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By Robert Goldsborough

U.S. stocks have little to show for themselves thus far in 2014, with the S&P 500 Index posting a slightly negative return (negative 0.8% as of this writing). However, after U.S. equities' tremendous gains in 2013, Morningstar's equity analysts consider the U.S. stock market to be fairly valued. The S&P 500 Index currently trades at a price/fair value of 1.01, while Morningstar's coverage universe is trading at a price/fair value of about 1.03.

While Morningstar's equity analysts deem all broad U.S. equity sectors fairly valued, we see a potential buying opportunity for contrarian investors in the beleaguered consumer staples sector, which currently has one of the lowest price/fair value ratios of any U.S. equity sector, at 0.97.

Over the past 12 months, the staples sector has lagged every other U.S. equity sector except the energy sector, and it has been the worst-performing equity sector thus far in 2014. While the sector's poor relative performance undoubtedly has frustrated staples fund investors, there are positive reasons to invest in defensive names right now.

First, let's discuss why staples companies have underperformed so significantly over the past year. The two biggest contributors, we believe, are the recent slowdown in consumer spending in emerging markets (which are a perceived growth catalyst for many consumer staples companies) and the rise in interest rates. As interest rates have risen and the Federal Reserve has made noise about curbing its easy-money programs, we believe that some spooked investors that had been using consumer defensive names--and their relatively strong dividend yields--as a proxy for fixed-income investments have rotated back to holding bonds and bond funds. Most recently, some staples firms with strong overseas sales have been facing foreign-currency headwinds that have had negative impacts on reported quarterly operating profits.

With all this bad news understood by the investment community and priced into companies' share prices, we see possible bright spots for contrarian investors considering investing in a basket of consumer defensive names. For one, consumer spending in emerging markets could rebound after its recent period of weakness. And we believe investors have a certain amount of downside protection, given the inherent quality bias in consumer staples companies and their strong dividends (broad exchange-traded funds devoted to the sector churn out dividend yields of anywhere between 2.4% and 2.8%, both of which are above the S&P 500 Index's 2.3%). Finally, the U.S. economy is widely considered to be in a midcycle expansion. Consumer staples is one of the few sectors that historically has performed well both during late-cycle expansions and during subsequent recessions. Put another way, the consumer defensive sector is reasonably well-positioned to benefit from inevitable changes in the business cycle in the medium term.

For investors willing to consider consumer staples stocks, one ETF we like is Consumer Staples Select Sector SPDR (NYSEARCA:XLP). This fund is suitable as a complementary satellite holding to a diversified portfolio and could be viewed as a defensive portfolio tilt.

This ETF has a very high-quality portfolio, with more than two thirds of assets invested in wide-moat firms, and a very low, 0.16% expense ratio.

Food and staples retailers make up 25% of this ETF's assets, followed by household products firms (21%), beverage producers (20%), food producers (17.5%), and tobacco companies (14.5%). This fund has been 81% correlated with the S&P 500 over the past five years.

Over the past 10 years, this ETF has been meaningfully less volatile than the broader market. It also has displayed less volatility than competing consumer staples ETFs. The fund is less volatile because unlike iShares US Consumer Goods (NYSEARCA:IYK), XLP holds Wal-Mart (NYSE:WMT) and several other large, defensive drug and discount retailers. These relatively steadier names have helped mitigate XLP's volatility. In addition, unlike another competing staples ETF, XLP does not hold any auto-related firms, which generally are far more volatile. For comparison purposes, XLP's five-year beta relative to the S&P 500 Index is 0.49, while Vanguard Consumer Staples ETF's (NYSEARCA:VDC) five-year beta is 0.51 and iShares Consumer Goods ETF's five-year beta is 0.82.

Fundamental View
In general, consumers buy consumer staples products and services regardless of the economic climate. As a result, the holdings in this ETF generally have stable revenue growth and cash flows.

Procter & Gamble (NYSE:PG) is this ETF's largest holding at 13.5% of assets. As a result, P&G's fortunes have an outsized impact on XLP. Like several of its peers, the consumer products giant recently reported weak earnings from currency headwinds earnings that are expected to persist in the near term. P&G also is continuing to wrestle with slowing growth rates, a bloated cost structure, and some questions surrounding the company's continued ability to innovate and command premium prices for its products. P&G's efforts at expanding into emerging markets also have run into problems, as Morningstar's equity analysts believe that the company tried to enter too many markets too quickly. Now, our equity analysts are cautiously optimistic about P&G's more-targeted approach toward emerging markets. Looking ahead, P&G now is focusing only on its largest developing markets. It also has embarked on an ambitious, $10 billion cost-savings plan aimed at ultimately freeing up more cash for reinvestment opportunities. At the same time, investors in this ETF should closely watch P&G's cost-cutting program, which our analysts fear either may not be attainable or may cut into important research and development staff.

Food and staples retailers comprise 25% of this ETF. XLP's largest retail holding is Wal-Mart, which has been reinforcing its everyday-low-price strategy through major price cuts and is making better capital-allocation decisions, such as shifting its capital toward higher-return domestic small stores instead of lower-return foreign ones. However, Wal-Mart has a negative moat trend from Morningstar's equity analysts, as it is facing greater competition from Costco (NASDAQ:COST) and Amazon.com (NASDAQ:AMZN), both of which have lower fixed asset bases and are willing to run their businesses at lower margins. (Amazon, which is not held in this ETF, also has begun competing in the online grocery space in California, and our equity analysts believe the rollout of this service across major urban centers in 2014 could be a key turning point in the evolution of online grocery sales.) Wal-Mart's small-store expansion may well cut into pure-play grocers held in this ETF, such as Safeway (NYSE:SWY) and Kroger (NYSE:KR). Finally, drug retailers held in this ETF, such as CVS Caremark (NYSE:CVS) and Walgreen (NYSE:WAG), over the longer term stand to continue to benefit from health-care spending growth and an aging population, although their success in the non-drug portions of their stores is less certain.

Tobacco companies, which make up around 14.5% of this fund's assets, have long been under pressure from increased government regulation, including requiring greater marketing restrictions, and higher taxation. Companies' more mature markets are experiencing lower cigarette demand, but their Asian operations are expected to be an engine for future growth. Philip Morris International (NYSE:PM) in particular has a well-balanced portfolio between developed and emerging countries, as the dominant player in the European Union and a leading position in much of Eastern Europe, the Middle East, Africa, and Asia. Unit volumes for Philip Morris are expected to rise in the coming decade in overseas markets such as Asia, Africa, and Eastern Europe, where populations are growing and there are looser restrictions on tobacco marketing. In the short term, however, we do also expect weakening emerging-markets currencies to provide a stiff headwind to the company's financial results. Other tobacco companies held in this ETF, such as Altria (NYSE:MO) and Reynolds American (NYSE:RAI), are more focused on the declining U.S. market. And while CVS recently announced that it will cease selling cigarettes and tobacco products across its 7,600 U.S. stores by October 2014, convenience stores and gas stations--both of which are fragmented markets--comprise the bulk of U.S. cigarette sales. So even if other pharmacies such as Walgreen and Rite Aid (NYSE:RAD) follow suit, tobacco should remain widely available for adults to purchase

Consumer staples ETFs' dividend yields typically are in the 2.4%-2.8% range, which is slightly higher than that of the S&P 500 Index. Morningstar's equity analysts believe that ultra-low interest rates have been helping to fuel the valuations of the consumer staples sector as a whole, with many investors stretching for yield. As a result, higher rates could revise investors' required returns upward, detracting from total returns on consumer staples stocks, despite steady dividend payments and earnings growth.

Portfolio Construction
A market-cap-weighted ETF, XLP invests in the consumer staples stocks of the S&P 500 and employs a cap-weighted structure. Sticking to S&P 500 companies provides an initial screen for quality, as holdings must meet the standards of S&P's selection committee. In fact, some 68% of XLP's assets are invested in wide-moat firms, and 22.5% are allocated to firms that Morningstar's equity analysts deem as having narrow economic moats (Morningstar's equity analysts define economic moats as durable competitive advantages). Constituents usually have to be leading U.S. companies that meet S&P's profitability criteria. The criteria eliminate large international companies, including Unilever (NYSE:UL) and Diageo (NYSE:DEO). XLP holds 40 companies. Consumer staples ETFs track indexes that are labeled either "consumer staples" or "consumer goods." Both types of indexes contain food producers, beverage companies, tobacco firms, and personal goods firms. However, consumer staples indexes--and by extension, the ETFs that track them--contain food and drug retailers, as well as Wal-Mart, while consumer goods indexes do not. Similarly, consumer goods indexes contain automakers, automotive retailers, and auto components manufacturers, while consumer services indexes do not.

Fees
The fund's 0.16% expense ratio is one of the lowest of any ETF in its category. XLP's estimated holding cost is slightly higher, at 0.23%. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share-lending revenue.

Alternatives
Investors seeking non-discretionary exposure to the consumer have plenty of ETF choices. The most similar alternative to XLP is the smaller and less-liquid Vanguard Consumer Staples ETF (VDC) (0.14% expense ratio). XLP holds just 40 stocks versus the 110 companies that VDC holds, but the two ETFs show almost perfectly positively correlated performance over the past five years (99%). In terms of assets under management and average daily trading volumes, XLP dwarfs VDC. Thus, large institutional investors demanding deep liquidity in order to move in and out of positions without having a market impact might favor the greater liquidity of XLP or might consider working with an ETF liquidity specialist. However, in our view, VDC still offers sufficient liquidity for individual investors. Given its lower expense ratio, VDC is our pick for investors seeking consumer staples exposure.

XLP and VDC have very similar subsector weightings and in fact have the same top-10 holdings. However, XLP tilts slightly more toward large-cap companies (89% of assets versus 82% of VDC's assets). Probably the biggest difference between the two ETFs is one of concentration--XLP's index assigns heavier weightings to its largest holdings than VDC's index does.

Another option is iShares US Consumer Goods (IYK) (0.45% expense ratio), which offers very similar exposure but excludes the major retailers held by VDC and XLP. Unlike XLP and VDC, IYK also holds auto manufacturers such as Ford (NYSE:F) and some apparel companies not found in other consumer staples ETFs, such as Nike (NYSE:NKE).

A recently launched and very inexpensive option is Fidelity MSCI Consumer Staples Index ETF (NYSEARCA:FSTA), which charges 0.12%. However, FSTA has minimal assets and is thinly traded. FSTA tracks a slightly different index from Vanguard Consumer Staples ETF; FSTA tracks the MSCI USA IMI Consumer Staples Index, while VDC tracks the MSCI US Investable Market Consumer Staples 25/50 Index. Fidelity customers with a minimum balance of $2,500 can buy FSTA commission-free, although beginning Feb. 1, 2014, they are subject to a short-term trading fee by Fidelity.

For those interested in gaining exposure to international consumer staples titans, we'd recommend considering iShares Global Consumer Staples (NYSEARCA:KXI) (0.48% expense ratio). KXI consists almost entirely of food and beverage producers and large European retailers.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: An Opportunity In A Fairly Valued U.S. Equity Landscape