VDC: Market Catching Up To Consumer Staples

| About: Vanguard Consumer (VDC)

Summary

An ETF built on consumer staples with a low expense ratio is a beautiful thing.

Vanguard designed a great ETF for surviving downturns in the market, but the sector valuations are getting high.

Investors are running out of options for attractive investments as the market rallies near record highs.

One of my favorite strategies for working on risk adjusted returns is focusing on the reduction in risk. It seems most of the market emphasizes the importance of maximizing returns and often takes on more risk than they want to admit. Since I have a preference for stable equity allocations, it should be no surprise that the consumer staples sector appeals to me. The unfortunate thing for investors in this area is that the market is valuing consumer staples at fairly high levels as well. If an investor wants a simple way to buy the sector while minimizing fees, the Vanguard Consumer Staples ETF (NYSEARCA:VDC) should be near the top of their list.

Expense Ratio

The ETF is posting .10% for an expense ratio. I want diversification, I want stability, and I don't want to pay for them. I view expense ratios as a very important part of the long term return picture because I want to hold most of my investments for a time period measured in decades.

Largest Holdings

The diversification within the ETF is significantly limited, but that should be no surprise since it is holding only one sector. This is easily the biggest critique of the ETF. Since the fund has such a top heavy allocation it would be feasible for investors to replicate a large portion of the portfolio by buying the individual stocks. Since the expense ratio is only .10% this wouldn't make sense for shorter allocations or for investors intending to buy every month or two, but for a simple buy and hold investor setting up a portfolio for the next 10 years it would be feasible to just incur trading fees once and replicate a substantial portion of the portfolio.

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I like the top holdings a great deal, but the prices are high enough to concern me. Pepsi (NYSE:PEP) is a company I've wanted in my portfolio for quite a while, but I can't swallow the very high P/E ratio on the company. I like the brands they've produced, but the multiple on earnings is painful. They are trading at about 28 times trailing earnings.

Unfortunately, that isn't particularly unusual for this group of stocks.

Prices

The following chart allows me to compare VDC with a few of the other excellent ETFs on the market:

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VDC demonstrates a P/E ratio of 25.9x. That emphasizes the challenge with buying into the consumer staples sector at this point. As investors look for safety it is normal for them to seek protection in the consumer staples sector. The result is a 25.9x P/E ratio when the earnings growth rate for the sector is only 4%. If we expected that trend to continue, it would suggest total returns to the sector would be significantly since we wouldn't expect dividends to outpace growth in earnings without dragging the earnings growth rate lower. Given the high P/E ratios, it isn't reasonable to think the sector can boost EPS substantially through repurchasing shares either. Retiring shares simply isn't as effective when prices are already so high.

Comparing to VIG

The Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) is another perennial favorite with investors that would like to focus on companies with a little more safety than the S&P 500 presents. However, VIG is also trading at fairly high ratios:

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The earnings growth rate has been slightly better at 4.5% and the P/E ratio is slightly lower at 25.1x rather than 25.9x, but that isn't enough to make it seem cheap. I believe this is another very solid ETF, but the market is simply rallying to levels that are too high to suggest any large purchases.

Comparing to VOO

Vanguard uses the Vanguard S&P 500 ETF (NYSEARCA:VOO) to track the S&P 500:

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VOO is significantly cheaper in terms of both the P/E ratio and the demonstrated earnings growth rate. However, I'm concerned that the earnings growth rate won't look near as strong in the future since the S&P 500 has a significant allocation to energy companies. As you probably know, oil prices have been plummeting for over a year and the result is falling earnings and in some cases bankruptcies in the oil sector. The growth rate of earnings should be limited as a result of substantially weaker earnings in the sector.

For the financial firms holding the debt of oil companies, there may be another hit to earnings as they deal with defaults on bonds. In my opinion the combined result should significantly reduce earnings growth and could certainly send it to negative territory.

Conclusion

VDC is a great ETF with a low expense ratio and a good chance to perform better if the economy enters a recession. On the other hand, the ETF suffers from the sector it tracks already trading at fairly high valuations despite low earnings growth rates. The consequence of trading at higher P/E multiples is a significant reduction in the ability of companies to grow earnings through repurchasing shares and the potential for a bigger fall during a market decline.

I still like the sector to outperform the S&P 500 over the next few years because I don't see enough growth in the economy to justify overwhelmingly bullish expectations. Despite a high multiple, I think VDC would still face less selling pressure than the S&P 500 or whole market ETFs in the event of another recession.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.