Seeking Alpha

Overvalued Consumer Staples - An Alternative

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Includes: DIS, GIS, KO, NKE, PG, VFC, XLP, XLY
by: SeeksQuality
Summary

The Consumer Staples giants offer weak forward returns at the present valuations.

To replace these stocks in a portfolio, we must find companies with similar operational strengths.

The Consumer Discretionary sector shares many of the same characteristics, and offers investors stronger expected returns at this time.

The Consumer Staples Dilemma

In my previous article, I discussed what I perceive to be a serious threat to DGI. The Consumer Staples giants are at the heart of the philosophy and the core of most DGI portfolios. Focusing on Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO), and General Mills (NYSE:GIS), I argued that they are facing unprecedented challenges, a combination of weak revenue growth, elevated debt levels, and a high payout ratio. While any one of these three in isolation would not be insurmountable, I fear that the combination may hold these stocks back over the next 5-10 years.

These companies will eventually correct these imbalances and recover; however, in the foreseeable future, I anticipate just 4-6% annual earnings growth with dividend growth in the 2-4% range. Total return is mathematically equal to dividend yield plus dividend growth in a steady-state environment, which in this case would support 6%+ compound growth; yet, I have to also anticipate a pullback in P/E valuation from the presently elevated levels. The net result is a scenario in which these stocks slog through a 2% annual total return for five years or longer. As investors, how might we respond to this dilemma?

Stay The Course

Remember that DGI is an investment approach that measures success over decades, not by the quarter. That is reflected in the comments from three leading members of the Seeking Alpha community.

Chowder offers his sage advice:

As the markets change, adjustments are made, but I don't think I have to dump what is already held to replace with new stuff. I can add new stuff and avoid taxable events, or the selling of high quality companies that have faced adversity before and overcome it. I can handle low to no dividend growth from quality companies as long as I make adjustments elsewhere as shown above.

Buyandhold2012 puts it even more strongly, writing:

Successful investing is not a game of musical chairs in which you trade in and out of stocks based on your opinion of their value. Successful investing in the stock market is a marathon. Investors should buy high quality stocks with durable competitive advantages whenever they appear to be attractively priced and then never sell them.

These companies and their peers epitomize quality and stability, with strong brand moats surrounding their operations. While the challenges in this sector may be greater than any in the past 50 years, there is no reason to believe they will not eventually prevail. As long as the investor can afford to hold through an extended period of low growth, buying and holding quality companies is a sound approach. The stocks may retreat for a time, but they are not going to zero!

Does this meet my needs?

Consider a hypothetical investment in PG, KO, and GIS beginning in 2011. If you had asked me at the time, I would have been comfortable with 8% compound total return, figuring on a 3% dividend with 5% growth. Projected over a 10-year span, an initial value of $30,000 would need to grow to $65,000 by 2021 to achieve this target. Thus far, the returns have exceeded that expectation! If I had invested $10,000 in each company on September 1, 2011 (with dividends reinvested), the PG position would have grown to $16,380, KO to $14,266, and GIS to $21,704 for a total portfolio value of $52,350 and a composite compound annual return of almost 12% over the past five years! (Source: longrundata.com)

Unfortunately, the 2% returns envisioned in my previous article are not sufficient to finish the job. At that rate, I would not reach my original target of $65,000 until 2027; we would need to see 4.3% returns over the next five years to achieve my original goal. While that is a plausible scenario if P/E valuations remain elevated, or if growth rebounds strongly, it is not something I am prepared to bet my retirement on. My investment approach calls for me to seek alternatives in this situation.

Following The Money

In contrast to the sentiment expressed by BuyandHold2012, David Van Knapp is not philosophically opposed to trimming or selling positions, writing:

One of my selling guidelines is to seriously consider selling if a stock becomes significantly overvalued. I have sold a couple of times with that as a partial reason, although it was accompanied by the position being over-large too. Obviously, both often go hand-in-hand.

He is not advocating major portfolio shifts, but talks in terms of trimming outsized positions and directing dividend reinvestment to whatever is currently undervalued. Dave doesn't see these sector concerns as a serious challenge to his approach:

My approach has more often been to think "dividends are where you find them," so following the money (a la All the President's Men) has led wherever it has led. That said, I think that your general statements about Consumer Staples sound pretty true. Following the money probably usually leads elsewhere at the current time.

That last is perhaps the closest to my own philosophy. When I shop for produce and meat in the supermarket, I survey the quality and price of the various offerings. I can build a meal from chicken and broccoli, or from ground beef and zucchini, or from steak and potatoes. If I decide on the menu before I enter the store, I might sometimes pay too high a price and other times walk away with inferior quality. If I wait to see what is available, then I can consistently put high-quality meals on the table at a reasonable price.

Quality is Not Optional!

I emphasize quality throughout my investment process. David Crosetti recently asked, "When you go into Kroger and you pass by the meat section and they have ribeyes on sale for $1.99 a pound, do you see that as a value and fill up your shopping cart?" Only a vegetarian would pass on that one! Yet, I've been known to pass on ground chuck in the clearance bin at $1.99 a pound, three days old and smelling funny. I will pay a higher price for quality meat before I will put that on the table. Heck, I would prepare dinner from dry goods in the pantry first! If I am replacing Consumer Staples stocks in my portfolio, I need to identify companies that can legitimately replace them as core holdings. The sector has historically been attractive due to strong brands, wide moats, low capital requirements, and steady growth. Thus, if we are to look for replacements, in a search for greater growth, we need to emphasize these same qualities or risk throwing the baby out with the bathwater (Perhaps the classic blunder of investing?).

Scoots makes a case for the "old tech" companies, such as MSFT, CSCO, INTC, QCOM, TXN, and AMAT, commenting, "They have a nice yield, some good relative strength, good capital appreciation, and new avenues to pursue," however, earnings in this sector are erratic and long-term growth depends on technological innovation. The decades-spanning brand strength that supports the Consumer Staples companies doesn't carry as much weight here. To paraphrase Buffett, these are not companies that can be effectively managed by a ham sandwich! (This is in contrast to Coca-Cola, which is surviving despite leadership from the deli counter). The tech titans may be excellent investments, but they cannot serve as a simple replacement for the Consumer Staples.

David Van Knapp mentions a recent purchase of Boeing (NYSE:BA), and I have to agree that is presently a good value, but this is a highly cyclical company that saw both its earnings and share price fall 70% in the last recession. Again it may be an excellent investment, but I cannot position it as a core holding in my portfolio.

Chowder emphasizes healthcare as a defensive sector, mentioning CVS, CAH, MCK, BDX, JNJ among others. I wholly agree with his reasoning, but already have a 30%+ allocation in my portfolio to this sector. My investment portfolio has traditionally been a three-legged stool, emphasizing Consumer Staples, Healthcare, and quality Industrials, and I do not want to risk balancing it on just two of these pillars.

Consumer Discretionary is a Sound Alternative

Understand that the principal driver behind the overvaluation of the Consumer Staples sector has been the "TINA" dilemma (which in other contexts is acknowledged as a logical fallacy, #93 on this list). There is no alternative for savers when savings accounts pay less than 1%, and 10-year Treasuries yield 1.5%, and so it is understandable that many retirees have piled into the Consumer Staples giants yielding a steady 3.0% (with a reasonable hope for further increases). This has pushed valuations higher, forcing investors to compromise on either the stability of the business or the yield if they hope to escape.

I am very reluctant to compromise on brand strength and quality, thus I am expanding my horizons from the steadier Consumer Staples sector to the more volatile Consumer Discretionary sector, accepting a lower dividend yield in exchange for superior growth prospects. While earnings and share prices are more stable in Staples, especially through a recession, I believe that brand strength in the Discretionary sector can be an even more powerful driver of long-term success and thus plays a similar role in a long-term DGI portfolio.

To illustrate my reasoning, I will focus on three companies from my portfolio that I believe offer a solid contrast to those I selected from the Consumer Staples sector: Nike (NYSE:NKE), V.F. Corp (NYSE:VFC), and Disney (NYSE:DIS). As with my previous article, there are many other companies with similar characteristics; my intent is not to recommend these specific companies, but to highlight what we might look for and expect in this sector.

The table below compares some of the business fundamentals for our six focus companies, where we see many similarities as well as one key difference. Profit margins are not unusually high in the Consumer sectors, however, the low capital requirements and ability to leverage results with debt help to generate strong returns for equity investors. These companies all enjoy an exceptional Return On Equity, well above the market average of 10% to 15%, and their Return On Invested Capital is also at least double the S&P 500 average of 5%. The Consumer Discretionary companies fare equally well by these metrics, averaging a 24% ROE and 19% ROIC. Moreover, all enjoy moats in their businesses. Even General Mills is arguably worthy of a Wide Moat. The principal difference between the two groups is in the certainty of the outlook. The Consumer Staples stocks all enjoy "low uncertainty" while the Consumer Discretionary stocks are seen as having "medium uncertainty".

Moat

Uncertainty

ROE

ROIC

PG

Wide

Low

17%

12%

KO

Wide

Low

28%

10%

GIS

Narrow

Low

34%

14%

NKE

Wide

Medium

30%

27%

VFC

Wide

Medium

23%

15%

DIS

Wide

Medium

20%

15%

This characteristic reflects the difference between discretionary and non-discretionary consumer spending. When the economic house of cards comes crashing down in a recession, it is natural for consumers to pull back on spending. Still, they will continue to buy food, diapers, deodorant, and a bottle of Coke with lunch. We see in the table below that all of the Consumer Staples companies were able to increase EPS in the last recession, cutting costs by more than any lost revenue, while the Consumer Discretionary stocks lost a remarkably uniform 19% to 24% of their net income from the 2008 to 2009 fiscal year.

2008 EPS

2009 EPS

New High

PG

3.64

4.26

N/A

KO

1.25

1.47

N/A

GIS

1.85

1.90

N/A

NKE

0.94

0.76

2010

VFC

1.35

1.03

2011

DIS

2.28

1.76

2011

Volatility is Expected, Not Feared

In light of this, it should come as no surprise that the Consumer Discretionary stocks crashed hard. The Consumer Staples Select Sector SPDR ETF (NYSEARCA:XLP) fell roughly 30% from April 2008 through March 2009, but the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY) fell by 45%! Turning that around, an investment in XLP retained 70% of its value while an investment in XLY retained just 55%. It was an ugly year for the stock market in general, but at least investors holding Consumer Staples could take comfort in the fact that they lost less than others.

Still, an investor who held through the volatility would have found that all three of our Consumer Discretionary companies had recovered and surpassed their prior level of earnings by 2011. They lost a couple years of growth, but their businesses and brands were not permanently impaired. Equally comforting to investors, they all recovered their April 2008 market levels by March 2010 - just a year removed from the bottom of the market. The Consumer Staples stocks may have lost less in the crash, yet both KO and PG took longer to recover those losses!

Many financial writers seem to equate "volatility" with "risk", perhaps viewing the market as a drunken walk built from either larger or smaller steps? Yet, for a long-term investor, the only true "risk" is the long-term impairment of the business. A strong company can afford to take a step backward as long as it is well positioned to recover that lost ground quickly. The true dangers are found in the financial reports as much as in operational volatility. A company that is forced by debt and losses to raise equity or sell assets in the middle of a crisis will come out with less shareholder value than it began. One that slashes R&D (or even SG&A) to bring expenses in line with falling revenues will struggle to profit from the rebound. Retaining earnings through a recession is important, but financial resilience is equally critical to the long-term health of a company.

Debt/ Equity

5-year EPS

10-year EPS

Projected Growth

PG

0.34

-1%

3%

5%

KO

1.10

NM

5%

5%

GIS

1.43

1%

7%

8%

NKE

0.16

15%

13%

15%

VFC

0.30

17%

10%

11%

DIS

0.34

19%

15%

9%

None of these companies carries a worrisome debt load. While KO and GIS are somewhat more leveraged than the others (that may change when Coca-Cola re-franchises its bottling operations), they enjoy stable cash flows and strong credit ratings that should enable them to roll over any maturing debt at favorable rates. The other four carry little enough debt that they could retire it over a few years from cash flow if needed. I have no fear that any of these companies will be forced to cut their dividends. On the other hand, the Consumer Staples giants have struggled to grow earnings. Their forward outlook is higher than what they have achieved over the past decade, but analyst estimates are often optimistic. Even if they do achieve the projected 5-8% growth, that is only minimally acceptable for equity returns.

In contrast, the Consumer Discretionary companies have generated double-digit returns over the last decade, with even stronger growth than that since the recession. Their growth projections may also prove optimistic, but are still likely to come in well ahead of their staid Consumer Staples peers. There is good reason to believe that these companies are financially sound, able to both meet their debt obligations and grow their dividends over the coming years. That latter point is in question for the Consumer Staples companies, given the slow growth and already-high payout ratios.

I further believe that the traditional economic sensitivity seen in the Consumer Discretionary sector may be moderating. Over the last 20 years, we have seen a steady increase in the "mass affluent" population, both in the US (roughly comprised of the top quintile of households) and elsewhere. These consumers may only represent a small fraction of the population, but due to their relative affluence they control some 60% of discretionary spending. The mass affluent tend to be well educated, with stable professional jobs, and are less likely to cut back on "small comforts" in a recession (Larger capital purchases may still be delayed). These consumers will still buy a North Face fleece, put Disney products under the Christmas tree, and pony up for Nike jogging sweats and sneakers. If this demographic thesis holds true, we should see continued expansion in the market for these Discretionary brands as well as a steady erosion of the distinction between the two sectors.

Comparing Valuation and Growth

Thus, I believe it is entirely reasonable for an investor to expect to pay a higher valuation for Nike than for Procter & Gamble. They are both blue-chip companies with strong brands and solid finances, however, Nike has proven the ability to grow both revenue and earnings throughout the last decade while Procter & Gamble has scuffled. We can reasonably debate how much of a premium is merited, but there is no good reason for a long-term investor to prefer the company with slower growth. Normalizing the P/E to the 2016 calendar year operating estimates for ease of comparison, we see:

2016 P/E

Div. Yield

Proj. Growth

Est. Return

Bird In Hand

PG

23.4

3.0%

4.8%

7.8%

5.4%

KO

22.7

3.2%

4.7%

7.9%

5.6%

GIS

21.2

2.8%

7.6%

10.4%

6.6%

NKE

25.0

1.1%

15.0%

16.1%

8.6%

VFC

18.9

2.4%

11.1%

13.5%

8.0%

DIS

15.7

1.5%

9.2%

10.7%

6.1%

The current P/E valuations show the precise opposite of what we would normally expect! The slower-growth Staples companies trade at 22.4x their current-year earnings while the faster-growth Discretionary companies trade at an average multiple of 19.9x. Adding dividend yield to projected earnings growth to get an estimate of "steady state" total return, we see that the Staples companies project to an 8.7% annual return while the Discretionary companies project to a more robust 13.5%.

Of course, in both cases, these estimates are likely to be optimistic. I sometimes like to calculate what I refer to as a "bird in the hand" return estimate, counting the dividend yield at full value while discounting the projected growth by 50%. After all, as the saying goes, a bird in the bush is worth just half a bird in hand. This calculation in the last column of the table brings the two groups closer together, but still leaves a gap of 5.9% vs. 7.6%. I need to see this gap in the five-year projections close before I can accept that the two groups are (relative to one another) fairly valued.

It is also important to recognize that the projections in the above table are built from "steady state" projections in which the P/E values and payout ratios remain constant. While the Discretionary stocks are trading within their historic valuation range, I believe that the Staples stocks are presently valued by 15% to 25% above their historic norms. If these valuations compress over the next five years, then the gap between the two groups further widens. Chowder writes, " I'll be gobbling up consumer staples that correct 10% or 15% [from their top], not selling them due to that type of draw down. I'm tracking them now, waiting to pounce." While I understand and sympathize with his love of the sector, these numbers suggest that I will need to see a 15% correction from the current levels to buy with confidence in my own portfolio.

Conclusions

In conclusion, I believe that a long-term investor may find better values in the Consumer Discretionary stocks today than in Consumer Staples. These sectors share many of the same characteristics that a DGI should look for: wide moats, strong brands, low capital requirements, and steady growth. I acknowledge that the Consumer Discretionary sector is more sensitive to economic conditions, and will likely fall harder in a recession, however, I am comfortable with that volatility as long as I believe in the long-term value of the company. As the last decade shows, the impact of a slowdown in consumer spending can be quickly overcome by a strong company.

The astute reader will note that I have thus far made little mention of the difference in the dividend yields. In the context of my personal situation, I am largely yield-agnostic (aside from my "bird in the hand" metric). I am seeking to generate 8% total returns with a high level of confidence over the next decade and looking for companies that can support me in that goal. An investor seeking income, perhaps to fund retirement needs, faces a tougher question. Do you accept weaker growth prospects in return for the immediate income? Or sacrifice a portion of your dividends in the hope that the share appreciation will compensate? My third article in this series will discuss strategies by which an investor might navigate either of these paths, both ways to generate additional income from the Consumer Discretionary portfolio and ways to potentially support total return from the Consumer Staples portfolio.

Remember that this analysis is not specifically about the six companies that I have highlighted. Apple (NASDAQ:AAPL) shares many of the characteristics of the companies highlighted from the Consumer Discretionary sector while 3M (NYSE:MMM) and Johnson & Johnson both have substantial Consumer divisions that fill more basic needs. Hormel (NYSE:HRL) and Starbucks (NASDAQ:SBUX) are both down more than 10% from their highs, and may offer better value than their higher-yielding peers at this time while McCormick (NYSE:MKC) has sustained exceptional growth. The dominant theme in the current market is the "stretch for yield", which suggests that this is a good time to look at lower-yielding companies for value. Dividend Growth Investing does not require that one should always buy the company with the largest dividend. Rather, it emphasizes long-term operational strengths that allow companies to increase dividends over decades. Consider what the philosophy recommends for your personal situation today?

Disclosure: I am/we are long MMM, ABT, AMGN, AAPL, BDX, BA, CSCO, KO, CVS, DIS, ETN, F, GILD, JNJ, NKE, PG, UNP, UTX, VFC, WFC. 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.