ETF Pair Trade To Maximize Gains In The Consumer Staples Sector

by: David Trainer

The consumer staples sector may be a less volatile sector than most, but that does not mean it is immune to market volatility.

Just look at Medifast, Inc. (NYSE:MED). This consumer staples stock saw its share price increase by nearly 40% in the last week of July last year, then declined by over 20% in one week in late December.

Don't think that it is just small-cap consumer staples stocks that display volatility either. Safeway Inc. (NYSE:SWY), which has a market cap of nearly $6 billion, fell in value by over 30% from late April through late July in 2012 and has surged in 2013, up over 43% year to date.

A fund's performance is only as good as its holdings. See Tackling Big Data for ETFs for more detail. When a fund's holdings are volatile, that volatility will translate to the value of the fund. First Trust Consumer Staples AlphaDEX Fund (NYSEARCA:FXG) has SWY as its largest holding. Not surprisingly, FXG saw its price decline by nearly 10% over the same period as SWY's decline last year and is up nearly 21% so far in 2013.

With the market outlook still uncertain, investors are flocking to the consumer staples sector for safety. This has the effect of pushing valuations higher, ironically making consumer staples stocks less safe.

This is not to say that the consumer staples sector is massively overvalued and dangerous for investors. In fact, it gets my top ranking in my Sector Rankings for ETFs and Mutual Funds report. Still, the potential for volatility is there.

A great way to manage volatility and minimize risk is through an ETF pair trade (i.e. long/short strategy).

One often-overlooked advantage to ETFs is that we know their holdings and allocations every day. Mutual funds often take weeks or months to disclose their holdings. Many articles have been written about how that lack of transparency allows mutual fund managers to window-dress their holdings at the end of reporting periods. That is not possible with ETFs.

My bottoms-up analysis of ETFs based on their holdings drives my predictive ratings (defined here) on ETFs. These ratings allow investors to know more about the relative merits of ETFs.

As I have shown in my Best & Worst ETFs articles, you cannot trust ETF labels. We cover 9 consumer staples ETFs and they hold anywhere from 22 to 118 stocks. That wide range means the performance of the ETFs is likely to be very different. My free ETF screener provides my ratings and reports on all 9 consumer staples ETFs.

Further, some consumer staples ETFs hold good stocks and others do not. Per Best & Worst ETFs & Mutual Funds: Consumer Staples Sector, investors need to tread carefully when considering consumer staples ETFs. Only five out of nine allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating.

The ETF pair trade I propose maximizes the value of my research for clients by identifying the very best consumer staples ETF to be long, Consumer Staples Select Sector SPDR (NYSEARCA:XLP), and the very worst ETF to be short, PowerShares S&P SmallCap Consumer Staples Portfolio (NASDAQ:PSCC). If PSCC is not liquid enough to short, my recommended alternative is PowerShares Dynamic Food & Beverage (NYSEARCA:PBJ).

XLP gets my Very Attractive rating because it allocates 66% of its value to Attractive-or-better rated stocks. Only 2% of its portfolio is in Dangerous rated stocks and it has zero investment in Very Dangerous rated stocks. It also has a low expense ratio of 0.18%, better than 85% of all ETFs.

PSCC and PBJ, on the other hand, allocate too much of their funds to lower quality stocks. Over 45% of PSCC's funds are allocated to Dangerous-or-worse rated stocks, and PBJ has nearly 21% of its funds allocated to Dangerous stocks. In addition, PBJ has an expense ratio of 0.60%, higher than nearly 70% of all ETFs.

This pair trade gives investors exposure to the best that Consumer Staples ETFs offer and minimizes risk of loss by shorting the worst that Consumer Staples ETFs have to offer. Win win.

Colgate-Palmolive Company (NYSE:CL) is one of my favorite stocks in XLP and earns my Very Attractive rating. CL is a very consistent company. It has grown after-tax profits (NOPAT) in every year but one (2004) since our model begins in 1998, averaging 8% growth compounded annually. With rising economic earnings and a healthy free cash flow yield of 4.6%, all signs point towards CL continuing this trend of steady growth. However, at a valuation of ~$118.75/share, CL has a price to economic book value ratio of only 1.1. The market is expecting CL to never grow NOPAT by more than 10% of its current value. With the kind of consistent growth CL has achieved, it ought to surpass these expectations easily. Throw in a recently announced 9.8% hike in quarterly dividends, and CL presents a lot of upside to investors.

The Anderson's, Inc. (NASDAQ:ANDE) is one of my least favorite stocks held by PSCC. It earns my Dangerous rating and a place on my Most Dangerous Stocks list for March. 2012 was a bad year for ANDE, as its NOPAT declined by 42%. ANDE had seen its gross margin fall in five of the past six years, and in 2012 it reached a new low of 6.8%. However, the market appears to be treating ANDE's poor 2012 as a fluke, as the stock is trading at ~$53.56/share, up 25% on the year. This valuation implies that ANDE will grow NOPAT by 13% compounded annually over the next 5 years.

ANDE posted record profits in 2011 and regressed back to a level of profitability more in keeping with the past few years in 2012. Twice in the past six years it has posted two consecutive years of 10% plus growth in profits. Both times, it saw profits decline by over 40% the very next year. Two steps forward and one step back is not going to be enough for ANDE to justify its sky-high valuation.

Going long on XLP allows investors to take advantage of the upside in the consumer staples sector and benefit from the consistent, stable growth of companies like CL. Shorting PSCC or PBJ allows investors to hedge and bet against the artificially high valuations of companies like ANDE. Whether the surge in consumer staples stocks (The Dow Jones U.S. Consumer Goods Index is up nearly 14% in 2013) continues or stagnates, this ETF pair trade should put investors in a position to profit.

Sam McBride contributed to this post.

Disclosure: Sam McBride owns CL. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.