Consumer Staples Panic: XLP And Altria In Focus

May 22, 2022 10:04 AM ETAltria Group, Inc. (MO), XLP36 Comments13 Likes

Summary

  • Instead of being the safe haven, the consumer staple sector is going through extreme volatility now with its leading stocks facing headwinds.
  • The large correction recently has brought the sector, as represented by the Consumer Staples Select Sector SPDR Fund, into a reasonable valuation.
  • Although we like one of its major components, Altria, even better.
  • Altria provides superior profitability, thicker dividend yield spread, and better inflation resilience.
  • Yet it is for sale at a fraction of the valuation compared to XLP.
  • I do much more than just articles at Envision Early Retirement: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Thesis

During turbulent times like this, investors often turn to consumer staples as a safe heaven. However, the safe heaven is going through a storm now. Last week, its leading stocks, retail giants Walmart (WMT) and Target (TGT), all reported headwinds due to inflation and higher costs. Both suffered large corrections after earnings: Walmart's stock price lost about 20% and Target about 28%. Such corrections brought enormous pressure to the consumer staple sector. The sector fund, Consumer Staples Select Sector SPDR Fund (NYSEARCA:XLP), lost close to 10% of its price last week.

Looking forward, we see that more volatility is coming to the consumer staple sector, especially during the next week. Other heavyweights in the sector, including companies such as Costco (COST), Best Buy (BBY), and Macy's (M) will announce their earning results. It is very likely that the earnings will report negative surprises and can trigger another round of sell-off.

And this brings us to the thesis of this article:

  • The consumer staple sector and XLP are currently at an attractive valuation level already as you will see from our market sector dashboard next (and you are welcome to download it here). Any additional correction will make it an even better entry opportunity.
  • However, we like some of its large component stocks even better, such as Altria (NYSE:MO). Altria has already reported its earnings and the earnings are positive in my view, and there it is better shielded from the volatilities due to negative earnings compared to XLP. The tobacco business leader has once again demonstrated its resilience in challenging environments like what we are going through now. It confirmed 2022 earnings guidance in a range of $4.79 to $4.93 (in terms of adjusted diluted EPS). Such guidance actually translates into a health growth annual growth rate between 4% to 7%. In addition, Altria also provides superior profitability, thicker dividend yield spread, and much lower valuation.

We will elaborate on the above points immediately below.

Market sector overview and XLP

As you can see from our market sector dashboard below (and you are welcome to download it here), the Consumer Staple Sector as represented by XLP is one of the more attractive sectors now.

Details of the mechanics of the dashboard can be found in our earlier article on XLE. As mentioned in that article:

We use the dashboard to put our finger on the pulse of the market and its major sectors. Especially, the simple yield spread (the TTM dividend yield minus the 10-year Treasury rates) is the first thing we look at. According to our dashboard, XLE was the most attractive sector compared with other sectors.

Indeed, the energy sector has been the one sector that has shown a sizable gain of 22% since a quarter ago. The other three sectors that have shown a positive return are healthcare (about 2%), basic materials (essentially 0%), and utilities (about 8%). And all other sectors have suffered substantial losses. With the recent sell-off in the consumer stable sector, it has become more reasonably valued with a positive dividend yield Z-score of 0.24. Although its yield spread Z-score is still in the negative (negative 0.7). But against, it is relatively mild in absolute terms (I won't be too alarmed for any Z-score that is between positive 1 and negative 1). And relative to other sectors, it is the 5th most attractively valued sector compared to the risk-free rates.

Market Sector Dashboard

Author

Why we like MO better than XLP?

XLP tracks a market-cap-weighted index of consumer staples firms in the S&P 500. As of this writing, it holds a total of 33 stocks. The fund's assets are almost all large-cap stocks. Although it is quite top-heavy. Its top 10 stocks represent more than 70% of its total asset, resulting in more focused exposure. And MO is one of its largest holdings, representing almost 4.35% of the total assets.

As you can see from the following chart, MO has delivered far superior performance in the long run than XLP. Since 2000 when the fund was launched, MO has delivered an annual return of 12.7% compared to about a 7% from XLP, leading to almost 4x total return over the past 22 years. Although note that MO, as a single stock, has suffered higher price volatility than the fund. It has suffered a standard deviation of 24.4%, almost 2x of XLP's 12.3%. Its worst year performance was 54% compared to XLP's 20%. And its maximum drawdown was a nerve-wracking 60%, compared to XLP's 32%.

Looking forward, I expect such outperformance to continue given MO's superior profitability and valuation, as detailed immediately next.

XLP top 10 holdings

Yahoo Finance

XLP ETF portfolio growth

Source: Portfolio Visualizer

MO's superior profitability

As you can see from the following chart, compared to XLP, MO deliver far superior profitability and historical growth yet is for sale at a significant discount.

The chart is made from data obtained after the market closed on May 20 from Yahoo Finance or Seeking Alpha. Particularly, MO's operating margin of 50.5% and ROCE (return on capital employed) of 137% are about 8 times and 6.1 times higher than the sector. Yet, MO is valued at only 10.9x PE and 10.3x price to cash flow, while XLP is valued at 25.5x PE and 15.6x price to cash flow. The valuation discount is about 57% in terms of PE multiples and 34% in terms of price to cash flow multiples.

MO vs XLP

Author

The following chart zooms in on the profitability comparison in terms of ROCE more closely. The ROCE here is calculated using MO's annual financials for the past 10 years. As can be seen, the ROCE of MO is on average about 137%. it started the decade with a ROCE of around 90% to 100%. And it dipped a bit to the 100% level again during 2016 and 2017. But overall way, its ROCE has been remarkably consistent and a level of 137% makes its profitability more competitive even than many of the FAAMG stocks. furthermore, its current ROCE is at 164%, higher than its long-term average by a whopping 27%.

In contrast, XLP's profitability is less impressive. Using the equity as an approximation for the sector capital employed, its ROE is about 22.5%. It is a respectable level and comparable to the overall economy, but nowhere near MO's long-term average of 137%.

MO stock ROCE

Author

MO and XLP: inflation and dividends

As aforementioned, leading stocks in the XLP such as Walmart and Target have reported headwinds due to inflation and higher costs. And other heavyweights in XLP such as Costco and Best Buy are very likely to report similar headwinds next week. Such headwinds are unlikely to subside until the Fed convinces investors that it can strike a delicate balance - tightening monetary policy to contain inflation on one hand by not triggering an economic downturn on the other hand.

MO, thanks to the unique nature of its products, is likely to fare better and weather such uncertainties in a more resilient matter. In its 2022 First-Quarter earnings release, it reported quite positive results. It does not only expect its earnings to decline but also reaffirmed that it expects its 2022 full-year earnings to grow by 4% to 7% thanks to its stable shipment volume and pricing power. As its CEO Billy Gifford commented,

We are off to a strong start to the year and believe our businesses are on track to deliver against their full-year plans. Our tobacco businesses performed well in a challenging macroeconomic environment and we continued to make progress toward our Vision to responsibly lead the transition of adult smokers to a smoke-free future. We reaffirm our guidance to deliver 2022 full-year adjusted diluted EPS in a range of $4.79 to $4.93. This range represents an adjusted diluted EPS growth rate of 4% to 7% from a $4.61 base in 2021. We continue to expect that adjusted diluted EPS growth will be weighted toward the second half of the year.

cigarette trips and volume sales trends

Altria 2022 Q1 Earnings Report

MO also provides a much higher current dividend yield to combat inflation. As you can see from the following chart, MO has consistently paid a higher dividend yield than XLP. Currently, MO pays a dividend yield of around 7%. Compared to the 2.2% yield paid from XLP, MO provides investors with a yield spread of more than 4.8%.

To put things into a broader perspective, the second chart shows the yield spread between MO and XLP over a longer timeframe. As can be seen, the spread has always been positive because MO has consistently paid a higher dividend yield than XLP. The spread started at around 3.5% at the beginning of the decade and gradually narrowed to its lowest level of 1% from 2016 to 2017 when MO reached its peak valuation relative to XLP. Since then, the yield spread has expanded to the current level of more than 4.8%, the thickest level in more than a decade. Such a thick yield spread suggests that MO is drastically undervalued relative to XLP.

MO vs XLP dividend yield

Author

MO vs XLP yield spread

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Summary and risks

  • Our sector dashboard shows the consumer staples sector as one of the more attractively valued sectors (you can see the full dashboard here). It features a positive dividend yield Z-score of 0.24 and a mildly negative yield spread Z-score of - 0.7. It is the 5th most attractively valued sector compared to the risk-free rates.
  • But we like MO even better. MO provides superior profitability and consistency over XLP, yet is valued at a fraction of XLP. MO's operating margin of 50.5% and ROCE of 137% are about 6 to 8 times higher than the sector average. Yet, MO is valued at only 10.x PE and price to cash flow, compared to XLP's 25.5x PE and 15.6x price to cash flow.
  • We expect MO, given the unique nature of its products, to be more resilient to the inflation and interest rate uncertainties ahead. In its 2022 First-Quarter earnings release, it does not only expect earnings decline but also reaffirmed anticipation of 4% to 7% growth. Its total return is also better supported by its generous high current dividend yield. Its yield spread relative to XLP is currently more than 4.8%, the thickest level in more than a decade.

Finally, we want to point out the risks of both XLP and MO before closing.

  • The speed and extent of the post-COVID economic recovery are unknown and can negatively impact MO. The demand elasticity of MO's products has been the subject of much controversy, especially during economic recessions. The most important secular risk is the demand decline of its smokables. Altria also constantly faces regulatory pressure in terms of taxes, lawsuits, and advertising.
  • Choosing a single stock over a sector fund (or vice versa) involves risks too and ultimately the choice needs to fit individual investor's risk profile. You may argue that the chance of XLP with 33 stocks all collapsing at the same time is substantially smaller than the chance of one stock collapsing. However, the opposite argument can also be made that the stock with the best profitability in any particular industry would be the last to collapse.

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** Master of Science, 2004, Stanford University, Stanford, CA 

Department of Management Science and Engineering, with concentration in quantitative investment 

** PhD,  2006, Stanford University, Stanford, CA 

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Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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