Why Is Consumer Staples Underperforming?

Towards the end of last year anyone and everyone you talked to would tell you one thing about investing in the equity markets: Overweight the healthcare and consumer staples sectors. Two months into this year, in what should not come as a surprise, the pundits were wrong again, with staples ranking 5th in year-to-date performance when compared to the other sectors in the S&P 500. Surprisingly, the information technology sector has performed the best year-to-date of the 10 sectors in the S&P 500. Let me offer my opinion on why the staples sector has underperformed, and what to expect going forward.

Herd Mentality: When all “experts” make a forecast, something else is going to happen: One of the famous market rules written by former Merrill Lynch legend Bob Farrell, seems to be coming true with the staples sector. When everyone agrees about a certain topic, it is normally at the height of the bullishness on the market subject. Staples seems to be a victim of a market where everyone tried so hard to implement a particular investing strategy, that it got to the point where it was not unique. You can't differentiate one portfolio from another.

When most of the stocks in a sector are owned, unless owners are comfortable with adding more risk to their portfolio by adding more stocks from that particular sector, they are essentially creating the top for the stocks in this sector, and thus their own portfolio. Let’s face it, beating the markets involves using analysis that other people may not have readily thought of, and trying to exploit it to your advantage. Clearly consumer staples was not the medium by which you should have tried to implement this strategy over the past few months.

When the market goes down by 5,10,15% then fire sales will arise out of fear. If your portfolio is over-weighted with staples stocks, then that is also when you begin selling to liquidate the heaviest position in your portfolio, building a cash position. The overweight rating that many subscribed to back when the Dow was at 8700, has also caused the collapse. Now people move from being comfortable with the perceived safety of staples stocks, to being completely jaded by the equity market, and not wanting any part of it.

Earnings Outlook: The earnings outlook for staples companies has been anything but rosy. When companies like Procter & Gamble (PG) report dismal outlooks in an economic environment where they should be thriving, it indicates that no company is immune to the worst economic downturn since the Great Depression.

When all the trends are in a sector's favor, investors are more than willing to allow the stocks in the sector to trade at a premium relative to market norms. Of course those stocks need to be able to keep up performance and maintain their fundamentals. At the first sign of weakness, though, investors will be the quickest to take away this premium which they feel may not have been warranted in the first place as they question the validity of their intuition.

Clearly some of the staples companies did not deserve to trade at premiums, and did so because every pundit said that an investment in the sector would be a great idea. Much of the earnings deterioration can be attributed to the fact that companies in the sector really pushed international growth in the past few years, and as this downturn goes global, not only are revenue streams affected in foreign countries, you are seeing currency hedges go wrong with the recovering dollar and foreign currencies collapsing with their respective economies.

Trade Down Effect: The trade down effect from brand name goods to private label goods has caused a change of epic proportions in the staples sector. While it is easy to say that people will revert to goods that Procter and Gamble provides during a recession because they provide relatively inelastic goods; the reality is consumers will go further to cut costs and begin to purchase generic brands. That is exactly what is going on in the private sector right now.

Brands like Kraft (KFT) are not the lowest level that customers are willing to go anymore. There are a lot of the private companies who offer goods significantly cheaper. It is definitely an interesting trend in the staples sector, that has played out much stronger than I had originally thought it would.

All in all, staples has not been a particularly good or bad investment within the equity markets. It has been merely average. I definitely did not expect that going into this year, but I guess that is just what makes the markets so interesting and offers anyone and everyone a continuous learning experience. It makes you wonder what the next day will bring, and where we will go from here. I guess that is the real question in these chaotic markets.

-Vinay Ayala

Disclosure: None

Comments

[Larry House:]

Thanks. I think you can apply the same logic to gold right now. It is too crowded. Things just don't work when too many are in the same position.

Mar 10 03:00 PM

[aarc:]

A lot easier to see what future price actions will be looking at charts.

Look at the monthly chart of XLY or consumer descritionary. It started going down mid-2007 and finally dropping like a stone late 2008. The downside momentum generated during the last period was simply too strong to be overcome in a very short period of time hence XLY underperforms since most investors had been shocked of the sudden change of events and are not capable of formulating new strategies in a very short period of time. It is only those short term speculators that are "enamored" by the sudden "cheapness" of XLY price.

Look at the monthly chart of HHH or internet sector. It had been going down slowly since Jan 2005 then finally succumb to the sell-off of 2008. The time it consumed going down slowly "prepared" most investors to the downside potential and hence initial recovery was basiclly expected with most investors not getting the shock treatment at all.

Thing to remember after a bull run: "It is eather you pay the fine or serve the time" after being caught over-speeding. XLF is paying the fine while HHH is still serving the time.

Mar 10 03:07 PM

[aarc:]

Another thing to remember after a bull run and the inevitable correction that follows:

Those who "paid the fine" generally had a hard time recovering while those who "served the time" have a much higher chance of fast and sustainable recovery.

Going further: the crash of 1929 to 1932 was very deep and painful and took only 3 years; hence the recovery took a very long time. The correction during the 1965 to early 1980's was shallow and hence took a very long time but the recovery was fast and sustainable for quite a long time too. This current correction that started in year 2000 and still in progress is not shallow nor very deep (yet) and is expected not to be a prolonged correction (hence not shallow either) considering the almost 20 years of sustained rally had to be corrected. Recovery is expected to be fast and furious but sustainability is questionable.

We will know in the years ahead whether this correction is just a part of the supercycle theory or whether the supercycle had already ended and we are to go thru a multi-decade correction much longer than Japan.

Mar 10 03:36 PM

[Lin:]

aarc

Re: It's going to be long , very long , like Japan . Folks aren't buying Kraft or Green giant any more , Kroger Generic brand + Walmart's generic brand just fine
FOLKS Go to site 321Gold see article ,I think # 10 down entitled " civil unrest in America " by global research .ca , Will give ona a " clue " to what's coming.
I went to UPS store today , poor fellow waiting on me said " I'm 25 + broke ". Seems he was trying to re-do his mortgage with a firm , who charged him $1800 , 4 months later , it turns out to be a scam + he will be ' out of his home by 6pm . All is NOT well is US !

Mar 10 04:54 PM

[Eokram:]

Both PG and KFT have some debt. 41 billion for PG and 20 billion for KFT. I think the standard heuristic of buy companies that make "soups and soaps" needs an additional qualification about debt.

Mar 10 05:15 PM

[wobatus:]

American Italian pasta rode the generic gravy train.

But I wouldn't count out the brand names so fast. I just bought soe PG a couple of weeks ago. rally today gets me almost even. But that is one for the long haul.

Very nice article and well thought out.

Mar 10 05:57 PM

[young padawan:]

wat firm was that? they need to be reported to bbb


On Mar 10 04:54 PM Lin wrote:

> aarc
>
> Re: It's going to be long , very long , like Japan . Folks aren't
> buying Kraft or Green giant any more , Kroger Generic brand + Walmart's
> generic brand just fine
> FOLKS Go to site 321Gold see article ,I think # 10 down entitled
> " civil unrest in America " by global research .ca , Will give ona
> a " clue " to what's coming.
> I went to UPS store today , poor fellow waiting on me said " I'm
> 25 + broke ". Seems he was trying to re-do his mortgage with a firm
> , who charged him $1800 , 4 months later , it turns out to be a scam
> + he will be ' out of his home by 6pm . All is NOT well is US !

Mar 10 06:16 PM

[Hopefull:]

Not many bought consumer staples when told they were safe because they were also going down with the market. What caused the recent slide is a combination of trade down and the US dollat strengthing which cause international sales to translate into fewer dollars. The trade down is under close watch by the food consumer staples for instance the price of Planters peanuts was adjusted to lower the price spread. In every recession some people turn more to private label, but when beter times return people go back to the brands because they work better or in the case of food taste better.Compare the taste of Fritos or Planters to any other comparable product,the brands are better. As to currency as long as your foreign sales in local currency don't fall signifigantly you are in good shape as the currency alignment changes all the time. How long before the dollar depreciates because we are printing too many? The key is to buy the consumer staples at a discount to long term value.

Mar 10 10:51 PM

[abec:]

So much for market efficiency.

An asset is worth what someone else is willing to pay for it, and I believe that people will be willing to pay MUCH MORE for PG in the future.

One day, when PG is much bigger, someone is going to assign a 30 multiple to it. A much bigger multiple to much bigger earnings. One day.

Yes, you may think I am drunk on Tide, but why not?

PG prints money consistently and without fail - - it is the real McCoy - a cash gusher. The CFO every quarter has to decide "do I buy more shares of my cheap stock, or do pay off some more debt from the G acquisition".

That's some job. (So far, they have been splitting the money.)

I pray that PG falls much further. I wouldn't mind owning a lot more of it at 7x cash flow. At 5x cash flow, I will fill out that home equity application in my desk. (By then, KO and PEP should be down to $30, too - - yeehaw!!).

Speaking of which, PG has 2x the cash flow of Coke.

I wish PG would say they have derivatives, or something, but I know they learned that lessen long ago.

Eventually, sooner rather than later, when PG pays off its debt from the 2005 G acquisition (provided they don't buy another uberfirm), watch their ROIC climb to over 30%.

PG will protect my dollars in an inflationary environment, too, by raising prices as they did this summer, and if Mao and his disciples don't intervene, PG is going to grow a lot more in unit volume as well.

PG - how else do I own thee. Let me count thy ways: Berk, WSC, VDC, KXI and in smaller portions everywhere.

I don't feel the same love for Colgate, either, yet, as for now, that much smaller firm is more expensive with its 30% ROIC - - that is, until it too does a major acquisition.

And if you think people are permanently going to become addicted to Walmart toothpaste, diapers, and detergent, go speak to your local Walmart manager and ask then about the importance of brands in their stores.

seekingalpha.com/artic...

Mar 10 11:25 PM

[wildfirexx:]

Simply put: what goes up must come down eventually,
whether it be gold stocks,consumer stocks and yes probably Bio-tech stocks next. As soon as there's some slippage in that sector, the profit takers emerge.

Mar 11 05:03 AM

[Alan Brochs...:]

You make some good points, but one of the previous comments really hits the nail on the head quite directly: It's all about the debt.

Consumer Staples companies have for years degraded their balance sheets to stretch EPS growth (share repurchases, acquisitions). Consider also that the relative PE of the group had held up quite well, so the valuation didn't reflect the reality of the credit crisis (higher future interest expense).

Again, though, you make some great additional points about particular issues affecting fundamentals like trade-down.

Mar 11 11:33 AM