What It Means To Buy A Blue-Chip Consumer Staple Stock Right Now

Includes: CL, CLX, HSY, KMB, KO, PEP, PG
by: The Conservative Income Investor

Because I have written favorable articles about many blue-chip consumer staples in the past, I have often received questions from readers wondering if it would be prudent to buy something like Kimberly-Clark (NYSE:KMB) or Procter & Gamble (NYSE:PG) these days, particularly after the recent run-up in share prices over the past three to 12 months. While not all consumer staple stocks are trading at the exact same valuation obviously, the general trend for the sector has been this: over the year and a half or so, the valuation for most blue-chip consumer staples has transitioned from moderate undervaluation to full valuation, and in some cases, mild overvaluation. For an investor considering buying a consumer staple today, what are the implications?

The best way to start this conversation is by reminding ourselves why Benjamin Graham made the "margin of safety" principle the cornerstone of his work. When Graham insisted that investors try to gobble up shares of companies trading at 67% or less of intrinsic value, the primary motivation was not to generate superior returns (although market-beating performance was often the end result). Rather, Graham believed that by insisting on a discount to intrinsic value, he could guard against future business performance that fell short of expectations (Graham believed that analysts and managements were often too optimistic with their predictions of future performance). Graham wanted to find a way to guard against this disappointment. Namely, if he expected 10% growth from a security but only achieved 5% growth, he would still generate satisfactory returns above that 5% threshold because he would presumably benefit from the P/E multiple expansion that moves a stock price as the other stock market participants eventually recognize fair value.

That's why I enjoy seeking out companies that are both excellent and undervalued. That way, my investment is covered by two layers of margin of safety. On one hand, I'm buying into a firm like Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Clorox (NYSE:CLX), or Colgate-Palmolive (NYSE:CL) that has an excellent track record of growing earnings by 8-12% annually and appears poised to continue that into the future. That's one layer of the margin of safety. The other is when I'm able to buy these kinds of companies at a discount relative to what they are actually worth. If I purchase at a discount, I could still achieve those 8-12% over a medium holding period even if the earnings growth lags that 8-12% target. This is the other layer of safety, which is the one that Graham often stressed in his own writings.

If you are going to buy a blue-chip consumer staple today, you should proceed with the expectation that your medium-to-long results will roughly equal the business performance of the company. You're likely giving up the ability to benefit from any meaningful P/E multiple expansion that could provide a margin of safety in the event that earnings growth falls below expectations. But of course, relying on earnings growth alone to be responsible for your total returns is not a terrible place to be. Pepsi has grown its business by 10.5% annually over the past decade. Colgate-Palmolive, too, has grown at a 10% rate over the past decade. And for Coca-Cola, that figure is 9.0%. It's clearly not a foolish thing to pay fair value for an excellent company, but you should be aware of the terms of such an investment: the business performance alone will account for your medium-to-long term results, assuming rational pricing at the time you sell.

It's up to you to determine whether owning one of these excellent businesses at the upper edge of fair value fits your needs. Your opportunity costs, personal temperament, and goals are different from mine, and therefore, your capital allocations will be, too. Coke currently trades at 20x earnings. If you take into account what analysts, Value Line, and Coca-Cola's own historical valuations indicate, it will probably be fully valued when it trades at 20x earnings over the next 5-10 years. If the business earns 7%, you'll probably get around 7%. If the business earns 10%, you'll probably get around 10%. You need to decide if you're comfortable with those terms. If you need a margin of safety in case Coca-Cola's business performs below expectations in the next 5-10 years, then you shouldn't buy today. If you believe that the business is excellent and has a high probability of growing at 10%, then buying Coca-Cola stock today may very well satisfy your needs.

Personally, I like to be picky: I want the double margin of safety that is available when you can buy a company that is both excellent and trading at a discount to intrinsic value. But, you still can create long-term wealth by paying full value for an excellent company. If you paid 18x earnings (roughly full value) for Hershey (NYSE:HSY) in 1993, you still could have turned every $1,000 invested into slightly over $10,300 today. That's because the earnings growth of the company was 11% over that time frame. When the business is excellent, you can still get rich as the business grows. But your conviction in the business strength is what must carry the day if you choose to purchase a consumer staple today without the margin of safety in terms of price.

Disclosure: I am long PG. 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.