People Often Want What They Don't Absolutely Need - Consumer Discretionary Sector: Part 6

by: Chuck Carnevale

What people want to consume can be just as necessary to them as what they need.

There are many strong and excellent companies found in the Consumer Discretionary Sector of the S&P 500.

Not all consumer discretionary stocks are appropriate for retirement portfolios.

Many advisers and pundits prefer index investing; I am not one of them.


One of the great benefits of having the privilege of living in a free enterprise capitalistic system is the opportunity to generate discretionary income. In many parts of the world, far too many people, in my opinion, are relegated to toiling only to meet the most basic human needs of food, shelter and clothing. However, here in the US and in most of the free world, most people earn more than enough income to meet their basic needs. This extra income represents money that they have discretion over how they spend.

The Consumer Discretionary Sector of the S&P 500 is comprised of companies that offer products and services that although not essential to life, often make living our lives better and more fulfilled. Moreover, just because people do not absolutely need a product or service, does not simultaneously indicate that they don't want it. In fact, in many ways, what people want to consume can be just as necessary to them as what they need. Consequently, there are many strong and excellent companies found in the Consumer Discretionary Sector of the S&P 500. So much so, that from an investor's perspective, many of the S&P 500's best long-term performing companies can be found in this sector.

Furthermore, just as it is with most of the other sectors of the S&P 500, the Consumer Discretionary Sector offers investment options for most every type of investor. Within this sector, there are high-quality blue-chip dividend growth stocks, pure growth stocks and most everything in between. What shouldn't go unnoticed about that last statement is that not every stock in the S&P 500 Consumer Discretionary Sector will meet the unique goals, objectives and risk tolerances of every individual investor. This undeniable fact is one of many reasons why I personally eschew investing in index funds. Once again, I believe it is a market of stocks and not a stock market. As such, I prefer to pick and choose only those companies that meet my own unique goals and objectives.

Importantly, especially as it relates to the underlying thesis of this series of articles, is the relative valuation of each of the consumer discretionary constituents in the S&P 500. There are many constituents in all categories be it growth, dividend growth or value that are attractively valued today. In contrast, there are many constituents in those same categories within the Consumer Discretionary Sector that are significantly overvalued. To me, this is another reason that motivates me to want to pick and choose.

The S&P 500 Consumer Discretionary Sector: A Look at Current Valuations and Appropriateness

The Consumer Discretionary Sector makes up over 12% of the S&P 500 index, and as such, is a very important component. The following is a brief description of the types of companies in the sector courtesy of Investopedia:

"DEFINITION of 'Consumer Discretionary' A sector of the economy that consists of businesses that sell nonessential goods and services. Companies in this sector include retailers, media companies, consumer services companies, consumer durables and apparel companies, and automobiles and components companies."

Below, I will be featuring specific examples of the 84 S&P 500 Consumer Discretionary constituents that possess differing investment characteristics and relative valuations. To facilitate this, I have organized the F.A.S.T. Graphs portfolio review on the S&P 500 Consumer Discretionary Sector constituents by capsize and earnings growth.

For an incomplete, but quick review of valuation, I have highlighted the "Current P/E" and the "Normal P/E" columns. For companies growing less than 15%, a fair value P/E of 15 or lower would be a valuation guide. For faster-growing companies, look for a P/E that's equal to the company's estimated growth rate. However, a low P/E is not the only valuation consideration, therefore, comprehensive due diligence needs to be conducted.

One of my primary reasons for producing this series of articles on the 10 Sectors comprising the S&P 500 is to provide the reader a more detailed perspective of the companies found in this index. Since most of my writing is oriented to the retired investor, I suggest that those readers in or near retirement ask themselves a simple question as they review the various featured examples in this article, as well as those presented in the other articles in this series. As a retired investor, would I be willing to consider this company an appropriate selection for my retirement portfolio?

Just below each section, I will feature a few companies that I believe support the general thesis of this series on the S&P 500. Importantly, the featured selections are not recommendations to buy or sell. Instead, they are offered because I feel that each featured company offers important lessons or tell meaningful stories about investing in common stocks and the associated risks and opportunities. In other words, my primary objective is to highlight the vast differences that exist between one company and the next, even when they are in the same broad sector.

Consumer Discretionary Sector: Large Cap over 5 Billion Dollars: Under 10% EPS Growth

There are several companies found in this first section that I would consider appropriate for retired investors and/or dividend growth investors. Of course, that is assuming that they are only appropriate investment candidates when valuations are sound and supported by fundamentals. Unfortunately, I see very few in this first section that meet the valuation requirement. On the other hand, there are also companies in this section that I would not consider appropriate on their own fundamental merit. I will provide examples of both with the featured companies following this section.

McDonald's Corp. (NYSE:MCD)

My first featured company from this section is McDonald's, a Dividend Champion found on fellow Seeking Alpha author David Fish's CCC lists, that has increased its dividend for 39 consecutive years. Therefore, based on those credentials, I would consider this blue-chip dividend-paying stalwart an appropriate candidate for inclusion in most retirement and dividend growth portfolios.

However, there are a few cautionary considerations that I feel the reader should reflect on. McDonald's does offer a very attractive current dividend yield of 3.6%. This is significantly above the current yield of the S&P 500 index, and its unbroken 39-year string of consecutive increases is a huge plus. On the other hand, and in spite of its high current yield, I believe the company is currently overvalued, especially when considering recent operating weakness (Note: the declining earnings results last year and forecast for this year as depicted by the orange line on the graph).

Nevertheless, and in spite of its moderately high valuation, McDonald's represents a classic example of a blue-chip dividend-paying stalwart. As a result, this company is widely held in many retirement portfolios and dividend growth portfolios. It should be obvious that its high current yield and excellent dividend record has been a major attraction to these kinds of investors.

McDonald's currently is receiving significant criticism from certain investors. Whether it is justified or not is up to the reader to decide for themselves. However, what many detractors might not clearly understand is how accomplished dividend growth investors think about their investments. Perhaps the clearest and best explanation of "The Dividend Growth Investing Mindset " I ever read was recently published by fellow Seeking Alpha author Chowder. For those retired investors and dividend growth investors struggling to find the right path, I highly encourage you to read Chowder's article. From my perspective, it is full of timeless and profound wisdom for the truly conservative investor seeking income. If you consider yourself a prudent investor, then I suggest that you follow the link above and read the article, it is well worth your time.

Newell Rubbermaid Inc. (NASDAQ:NWL)

My second featured company in this section is Rubbermaid, a company that has had a rather inconsistent historical operating history based on earnings growth and its dividend record. Therefore, I would personally not consider this an appropriate buy-and-hold candidate for the retired investor or the dividend growth investor. Although the company has seemed to have found its footing post the Great Recession, I consider this company currently overvalued in spite of that recent success.

Genuine Parts Company (NYSE:GPC)

My final featured company in this section is Genuine Parts Company, another Dividend Champion that has increased its dividend for 58 consecutive years. Although I greatly admire this blue-chip dividend growth stock, I do not like its current valuation. For disclosure, I have been long this stock for several years. However, I purchased it when its P/E ratio was approximately 15 and its dividend yield above 3%. Consequently, I continue to hold it, but I have placed it on a sell watch list. I believe at its current valuation, this represents a classic example of how you can overpay for even the best companies.

Consumer Discretionary Sector: Large Cap over 5 Billion Dollars: 10%-15% EPS Growth

There are also several companies found in this second section that I would consider appropriate for retired investors and/or dividend growth investors. Of course, that is assuming that they are only appropriate investment candidates when valuations are sound and supported by fundamentals.

Unfortunately, I also see very few in this second section that meet the valuation requirement. On the other hand, there are also companies in this section that I would not consider appropriate on their own fundamental merit. I will provide examples of both with the featured companies following this section.

Hasbro, Inc. (NASDAQ:HAS)

Hasbro is a Dividend Contender that has increased its dividend for 11 consecutive years. I really like this company and believe it has a bright future - at least over the mid-to-intermediate term. However, as a stickler for valuation, I would suggest patiently waiting for the price to come back into alignment with fair value (approximately a P/E ratio of 16 or less). Nevertheless, other than valuation, I believe this is an appropriate choice for retired investors or dividend growth investors.

Viacom, Inc. (NASDAQ:VIAB)

My next featured company, Viacom, is offered as an example of a company that I consider attractively valued today. The company is a Dividend Challenger that has increased its dividend for 5 consecutive years, and offers above-average future growth potential. Consequently, I believe this S&P 500 constituent is attractive for both retired investors and dividend growth investors, especially those most interested in generating an above-average total return, coupled with a reasonable current and growing dividend yield.

As most of my regular readers know, I routinely illustrate my investing thesis on individual stocks by utilizing the fundamentals analyzer software tool F.A.S.T. Graphs, which I co-founded. When I include an earnings and price correlated graph on a company in an article, I have up to now only been able to offer a picture of a fully functioning graph. And, for most of the examples in this article, I will do the same.

However, with this fairly-valued featured company, I offer a fully functioning, live and interactive F.A.S.T. Graphs on Viacom. This will empower loyal readers who are non-subscribers to more comprehensively analyze the historical operating results of Viacom, to include how the market has valued this up-and-coming dividend growth stock.

The future return potential for this year and next can also be calculated by pointing to the last price dot on the graph until it turns red, and then point to either one of the forward triangles on the orange earnings justified valuation line and a performance calculation to include dividends will be provided.

The orange horizontal column at the top of the graph will allow you to evaluate Viacom over every time frame since it went public in 2006. Just point-and-click on any of the numbers (for example 5Y), and the earnings and price correlated graph for that time frame will be instantly drawn and earnings growth rates and adjusted historical normal P/E ratios are revealed in the box to the right of the graph. Note that all graphs are produced in calendar years and include the current year, plus one year of forecast. However, the data is presented based on fiscal year reporting.

The reader can also point to any price (the black line on the graph) and a pop-up will appear with the date, price and P/E ratio at that time. You can also click on any price point (point A, a red dot will appear) and then to any other price point on the graph (point B) and performance calculations, to include dividends, will appear.

The legend at the bottom of the graph (orange rectangle) is also interactive. If you look closely, you will see the grayed out words "Dividend YLD," if you click on those words a dividend yield overlay will be added to the graph. This provides an additional valuation measurement that can be analyzed. To be clear, a higher dividend yield will correspond to a lower price valuation and vice versa. You can also add and delete the various metrics found in the orange rectangle by simply clicking on them. For anyone interested in learning more on how to navigate the graph, follow this link.

Consumer Discretionary Sector: Large Cap over 5 Billion Dollars: 15-20% EPS Growth

As I move down the list into faster-growing S&P 500 Consumer Discretionary Sector constituents, I find fewer and fewer companies that I feel are appropriate for retired investors or dividend growth investors. There are several reasons why I feel this way. First of all, many of these faster-growing companies pay no dividend, or offer very little dividend yield if they do.

This puts a spotlight on one of the reasons why I personally eschew index funds for retired investors, especially those that are desirous of income. In my opinion and experience, a well-constructed portfolio of blue-chip dividend growth stocks is capable of generating significantly more dividend income than the index.

That same portfolio may or may not outperform the S&P 500 on a total return basis over any given period of time. On the other hand, if the investor pays close attention to fair valuation when initiating a position, many blue-chip dividend-paying stalwarts do outperform over the long run. And once again, it is very common that a blue-chip dividend growth stock bought at fair value will produce more cumulative dividend income and more dividend growth than the index at large.

Ford Motor Company (NYSE:F) and General Motors (NYSE:GM)

I was inspired to feature Ford and General Motors as my first featured companies in this section by a comment that was made on my last article. The commenter favored General Motors over more traditional blue-chip stalwarts such as Coca-Cola (NYSE:KO) or Procter & Gamble (NYSE:PG). The author of the comment will remain anonymous, but I offer the following short excerpt that motivated me to present these two examples:

"The way I look at dividend paying stocks, they are stocks first and growth has to be present and they are dividend paying securities second. So for me I would find GM much more attractive than the likes of KO, PG, DUK, and MO."

The reason I chose to present both Ford and General Motors is to illustrate the true nature of investing in automobile manufacturers. However, I'm sure the reader remembers that General Motors had to be bailed out by the federal government and forced to file Chapter 11, and then reemerged as a public company in 2010. Otherwise, I would have simply presented General Motors since it was the company mentioned in the above comment. But unfortunately, I had no data to graph prior to 2010. Therefore, since I remember that Ford and General Motors had similar long-term operating histories, I offer the Ford historical earnings and price graph as a proxy to illustrate the incredibly cyclical nature of these businesses.

A careful examination of the historical operating history (earnings and dividend record) of Ford clearly supports my contention that these companies are not appropriate buy-and-hold investment candidates. Since I believe that buy-and-hold investing is the most appropriate strategy for retired investors and dividend growth investors, I therefore do not consider these companies appropriate additions to retirement portfolios.

It is clear from the following graphs on both Ford and General Motors since the beginning of 2011 that their cyclical nature has not changed. But to be as fair as I can be to the comment referenced above, both companies have been profitable over that time frame and do offer an above-average, and some might say generous current dividend yield.

Admittedly, if you were simply judging either of these companies based on a current quote, it is easy to see why an investor would consider them attractive. Both companies are currently trading at P/E ratios that are below market values and below theoretical fair value based on current and near-term earnings expectations. Additionally, both are offering current yields above 3%, which is very attractive in today's low interest rate environment.

Therefore, I would concede that both of these companies might be attractive near-to-intermediate-term investment opportunities. On the other hand, their past cyclical nature should also be given careful consideration. On that basis, I would personally be reluctant to recommend either being included in a retirement or dividend growth portfolio.

O'Reilly Automotive, Inc. (NASDAQ:ORLY)

My final featured company in this section is O'Reilly Automotive, which I consider a classic and even quintessential example of a pure growth stock. Although as I will soon illustrate, this company's long-term total return performance has been exceptional, it has been derived solely from above-average earnings growth. Consequently, it might be an excellent candidate for investors interested in earning maximum total returns from growth stocks, but I would not consider it appropriate for retired or dividend growth portfolios. This last statement is made notwithstanding the company's current high valuation.

Growth stocks can be excellent long-term total return investments as evidenced by the following performance report on O'Reilly Automotive in comparison to the S&P 500 index. Clearly, this company dramatically outperformed the index in spite of the fact that it pays no dividends. It is a market of stocks, not a stock market.

Consumer Discretionary Sector: Large Cap over 5 Billion Dollars: 20% EPS Growth

With the exception of Harman International Industries (NYSE:HAR), none of the companies in the following high-growth section pay a dividend. Consequently, I would not consider any of them conservative-enough investments to appropriately be included in a retirement portfolio. Many of the following names might fit nicely into a growth portfolio for those investors willing to take the associated risks. Nevertheless, they are constituents of the S&P 500 Consumer Discretionary Sector.

Chipotle Mexican Grill (NYSE:CMG)

My first featured company from this section is Chipotle Mexican Grill, and another classic example of a pure non-dividend paying growth stock. There are many investors suggesting that it is this company, and companies like it that portend the demise of McDonald's, which I featured earlier.

An interesting aspect of high-growth stocks is that you can overpay for them and still generate a positive return (see performance calculation on graph). However, you need to ask yourself: Is the return worth the valuation risk?, Inc. (NASDAQ:AMZN)

Frankly, I cannot pass up the opportunity to feature Amazon. In many ways, I consider this company an enigma. It is truly a powerhouse, and almost inarguably disruptive to the standard brick-and-mortar retailers. However, from a perspective of profitability, its lofty valuation is a riddle. I cannot think of any other company that I have seen in my 45 years as an investment professional that has been given such a high valuation with so little earnings. The following earnings and price correlated graph clearly illustrates my confusion.

On the other hand, when Amazon is viewed based on cash flow and price, its long-term total return performance makes more sense. Yet, to me at least, it begs the following question: How long will the market be willing to wait for the company to make a meaningful profit? I believe that shareholders of Amazon should be regularly asking themselves that question.

Sector: Mid Cap 1-5 Billion Dollars

This final section of the S&P 500 Discretionary Sector constituents reviews the few mid-cap companies in this sector of the index. With the exception of GameStop Corp. (NYSE:GME), none of them pay a dividend. Nevertheless, retired investors that prefer indexing are investing in them all. Interestingly, many of the following constituents are currently trading at fair or attractive valuations. That might give them a certain amount of investment appeal, but not necessarily appropriate for conservative portfolios requiring income to live on.

Fossil, Inc. (NASDAQ:FOSL)

My final featured company, Fossil, is an interesting S&P 500 Consumer Discretionary constituent in the apparel and accessories business. In my opinion, there are interesting investment lessons that can be gleaned from this example. First of all, the company has a relatively consistent above-average history of growing its earnings, but it pays no dividends. The level of price volatility that has occurred over the years is also important to recognize, especially in 2011 and 2012.

As you can see (red circle), long-term shareholders in this growth stock have done quite well. However, with that much volatility, how many investors would have the fortitude to stay for the long run? I like this company, and I like its current valuation, but I don't believe it's an appropriate choice for retirement portfolios.

Summary and Conclusions

The Consumer Discretionary Sector of the S&P 500 is comprised of many diverse companies. Frankly, there are some excellent investment opportunities to be found in this sector. On the other hand, I found it currently difficult to find many that were fairly valued. Not just today, but many of the best companies in this sector are often and/or routinely highly valued by the market. In that respect, and considering that this sector is such an important part of the overall index, it suggests to me that this sector is, and has been, a major contributor to the positive performance of the S&P 500.

The one thing I feel I can say with certainty is that there are a lot of companies in this sector, just like I found in all the other sectors I reviewed, that I would not consider appropriate investments for retirement. One of my main motivations and objectives of presenting this series of articles is to provide the reader a deeper look and understanding of what the S&P 500 index truly is. There are many advisers and pundits that prefer index investing. I am not one of them. I would concede that index investing may be appropriate for those investors that are not interested or do not feel capable in managing their own portfolios. However, for those investors that are interested and capable, I believe there are better options that would more closely meet their specific goals and objectives.

This series of articles is offered to provide a comprehensive look at the state of the market utilizing the S&P 500 as a proxy via a series of articles presented on a sector-by-sector basis. Importantly, this series of articles is also offered as a sector-by-sector valuation perspective, and for appropriateness considerations.

In Part 1 found here, I presented a valuation overview of the S&P 500. In Part 2, I reviewed the Energy Sector component of the index, and in Part 3, I reviewed the Information Technology Sector. In Parts 4A and 4B, I reviewed the Financial Sector, and in Part 5, the Healthcare Sector. In this Part 6, I reviewed the Consumer Discretionary Sector. In Part 7, I will review the Industrial Sector of the S&P 500.

Disclosure: Long AZO, COH, JCI, KSS, DRI, F, MBC, GPC, ROST, TJX, TGT

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: The author is long AZO,COH,JCI,KSS,DRI,F,MBC,GPC,ROST,TJX,TGT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.