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By Joseph Hogue, CFA

Before 2011 is in the ground, the pundits will be bringing out their 2012 forecasts and projections. From what has been released, it looks like next year will be a positive year for the markets and a slow climb out of the darkness for the economy. Given marginally improving data and rumors from Europe, I would be inclined to believe the prognosticators had I not heard the same thing almost twelve months ago. As 2011 disappointed with market volatility and sideways investments, so may the next year. Regardless of your view on next year’s markets, the stocks in one sector should provide stable returns and a sound dividend. The consumer staples sector is typically defined as those companies in food processing, beverages, tobacco, personal & household products, and office supplies.

The sector has played its defensive role during the recent market turbulence with the Consumer Staples Select Sector SPDR (XLP) returning 3.0% over the last six months compared with a loss of (1.4%) for the S&P500 (NYSEARCA:SPY). The fund pays a dividend yield of 2.7% and has returned 10.4% over the last year.

Consumer Staples, aka consumer non-cyclicals, are a typically defensive investment because the companies more easily withstand sluggish growth. Necessity products like food, toothpaste, and toilet paper are on everyone’s shopping list even if that shiny new Lexus is not. Some staples, such as alcoholic beverages, even manage to do better during times of economic weakness.

Most companies within the sector are fairly large with all our picks below above $16 billion in market cap. The industry is a mature one meaning growth is either bought through acquisition or by moving into new markets. Over the last ten years, much of the growth in the segment has come from revenue in emerging markets. As is typical in mature industries, debt is used to a high degree to augment lower margins.

Despite stronger relative sales during rough economic times, investors still need to do their homework and select good stocks within the group. There are still risks to the group and to specific industries. The tobacco industry is prone to litigation risk, while food processors face risks of product recall due to health concerns. As the companies move into new markets within emerging countries, they must either grow through acquisition or develop their own brands. This poses challenges as well and can significantly affect prices as recently seen in shares of Avon (AVP). The door-to-door cosmetic retailer is under investigation by the Department of Justice for violations of the Foreign Corrupt Practices Act. While shares have been hammered by lower earnings and regulatory problems, I believe the company is undervalued based on legal precedent.

Standard & Poor’s proprietary STARS (Stock Appreciation Ranking System) was designed to focus on appreciation potential for equities over a 6-12 month period. S&P analysts rank equities from five stars (strong buy) to one star (strong sell) based on an undisclosed system but grounded in fundamental analysis. Since 1986, stocks in the one-star portfolio have underperformed the broader market by 6.7% while those in the five-star portfolio have outperformed the S&P500 by an annualized 6.1%. Presented below are some of the five-star picks in the consumer staples sector.

General Mills (GIS) manufactures and markets consumer foods worldwide. The company’s products cover the spectrum of food processing but are concentrated in grains. This makes the shares especially sensitive to volatility in commodity prices and can affect the company’s margins. The stock’s beta is extremely low at just 0.16 meaning it is much less volatile than the broader market. The company took a controlling interest in Yoplait this year increasing its exposure to the dairy market.

H.J. Heinz (HNZ), also operating in the food processing industry, does not have the range of products or the geographically dispersed revenue as General Mills. Despite this, the company is well-diversified geographically and across product lines. A key strategic move this year has been the aggressive acquisition of companies in Brazil and China to diversify sales into emerging markets. Much of the company’s core products are more discretionary than those of General Mills hence shares are relatively more sensitive to changes in consumer spending. The company’s price-to-earnings ratio is the highest of the group. This is not as alarming when compared to the average of 17.5 times trailing earnings for food processors, but still high given an absolute measure of valuation.

Coca-Cola (KO) owns or licenses more than 500 non-alcoholic beverage brands around the world. For 2010, sales to North America accounted for 31.7% of revenue with 23.4% of total revenue coming from bottling investments and the rest from international sales. Coca-Cola has the highest return on assets of the group (ROA=ROE/Debt-to-Equity), a sign of operational efficiency. While the company’s dividend yield is lower than the other four picks, it is still a very respectable 2.8% and the share’s trade at the lowest valuation on an earnings basis. Strategically more important for the company is its five-year earnings growth of 20.0%, almost double that of rival Pepsi (PEP) at 10.4%. For long-term return stability and current valuation, Coca-Cola is my favorite of the group.

Following the spin-off of Kraft (KFT) in 2007 and Philip Morris in 2008, Altria (MO) operates generally within the tobacco and smokeless tobacco industry but does generate some revenue from wine. Altria’s price-to-earnings is fairly high relative to other mature companies but only marginally above the average for tobacco companies at 16.2 times trailing earnings. The company’s debt/equity ratio is lower than that of Philip Morris, but still higher than the industry average of 2.5 times.

Philip Morris (PM) is more focused in the tobacco and smokeless tobacco industry than Altria and more than twice the size by market capitalization. The company is the largest manufacturer of tobacco products with 16% of the 2010 international market. Philip Morris has the highest debt/equity ratio of the group and a little alarming even for a mature company. The high level of leverage makes it possible to achieve a triple-digit return on equity but masks a much lower return on assets. Partly due to its excessive use of leverage, the shares have the highest beta of the group at 0.93 making them almost as volatile as the broader market. The lower price/earnings ratio relative to Altria is attractive but does not compensate for the lower dividend yield and much higher leverage.

Though consumer staples companies may not increase substantially with technology or financials in a rebound, they will not disappoint as a core portion of your portfolio. With well over 300 companies in the sector, investors need a formal process to find relative winners in the group. The S&P Stars portfolio ranking system provides a good place to start but investors should also analyze the companies further before investment.

Source: Standard & Poor's 5-Star Consumer Stocks Look Good For 2012