor sentiment was very weak two years ago but is much more bullish now. A recent casualty of this change in sentiment has been the consumer staples sector, which has severely lagged the equity market rebound. To some extent this is understandable given its lower economic sensitivity, but relative valuations have now contracted significantly. Markets may be overreacting somewhat.

Since the low in markets in February 2016, the consumer staples sector has returned just 14% in US Dollar terms (including dividends), while the IT, financials and energy sectors have delivered four to seven times that gain! The price to forward earnings valuation multiple of the sector is now at just a 12% premium to the rest of the market, compared to 37% back then, while the 3% dividend yield is a quarter higher than the broader market for the first time since 2011. Many companies in the sector have incredible track records of delivering high and stable returns on capital by virtue of their world-renowned brands and the resulting pricing power, which has justified a substantial valuation premium in the past.

Some would point to the concurrent rise in bond yields to explain the sector's recent weakness. That may be partially true but it is a lazy argument predicated on viewing these stocks as 'bond proxies'. Clearly the high quality, stable and cash generative nature of businesses in this sector made them relatively more attractive when bond yields were lower, but the comparisons end there and investors should not treat these stocks like bonds.

A combination of relatively disappointing earnings results of late and fears of disruption to their business models seem to be the more important factors. Multinational makers of everything from soap to soup are struggling to adapt to new consumer preferences and private label products. The dominant incumbents in the tobacco industry are investing heavily to develop new products while facing pressure from new players. The channels these companies sell through are battling to keep prices down while adapting to combat Amazon or discounters. Such shifts in industry dynamics are leading investors to worry about future pricing power and the ability to maintain margins.

The jury is still out on how successful businesses in this sector will be at adapting, however many have track records of doing so for several decades (if not centuries) so probably deserve the benefit of doubt. Admittedly the pace of change and level of disruption feels higher now than ever before but the recent underperformance leaves the relative valuation for the consumer staples sector offering a better margin of safety than it has for several years. The market is probably overreacting again which is creating a good opportunity for our active managers to buy into these high quality businesses at much more reasonable valuations than a couple of years ago. As easy and tempting as it is to extrapolate a trend, it often leads to the wrong conclusion…

Download the above article

Previous Weekly Digests

Global Investment Management