Consumer Staples to Continue Outperforming the Market

by: Zacks Investment Research

Weaker markets always seem to make Consumer Staples stocks look more attractive. But where are the best buys in this group? We met with Zacks senior analyst Steven Ralston, CFA to find out.

How have any companies under your coverage versus expectations thus far?

In the industries under my coverage, 14 companies have reported earnings for the second calendar quarter. Half of the companies reported upside surprises resulting in the stocks rallying between 5% and 9% on the day of the earnings report.

I discern two significant pieces of information from these earnings reports and the subsequent stock reaction: 1) stocks have declined to an attractive level from which any good news sparks a significant rally, and 2) the operations of consumer staples companies have not been adversely affected by the credit crisis and high energy prices.

What are you expecting from this industry as a whole this quarter?

With half the earnings reports being delivered above expectations, I expect the consumer stocks to continue outperforming the stock market, despite having outperformed for the two prior years. Valuations are generally in the middle quintile of historical ranges. With unemployment at 5.0% in June and steep declines in new home sales, economists are somewhat in agreement that the economy’s de-acceleration will result in a recession.

In this environment, the Consumer Staples sector has traditionally performed better than the stock market. Institutional portfolio managers should continue to favor the Consumer Staples sector, especially in the second half of the year when cyclical companies should report disappointing earnings.

Which are your top Buy recommended stocks in this space?

With the recent decline in equity values, I have upgraded several stocks to a Buy: Avon Products (NYSE:AVP), Snap-on (NYSE:SNA), DeVry (DV), and Strayer Education (NASDAQ:STRA).

Avon appears attractive on a valuation basis. Though the company’s direct selling business model is struggling in the mature market of the U.S., sales are growing at a double-digit rate in Latin America, Western Europe, Middle East and Africa. And in China, sales increased 29% in the most recent quarter. Management is still aggressively emphasizing the higher margin Beauty products and has instilled financial discipline through a multi-year supply chain cost reduction program. On the recent price weakness in July, we upgraded the stock to a Buy.

Snap-on, DeVry, and Strayer Education are three companies that have exhibited strong earnings growth despite a weakening economy, and the recent market pull-back has provided attractive entry points in their stocks. Snap-on is a global provider of professional tools and equipment. Having reported upside earnings surprises for ten consecutive quarters, once again earnings momentum investors are expected to return and buy the stock. Management has successfully delivered more predictable and consistent financial performance through the implementation of the Driven to Deliver and Rapid Continuous Improvement programs.

DeVry and Strayer are providers of post-secondary education, primarily targeting working adults. Both managements continue to execute well with both companies reporting positive enrollment trends. Annual tuition increases augment top line and bottom line growth. In addition, Strayer Education and DeVry have reported earnings results above expectations in the past three quarters.

Any Sells, and/or general issues to be wary of?

Over the last two years, I have been a table-pounding buyer of Anheuser-Busch (NYSE:BUD) under $50. With the final friendly offer of $70 per share from InBev on July 14th, I finally downgraded the rating to a Sell.

However, more is brewing in the beer industry: a structural change is about to occur. With the merger, excess costs will be wrung out of Anheuser-Busch by InBev. In addition, a joint venture between Molson Coors (NYSE:TAP) and SABMiller should produce a more competitive brewer with greater scale, resources, and distribution synergies from the optimization of production and distribution networks.

Therefore, the cost rationalization at Anheuser-Busch (instigated by the merger with InBev) and the joint venture between Molson Coors and SABMiller are expected to spark more intense competition, resulting in the loss of the positive pricing trends enjoyed by the industry for the last two years, in other words, a beer war. Most likely, both companies will pursue higher levels of promotional initiatives and marketing spending. As a result, overall profitability for the industry is expected to suffer. Molson Coors is also rated a Sell.

Steven Ralston, CFA is a Zacks analyst covering a variety of companies in various industries of the Consumer Staples sector.