Gearing Up for Guilty Pleasure in a Questionable Market

by: Tematica Research

With the overall market down the last three weeks and growing concerns that it is poised for a pullback, I am looking at companies across several verticals that fall into what I call Guilty Pleasure. This investment theme refers to those little treats and would be harmless vices that we as consumers like or need to have from time to time even though there may be a form of guilt associated with indulging. Chocolate, beer, wine, spirits, cigarettes, junk and fast food, gambling and more are typical products from these companies, which tend to have inelastic demand for their products, good cash flow generation and meaningful dividend income on average.

As with several of my investment themes, Guilty Pleasure cuts across several traditional Wall Street industry verticals, as it focuses on those companies that bring the kinds of products that consumers won't do without, regardless of the economic climate. With that in mind, it should come as little surprise that the Guilty Pleasure group of stocks held up well during the last two recessions and performed even better on a relative basis when compared to several stock market indices. A 2009 report by Merrill Lynch that examined the performance of tobacco, alcohol and casino stocks during all of the recessions since 1970, found that while the broad S&P 500 fell by 1.5 percent on average, the Guilty Pleasure group of stocks rose on average 11 percent. During the great tech meltdown, the broad market fell 20% between June of 2001 and 2002, but during that time tobacco stocks gained 8% and gambling related stocks nearly 20%.

The inelastic demand associated with these need-to-have products, coupled with this historical performance, has resulted in lower betas for Guilty Pleasure companies in general. Looking a tad deeper, however, we find that not all Guilty Pleasure companies are the same. True enough, the industries they serve and the products offered can differ, but what I am getting at here is their beta varies as well. Those companies, such as Altria Group (NYSE:MO), Reynolds America (NYSE:RAI) and British Tobacco (NYSEMKT:BTI) that serve the tobacco industry have a much lower beta than gambling companies such as MGM Resorts (NYSE:MGM), Las Vegas Sands (NYSE:LVS), and Wynn Resorts (NASDAQ:WYNN).

The inelastic nature for the products produced by these Guilty Pleasure companies has enabled them to weather price increases better than other products and services that are considered to be more of a commodity in nature. Perhaps the best example is in the tobacco industry. Consider that while the domestic tobacco business is in a decline as more people become aware of the health effects of smoking on their well-being and taxes are raised each year on cigarettes, the levels of price increases that cigarette makers generate more than offsets the decline in consumption by customers. Last month, The Hershey Company (NYSE:HSY) raised wholesale prices by 9.7 percent on most of its candy products, which include Reese's, Kit Kat, Hershey's Kisses and Twizzlers among others. The price increase reflects increased costs for raw materials, fuel, utilities and transportation.

Given my current concern over the ability to spend amid significant increases in food and gas prices, as well as soon to be felt across a number of products given recent announcements from Proctor & Gamble (NYSE:PG), Kimberly-Clarke (NYSE:KMB), McDonald's (NYSE:MCD) and others, I see the Guilty Pleasure stocks as a potential safe haven, given not only the nature of their products, but also because of their strong cash flow, dividends and brand loyalty.

Because of the inelastic demand of these types of products, Guilty Pleasure companies tend to have strong cash flow and modest capital expenditures and innovations associated with those products, which means a return of capital to shareholders.

The two most common usages of free cash flow, excluding acquisitions, tend to be repurchasing shares and dividends. While the representative group of Guilty Pleasure stocks have an average dividend yield of 2.0%, its more valuable to look at the range which spans from no dividend to a high of 5.9 percent. Aside from whether or not one of these companies pays a dividend, it is also to look at the trend in dividend increases. Much like McCormick & Company (NYSE:MKC), which has a track record of increasing its annual dividend, several in my Guilty Pleasure thematic have a track record of increasing respective dividends. For example, Reynolds America has increased its dividend seven years in a row, while Altria has raised dividend distributions for 43 consecutive years. No wonder, their betas are well below 1.0, much the way McCormick has a low beta, and in my view an investor's portfolio should have balance between high beta stocks and those that have lower betas and favorable dividend yields.

At the same time, demand outside of the U.S. is poised to benefit for several reasons. The economic recovery and expansion in several markets, such as China and India among others, is leading to improving standards of living and higher disposable incomes. Add to this both recent weakness in the dollar and strong brand associated with a number of these products and prospects for Guilty Pleasure stocks are attractive. Examples of strong global brands that fit the Guilty Pleasure perspective include Marlboro, Budweiser, Jack Daniels (Brown-Forman; BF.A), Moet & Chandon, Corona Extra, Smirnoff [Diageo (NYSE:DEO)], Johnnie Walker (Diageo), Heineken, McDonald's,Starbucks, Nescafe, Coca Cola, Pepsi, KFC and Pizza Hut [both of which are owned by Yum! Brands (NYSE:YUM)], all of which were among InterBrand's Best Global Brands in 2010.

The representative group of Guilty Pleasure companies has had a good run year to date. As such, in the coming weeks, I'll be digging deeper to uncover those companies that are not only favorably positioned on a reward to risk basis but also to identify those best positioned over the next 12-18 months. Should the market pull back, I'd be looking to capitalize on any significant downward moves in several of those companies mentioned above.

Stay tuned.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.