A popular TV pundit warned investors last week that they should be looking to take profits in company's of consumer packaged goods after any bounce in the shares. I would agree that valuations and the outlook for many of these companies are flashing sell signals but I think he is wrong to suggest waiting for higher prices. The downside risk in many of these names does not justify the possibility of a few extra percent and you need to get rid of them immediately!
A bubble can burst anywhere
I warned investors in May that the bubble in consumer staples could burst at any time. The Consumer Staples Select Sector SPDR (XLP) has jumped 117% since the market bottomed in 2009, outperforming the S&P500 by 26% over the period. When defensive sectors with lower prospects for growth outperform cyclical, growth stocks then something is wrong in the market. Investors, rushing to the safety of mature revenue growth and dividends, have created a bubble in the last place most would think possible.
The sector now sells for a forward multiple on earnings of 17 times, a 15% premium on the 14.8 times investors are willing to pay for the forward earnings of the S&P500. This is despite the sector only posting compound annual sales growth of 3.6% over the last five years.
The outlook for companies in the consumer packaged goods industry is flat at best and could go from bad to worse in a heartbeat. Many of the companies benefited from falling commodity prices this year. A sluggish economy has left less room for discretionary purchases, making staples look relatively better. If the economy picks up over the next few quarters, these stocks lose their appeal. Expectations for revenue growth on the four stocks below are between 70% and 311% higher than their five-year averages and I doubt that this growth will be achieved.
Household names you should put in the trash
Kimberly Clark (KMB) trades at 20 times trailing earnings, a high established last year and twice its lowest multiple of 10 times earnings seen in 2009. Sales at the $35.7 billion personal and home care products company have grown at a 2.8% annualized pace over the last five years. The shares have jumped 11.5% over the last year against a 20-yr compound annual return of 7.8%. Earnings for 2013 are expected to increase 8.2% to $5.68 per share. Even at a valuation of 15 times per share, the stock would be worth $85.20 or 9% lower than its recent price.
The Hershey Company (HSY) is valued at 28 times trailing earnings, compared to a previous high of 26 reached last year and a five-year low at 16 times earnings. Sales at the $20.5 billion chocolate and candy manufacturer have grown at a 6.0% annualized pace over the last five years. The shares have jumped 27.3% over the last year against a 20-yr compound annual return of 10.6%. Earnings for 2013 are expected to increase 14.5% to $3.71 per share. I doubt that the company can achieve that level of growth. Even at a valuation of 21 times per share, the stock would be worth $77.91 on the forecasted number, or 15% lower than its recent price.
Clorox (CLX) trades for 19 times trailing earnings, under its high of 36 times in 2011 but still well above the low valuation of 12 times earnings in 2009. Sales at the $10.9 billion household products company have grown at a 1.7% annualized pace over the last five years. The shares have jumped 13.3% over the last year against a 20-yr compound annual return of 9.6%. Earnings for 2013 are expected to increase 7.0% to $4.62 per share. At a valuation of 16 times per share, the stock would be worth $73.92 or 11% lower than its recent price.
General Mills (GIS) is trading at 18 times trailing earnings, compared to a previous high of 17 times last year and a low of 10 over the last five years. Sales at the $31.6 billion branded foods manufacturer have grown at a 5.0% annualized pace over the last five years. The shares have jumped 25.2% over the last year against a 20-yr compound annual return of 6.9%. Earnings for 2013 are expected to increase 8.5% to $2.92 per share. On the forecasted earnings and at a valuation of 14 times per share, the stock would be worth $40.88 or 17% lower than its recent price.
Investor behavior and the house money effect
The danger in the pundit's advice to wait for the next bounce before investors sell out of the shares is known as the House Money Effect. This behavioral bias is seen in gamblers and investors after they have made a winning bet. People have a tendency to take greater risks with this money, much higher than the risks they would normally take. The casino is counting on the gambler to keep playing and eventually give the money back along with a little extra.
Investors with a profit in the consumer staples may rationalize sticking with the stocks until the next bounce in the same way. If their picks bounce higher, they have made a few extra percent. If the shares come down then it was free money anyway.
The problem is that these stocks really have no reason to move higher from already lofty valuations and a few extra percent is not worth losing money you've earned. Your investment process and guidelines for picking stocks should stay the same regardless of how you earned the money, whether through a 9-to-5 job or through profits on investing.
Go on, take the money and run
It gets harder when you have just invested in the sector and have yet to see much return. In this case, reevaluate your outlook on the shares. A closed out trade with no return is still better than losing money.
For those of you that have benefited from the herd's stampede into the high-yielding consumer staples, enjoy your gains and buy yourself something nice. Resist the urge to take more risk than you would normally take and sit on a bad investment just for a few additional percent return.