Vanguard Consumer Staples ETF: An Eventual Economic Recovery May Be Its Biggest Risk

Summary

• VDC’s portfolio of stocks consists of mostly large-cap stocks in the consumer staples sector.
• The fund is a good defensive choice as these stocks provide essential products for consumers regardless of an economic recession or not.
• VDC’s growth profile is inferior than the S&P 500 Index and may not be a good place to invest if the economy gradually recovers.

ETF Overview

Vanguard Consumer Staples ETF (NYSEARCA:VDC) owns a portfolio of large-cap stocks in the U.S. consumer staples sector. The fund seeks to track the consumer staples sector of the MSCI US Investable Market Utilities 25/50 Index. These are stocks that are recession resilient but have lower growth profile than the S&P 500 Index. Given the fact that VDC is trading at a valuation above its historical average, we think investors may want to look at other defensive sectors or sectors that will benefit from the long-term secular growth trends such as healthcare and technology sectors.

Data by YCharts

Fund Analysis

VDC is still overvalued

Below is a table that shows VDC’s top 10 holdings. The selloff of the broader stock market in March 2020 has helped to reduce VDC’s weighted average forward P/E ratio. However, the stock market has since rebounded strongly. Hence, VDC’s top-10 stocks are still trading at a weighted average forward P/E ratio of 21.7x. This is nearly 1x higher than its 5-year weighted average of 20.9x. For reader’s information, VDC’s weighted average forward P/E ratio for its top-10 holdings was about 22.8x back in February 2020. Therefore, we think VDC is still overvalued.

Ticker	Top 10 Holdings	Forward P/E	5-Year P/E	Weighting
PG	Procter & Gamble Co.	22.32	21.19	15.2%
KO	Coca-Cola Co.	22.88	22.00	10.0%
PEP	PepsiCo Inc.	22.94	20.96	9.2%
WMT	Walmart Inc.	23.64	18.64	8.9%
COST	Costco Wholesale Corp.	31.85	28.31	4.7%
PM	Philip Morris International Inc.	14.27	18.06	4.5%
MDLZ	Mondelez International Inc.	19.53	19.90	4.3%
MO	Altria Group Inc.	8.55	16.58	3.9%
CL	Colgate-Palmolive Co.	23.31	22.87	3.2%
KMB	Kimberly-Clark Corp.	18.73	18.61	2.6%
	TOTAL	21.71	20.86	66.5%

Click to enlarge

Source: Created by author

Although VDC’s valuation appears to be overvalued, investors should keep in mind that its top holdings are companies with competitive positions and have strong financial health ratings. Companies such as Procter & Gamble (PG) is a leading household and personal-care manufacturer internationally. P&G has established several well-known brands to sell these products. Its second and largest holdings Coca-Cola (KO) and PepsiCo (PEP) also have strong brands that are well-known internationally. Many other companies such as Walmart (WMT) and Costco (COST) have many locations across North America and many parts of the world and should continue to enjoy economies of scale. These stocks have benefited from COVID-19 lockdown as people need essential products and services provided by these companies.

Ticker	Top 10 Holdings	Morningstar Moat Rating	Financial Health Rating	Weighting
PG	Procter & Gamble Co.	Wide	Strong	15.2%
KO	Coca-Cola Co.	Wide	Strong	10.0%
PEP	PepsiCo Inc.	Wide	Strong	9.2%
WMT	Walmart Inc.	Wide	Strong	8.9%
COST	Costco Wholesale Corp.	Wide	Strong	4.7%
PM	Philip Morris International Inc.	Wide	Moderate	4.5%
MDLZ	Mondelez International Inc.	Wide	Strong	4.3%
MO	Altria Group Inc.	Wide	Moderate	3.9%
CL	Colgate-Palmolive Co.	Wide	Strong	3.2%
KMB	Kimberly-Clark Corp.	Narrow	Moderate	2.6%
	TOTAL			66.5%

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Source: Created by author

VDC’s total performance is slightly inferior to XLP

Let us now compare VDC’s total return with its peer Consumer Staples Select Sector SPDR ETF (XLP). For reader’s information, XLP’s portfolio consists of consumer staples stocks in the S&P 500 Index. As can be seen from the table below, VDC’s expense ratio of 0.10% is slightly less than XLP’s expense ratio of 0.13%. However, its total returns in 1, 3, 5, and 10 years are all slightly inferior to XLP’s total returns. This slight variation in performance does not mean that VDC’s portfolio is in anyway inferior. It could simply due to the fact that XLP has a slightly higher concentration of large-cap stocks (XLP has about 75 stocks in its portfolio) than VDC’s portfolio (about 93 stocks in its portfolio). As we know, large-cap stocks may be more stable and generate consistent returns than their smaller peers.

	VDC	XLP
Expense Ratio (%)	0.10%	0.13%
1-Year Total Return	1.03%	3.10%
3-Year Total Return	12.13%	14.57%
5-Year Total Return	31.59%	34.84%
10-Year Total Return	170.5%	172.1%

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Source: Created by author

Should you buy VDC right now?

Consumer Staples sector is a defensive sector and is generally recession resilient. Companies in this sector generally derives their revenue from household goods, food, beverage, hygiene products, etc. Therefore, this sector should be less impacted and perhaps even benefit from the COVID-19 outbreak. However, this sector may have limited growth potential as there is only so much people will need to buy for these essential products. VDC’s average sales growth and cash flow growth rates are only 3.69% and 3.97% respectively. This is much lower than the S&P 500 Index’s 6.91% and 7.60%. Similarly, its book value growth of 0.82% is also inferior to the S&P 500 Index’s 6.43%.

	VDC	S&P 500 Index
Sales Growth (%)	3.69%	6.91%
Cash Flow Growth (%)	3.97%	7.60%
Book Value Growth (%)	0.82%	6.43%

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Source: Created by author; Morningstar

The question is whether COVID-19 can be contained by the end of Q2 2020 or whether the lockdown and social distancing in different parts of the world will continue for the rest of 2020 and extend into 2021. In the former situation, a V-shape type of economic recovery will be likely and consumer staples sector will likely underperform against other cyclical sectors. We noted that many people have stock-up a lot of food products, toilet papers, hygiene products, etc. Therefore, if the threat of COVID-19 recedes in the future, demand may drop sharply and quickly result in declining sales.

Risks and Challenges

Concentration risk

Investors of VDC faces considerable concentration risk as its top 10 holdings accounts for about 66.5% of its total portfolio. In fact, its top 2 holdings accounts for 25% of the total portfolio. Therefore, if VDC’s top companies face any headwinds, its fund performance can be impacted negatively.

Exposure to emerging markets

Many of VDC’s top holdings have sizable businesses overseas. If we look at the top 10 holdings of VDC, we will realize that most of these companies (e.g. Coca Cola, PepsiCo, P&G, Walmart, Costco, Colgate-Palmolive, etc.) are well-known international brands and have sizable revenues outside of the United States. As we know, emerging markets may be much more volatile than the market in the U.S. and that revenues and incomes from these markets may be impacted by foreign exchange rates.

Interruption to logistics

Lockdowns due to COVID-19 may cause some interruption in logistics. It may be difficult for companies in VDC’s portfolio to ship their products to some emerging markets. Likewise, it may be difficult to obtain some raw materials.

Investor Takeaway

VDC is a good defensive choice for investors in the time of uncertainty due to its recession resilient characteristic. However, VDC is not cheap right now. Investors may want to look at other choices such as utilities or perhaps seek to invest in sectors that have long runways of growth (e.g. technology, or healthcare sectors).

Analyst’s 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.

This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

Comments

[erdlust]

Thanks for another good analysis. I've had VDC as a defensive position for about five years and have recently been considering selling some.