The Vanguard Consumer Discretionary ETF Does Well Without Inflation

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About: Vanguard Consumer Discretionary ETF (VCR)
by: Vanaheimr Capital
Summary

Since the market bottom on March 6, 2009, VCR has significantly outperformed the overall S&P 500.

We believe the primary driver of this outperformance was low inflation, which allowed companies to maintain margins throughout the cycle.

In an environment of stagflation, we expect VCR to significantly underperform the other sectors.

Our Investment Thesis on the Consumer

Over the past decade, the Vanguard Consumer Discretionary ETF (VCR) has returned just under 300% due to the post-recession recovery of consumers and the environment of low global inflation which drove profit growth for consumer brands. VCR will significantly underperform during growth scares and signs of a recession as it has in the past. When the next economic recession is over, VCR will outperform as the economy rebounds as long as inflation remains in check. Since we believe that the U.S. and Europe are getting closer to a recession, likely around 2020, we are beginning to reduce our positions in consumer names and avoiding VCR.

Consumer Discretionary vs. S&P 500

Since the recession in 2009, the consumer discretionary sector has significantly outperformed the S&P 500. We use the Vanguard S&P 500 ETF (VOO) to compare with VCR. The outperformance, in our view, is a double-edged sword considering that the consumer discretionary stocks do very well in an economic expansion, but as you can see in the below chart will tend to underperform during any growth scares or market drawdowns. This relationship has been consistent for decades and only begins to break down during an unusual period with characteristics of high inflation and/or high unemployment that drags on the consumer.

Source: YCharts

Inflation Hurts Consumer-Focused Companies

The vast majority of companies represented in the ETF are sensitive to inflation and will see earnings decline in periods of unexpected inflation as they cannot pass on price increases quickly without seeing some fluctuation in demand. Amazon (NASDAQ:AMZN), for example, is well known for offering great prices on millions of items. Amazon has incredible brand loyalty and a sticky user base, yet that still isn't enough to fully insulate investors from inflation risk. High inflation would harm their business over the short term until they can pass on the rising costs to consumers. The same can be said for virtually every other company on the list. Companies do not have the ability to change their advertised prices as frequently as underlying input costs change. When a restaurant sees the price of food fluctuate daily, it will continue to honor the prices on the menu in order to keep customers happy and avoid confusion. This phenomenon is probably the single biggest determinant of massive profit margin expansion over the past decade. The consistent environment of low inflation that we have seen in the past produces unprecedented clarity into costs which allowed businesses to maintain and increase profit margins consistently. If inflation begins to increase unexpectedly, you will generally see the exact opposite occur as companies scramble to deal with the fallout.

VCR is at the top of the cycle

The Vanguard Consumer Discretionary ETF contains companies that trade at record price to earnings ratios. VCR's PE of over 20 is well above the overall market's PE of 16 as of 12/31. Keep in mind these are not small-cap businesses as the median market cap is over $57 billion. The Vanguard Consumer Discretionary ETF holds 327 U.S. stocks, all focused on selling discretionary merchandise and services to consumers around the world. VCR holds all of the companies consumers deal with in the U.S. on a daily basis such as Amazon, Home Depot (NYSE:HD), Lowe's (NYSE:LOW), McDonald's (NYSE:MCD), Nike (NYSE:NKE), Starbucks (NASDAQ:SBUX), Tesla (NASDAQ:TSLA), TJX (NYSE:TJX), General Motors (NYSE:GM), and Booking Holdings (NASDAQ:BKNG) just to name a few. The top ten holdings mentioned encompass 53% of the total holdings which makes this product incredibly top-heavy although that is common with market cap weighted indexes. The projections for earnings growth are aggressive at 13.5% which in our view makes the product even more sensitive to inflation and a slow down or softening of economic conditions.

As of 12/31/2018

VCR

Number of stocks

327

Median market cap

$57.1 billion

Price/earnings ratio

20.4x

Price/book ratio

4.6x

Return on equity

21.10%

Earnings growth rate

13.50%

Source: Vanguard.com

The Economy Will Make or Break VCR

The European Commission issued its latest economic forecast on February 7th which warned of a significant slowdown in growth for 2019. The forecast is largely a result of the poor economic performance of several major economies and rising global trade uncertainty. In its last projection, the Commission predicted a 2019 growth rate of 1.9% for the eurozone. The new forecast moves that figure down to 1.3%. The 2020 estimate was also revised down, less significantly, to 1.6% from 1.7%. In our view, the U.S. economy will perform relatively better than the eurozone given the superior demographics; however, we think the U.S. is close to a recession and that the trade war and uncertainty in Washington will push us there. If this is correct, we think that VCR will underperform to the downside compared to other sectors of the market and compared to the market overall.

Why Prefer Vanguard

As we have stated previously, we prefer Vanguard given their superior ownership structure and track record of doing what is best for their customers. With the ETF price wars, they will not always be the lowest cost provider; however, we don't want to go for the lowest price when the difference is marginal to get a superior provider like Vanguard. There are other similar ETFs from iShares and State Street which work just as well for traders in our view. For anyone investing for the longer term, we highly recommend choosing Vanguard ETFs such as the Vanguard Consumer Discretionary ETF.

Conclusion

We think the risk of inflation is low in the short term; however, if it were to rise unexpectedly, we think VCR should be sold. Over the next 18 months, we think VCR will underperform given what we think will be a recession in Europe and in the U.S. as well as an escalating trade conflict. In this environment, we believe that VCR should be sold. On the bright side, after the recession, VCR is much more likely to be a top performer coming out of it.

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