Here we are in Round Two of our ongoing series for long-term investors. During the market action of the last few weeks, the Consumer Staples vs. Discretionary title bout has been a lopsided demolition. Staples have a big lead and nary a scratch or bruise. But this is a 10-year trade and there's a lot of future that still needs to be written.
Round One of our Trade of the Decade series was Energy vs. Financials. Each of those sectors have been spanked pretty hard during the selloff, but given the revised economic outlook for the next 18 months, my guess is that the former has a much better shot of stabilizing and bouncing back. This correction has exposed a new round of fear and weakness in the bank sector, particularly Bank of America (BAC) and some of the big European banks. Again, remember that these investments are marathons, not sprints. I'm not getting too excited about writing about categorically avoiding financials and then watching the financials completely disintegrate almost immediately thereafter.
That was dumb luck.
The Macro Thesis
The gist of our trade is that the economy ahead - the next 7-10 years or so - looks totally different than it did during the long boom. You're going to need an investment philosophy that fits that world. And if you think what worked best during the long boom is going to keep on working, you've got a lot of disappointment and heartburn in your future. It's time to rethink portfolio construction.
A world of lower-than-normal economic growth, slow job creation, and perhaps most importantly, credit contraction and continued deleveraging, demands a different strategy. The crux of our thesis is that investors should get long with the stuff that people need in countries and companies with clean balance sheets, and get short in the stuff that people don't need in places that are still highly leveraged or hold questionable assets.
You're going to need two things in the decade to come that you really didn't need during the long boom: caution and skill. Gone are the days of mindlessly buying an index fund on margin and watching the profits roll in.
Consumer Staples vs. Discretionary
Today's idea is to get long Consumer Staples over Consumer Discretionary. I know that's not rocket science, but somewhere in all this noise that alternates between IPO/recovery frenzy and total global chaos, there is a legitimate place for boring, simple, overlooked strategies.
Here's what that trade looked like over the last decade. I used the two major consumer ETFs, XLP and XLY, as a broad proxy for each sector, and charted the performance of $10,000 invested in each at inception. It includes dividends.
Discretionary has outperformed, but in the last few weeks it has given back almost all of the lead that it spent a decade building. And you can see that in a really nasty environment like 2007-2009, it can lose its entire advantage and then some. Such is the trouble with sectors that are more tightly linked to the health of the economy.
Even if someone handed me this chart back in 1998 and told me to choose one for the next 10-15 years, I'd still probably pick the green line since it's so much less volatile. 1998 was a crazy time, though, so who knows. I probably would have said, "Are you nuts?! I'm loading up on this Internet thing!" Laughing all the way to my start-up web job in my leased BMW.
So that's one way you can go. You can own XLP or something similar and short (or avoid) something like XLY. Let's start with Consumer Staples. Here's what's in the XLP, which is based on the weighting of Consumer Staples inside the S&P 500.
Giddy up. Can you say boring? I love boring! If this next decade is as brutal as I'm worried it might be, then boring companies will help you sleep better. And who among us doesn't want a better night's sleep?
Seriously, though. These are the types of companies that hang in there through the full economic cycle. These companies aren't very volatile. They all pay 3-5% dividends. And these are a lot easier to buy tactically, scaling into them during periods of market turmoil.
Procter & Gamble (PG) is probably the most extreme example of this. Check out their 5-year price chart.
Procter & Gamble basically gives you Inflation + a 3.5% Dividend. And for the next decade? I'll take that. I'll take that over a 30-year Treasury currently yielding 3.4%. I'm not greedy. This decade of deleveraging and economic turbulence is going to be about capital preservation. I want to have some powder left when the really awesome opportunities come further down the road. I'm playing a very long-term game.
I know Wal-Mart (WMT) has had some trouble this year, but that's the place that consumers go to buy these goods that they need to buy. I feel pretty good about Wal-Mart hanging in there through thick and thin. In contrast, Whole Foods (WFM), which has had a rather nice year, is the type of place that people go to buy the goods they want to buy. For the next decade, I'm sticking with need over want and I'm starting today. I think there are more tough times still ahead and I'm bad at timing. Whole Foods could continue to be great for a while.
Finally, iShares runs a global Staples fund, (KXI), which is an interesting idea. If you look inside, you'll see that it owns a lot of Nestle. That's cool. Nestle should also be a very relevant and resilient company in the next decade.
The other side: Consumer Discretionary
Our big proxy for Discretionary is the XLY ETF. This is the stuff to avoid. But honestly, when I look at the largest holdings in XLY, I don't hate them categorically the way I do the financials.
See for yourself:
McDonald's (MCD) is a fantastic and fantastically relevant company for the coming decade. Is it technically a discretionary stock? I suppose so, but I think it's a good one. McDonald's has a reputation for putting up nice numbers in a weak economy, and right now I see no reason why that would change. There are growth opportunities for them in stronger economies and their business remains highly defensible even in a weak domestic economy. The risk with McDonald's, I suppose, is that the U.S. goes on a massive wealth creation tear and they get left in the dust by upscale food chains like Darden (DRI). Darden has been a phenomenal success story and controls a powerful, well-managed portfolio of brands. But this is a stock that has been eviscerated in every past recession. And I happen to think that recessions will be more frequent in the coming decade or two than they were in the last few. If I was really bullish about the long-term economy, Darden is exactly the kind of company I'd bet on.
Disney (DIS) and Amazon (AMZN) are also fantastic companies that will each play a crucial role in the rebuilding of the middle class. That's probably a Trade for a Future Decade and I'm not sure when that trade officially begins. Until then I don't want to bet too heavily against companies like Disney or Amazon.
Still, the fact remains that those two and every other company on that list and in the consumer discretionary index will probably take it on the chin if the economy slows down. So I'm staying away. If you're looking for candidates to short, don't go looking at the discretionary names inside these major ETFs. Look at the ones on the fringe with higher betas. This is a list that's large and diverse, so you'll have to do a lot of your own legwork and exercise appropriate caution. But something like Marine Products Corporation (MPC) is an example of the type of company to look for. Or how about GameStop (GME), a company with a dying business model neck-deep in the realm of discretionary purchases?
The point is that Consumer Discretionary are companies that get hurt extra hard during periods of economic distress and Staples are the ones that hold it together. The last month is an excellent example. Check out how dramatically Staples have outperformed Discretionary.
That's some impressive resilience. I feel pretty good that if my thesis about the nature of the economy in the next decade is correct, then this specific trade will execute rather nicely. If the economy of the next decade is going to be a long slog full of more recessionary potholes than the last few decades, Staples should outperform Discretionary, especially on a risk-adjusted basis.
The risk, of course, is that my thesis is wrong. For those of you who have been tracking our Predictions for 2011, the fact that I am frequently wrong about the future should come as no surprise.
Even if you disagree with my thesis, then this analysis is still useful. If you think the economy is going to be awesome in the coming decade, my suggestion is that you double down on economically-sensitive stocks like Home Depot (HD) and avoid the boring stuff like Coca-Cola (KO).
This whole thing comes down to a guess about economic landscape up ahead. I've written extensively about what I think that world looks like. I think the environment is ripe for a trade that emphasizes resilient sectors like Energy and Staples and avoids economically-sensitive sectors like Financials and Discretionary.
I may be wrong. But if you agree, there are simple things that you can do about it.
Last week I suggested a strategy so easy you could write it down on an index card and then go open your own hedge fund. In fact, I'll bet there are hedge funds out there that actually manage a similar portfolio and charge 2 and 20 for the privilege. So feel free to steal that base strategy and add the following twist: take the portion allocated to Consumer Discretionary and give it to the Staples.
Now your portfolio (or hedge fund) looks like this:
Energy - 24%
Staples - 23%
Health Care - 12%
Industrials - 11%
Technology - 19%
Materials - 4%
Telecom - 3%
Utilities - 4%
That's not bad. That looks like the kind of equity fund that is MUCH better equipped to deal with the challenges of the next decade. I think that fund right there outperforms the S&P over the next ten years, don't you?
I suppose the good news is that if we're wrong and it lags the S&P, it'll be because the world went back to being as awesome as it was during the good ol' boom days.
I'm happy with that outcome, too.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.