Why Is Consumer Staples Underperforming?

Includes: MDLZ, PG
by: Vinay Ayala

Towards the end of last year anyone and everyone you talked to would tell you one thing about investing in the equity markets: Overweight the healthcare and consumer staples sectors. Two months into this year, in what should not come as a surprise, the pundits were wrong again, with staples ranking 5th in year-to-date performance when compared to the other sectors in the S&P 500. Surprisingly, the information technology sector has performed the best year-to-date of the 10 sectors in the S&P 500. Let me offer my opinion on why the staples sector has underperformed, and what to expect going forward.

Herd Mentality: When all “experts” make a forecast, something else is going to happen: One of the famous market rules written by former Merrill Lynch legend Bob Farrell, seems to be coming true with the staples sector. When everyone agrees about a certain topic, it is normally at the height of the bullishness on the market subject. Staples seems to be a victim of a market where everyone tried so hard to implement a particular investing strategy, that it got to the point where it was not unique. You can't differentiate one portfolio from another.

When most of the stocks in a sector are owned, unless owners are comfortable with adding more risk to their portfolio by adding more stocks from that particular sector, they are essentially creating the top for the stocks in this sector, and thus their own portfolio. Let’s face it, beating the markets involves using analysis that other people may not have readily thought of, and trying to exploit it to your advantage. Clearly consumer staples was not the medium by which you should have tried to implement this strategy over the past few months.

When the market goes down by 5,10,15% then fire sales will arise out of fear. If your portfolio is over-weighted with staples stocks, then that is also when you begin selling to liquidate the heaviest position in your portfolio, building a cash position. The overweight rating that many subscribed to back when the Dow was at 8700, has also caused the collapse. Now people move from being comfortable with the perceived safety of staples stocks, to being completely jaded by the equity market, and not wanting any part of it.

Earnings Outlook: The earnings outlook for staples companies has been anything but rosy. When companies like Procter & Gamble (NYSE:PG) report dismal outlooks in an economic environment where they should be thriving, it indicates that no company is immune to the worst economic downturn since the Great Depression.

When all the trends are in a sector's favor, investors are more than willing to allow the stocks in the sector to trade at a premium relative to market norms. Of course those stocks need to be able to keep up performance and maintain their fundamentals. At the first sign of weakness, though, investors will be the quickest to take away this premium which they feel may not have been warranted in the first place as they question the validity of their intuition.

Clearly some of the staples companies did not deserve to trade at premiums, and did so because every pundit said that an investment in the sector would be a great idea. Much of the earnings deterioration can be attributed to the fact that companies in the sector really pushed international growth in the past few years, and as this downturn goes global, not only are revenue streams affected in foreign countries, you are seeing currency hedges go wrong with the recovering dollar and foreign currencies collapsing with their respective economies.

Trade Down Effect: The trade down effect from brand name goods to private label goods has caused a change of epic proportions in the staples sector. While it is easy to say that people will revert to goods that Procter and Gamble provides during a recession because they provide relatively inelastic goods; the reality is consumers will go further to cut costs and begin to purchase generic brands. That is exactly what is going on in the private sector right now.

Brands like Kraft (KFT) are not the lowest level that customers are willing to go anymore. There are a lot of the private companies who offer goods significantly cheaper. It is definitely an interesting trend in the staples sector, that has played out much stronger than I had originally thought it would.

All in all, staples has not been a particularly good or bad investment within the equity markets. It has been merely average. I definitely did not expect that going into this year, but I guess that is just what makes the markets so interesting and offers anyone and everyone a continuous learning experience. It makes you wonder what the next day will bring, and where we will go from here. I guess that is the real question in these chaotic markets.

-Vinay Ayala

Disclosure: None