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Demographics Explain Warren Buffett's Shift From Consumer Staples To Manufacturing

|Includes: The Hain Celestial Group, Inc. (HAIN)

Summary

Berkshire Hathaway's acquisition of Precision Castparts indicate Warren Buffett sees potential in manufacturing.

Manufacturing is a pivot from consumer staples. The Kraft/Heinz integration was completed.

Demographics indicate growth in consumer staples and manufacturing.

The market's downtrend make it risky to invest in any sector, even those with strong fundamentals.

Warren Buffett acquired Precision Castparts, an aerospace parts manufacturer, on August 10. He paid $235 a share ($37.2 billion in cash). This was a 21% premium to the previous closing price. The shares had dropped 17% in 12 months amid the slump in energy prices. It is also in the oil and gas industry.

Precision Castparts is one of Buffett's largest acquisitions. Heinz was acquired for $28 billion on February 14, 2013. Earlier this year, he partnered with 3G Capital again to add Kraft Food Groups. Kraft/Heinz is the world's fifth largest food and beverage company. The price tag on Kraft: $55.4 billion.

Fortune found manufacturer's energy costs have fallen with the cost of domestic oil and gas. The price for industrial energy in the U.S. is now 30% to 50% lower than those of other major exporters. The low cost of energy offsets the higher cost of domestic labor. Cheap energy narrows the productivity gap of U.S. manufacturing versus emerging markets.

Buffett compares market capitalization with GDP to get a read on stock valuations. The approach suggests stocks in some markets may still have room to rise. Despite this, traditional fundamental and technical measures indicate many markets around the world are near peak valuations.

The CAPE ratio divides the level of the S&P 500 by its average earnings over the past 10 years. The ratio is also known as the Shiller P/E after Professor Robert Shiller, who popularized the metric. The CAPE ratio stands at 27. The one-year P/E ratio stands at 19. Both are above the long-term average of 16.

I like the CAPE ratio. Implicit in the measure is the idea that the stock market moves in cycles. A ratio that measures valuations over the past 10 years recognizes this. I have written on this subject at length before, so I will not tire my readers with a rehash.

There was an article in the Wall Street Journal titled, "Industrial Stocks Lure Bargain Hunters" by Dan Strumpf on August 10. It was paired with an announcement of the Precision Castparts acquisition. In short, compared to other sectors, manufacturers are undervalued. Buffett, true to form, bought a quality company in a sector with low valuations.

A June 2, 2015 article by Justin Lahart in the Wall Street Journal found that, until late 1999, the availability of dot-com shares was limited. Many shares were held off the market by insiders subject to lock-up agreements. The float in dot-com companies rose from $70 billion to $270 billion in the five months before April 2000.

In "Stock Rout's Tricky Explanation" Spencer Jakob of the Wall Street Journal found the number of stocks hitting their 200-day moving average has declined since mid-2012. Since then, fewer and fewer stocks have hit new highs.

An article by Ben Levisohn appeared in the September 5 issue of Barron's titled: "Guess Who's Killing the Market?" He thinks we have seen an investment crises, not a financial crises. Levisohn quoted Michael Shaoul, CEO of Marketfield Asset Management, who said the stock market's drop was driven by "lopsided positioning." When the market falls, people (mistakenly) find an economic reason to justify the decline.

According to Lipper data, investors pulled $16.2 billion out of equity funds in the week ended September 9. A survey by Investors Intelligence showed more investors were bearish than bullish for the first time since October 2011.

The S&P MidCap 400 Growth Index is up 4.3% in the past year, compared with a 4% decline for the value index. In the past year alone, the Russell 1000 Growth Index is up 3%, while its value counterpart has fallen 7%.

Conclusion

The seven-year bull market has made stocks in even staid sectors (consumer staples, manufacturing, utilities) vulnerable. As of June 23, the S&P 500 had not posted a gain or loss of two percent or more for 126 days. It was the longest such streak since the one that ended in February 2007.

On Nov. 26, 2013, I wrote consumer staples stood to benefit as Generation Y aged into its family rearing years. Further out, manufacturing stands to benefit.

"The trend of rising demand for consumer staples gives that sector a good chance of outperforming the market average until 2018...

Strength in the consumer staples sector could cause it to thwart the downward trend in the stock market that is in place until 2018."

from Regional Banks, Biotechnology And Manufacturing

In the same essay, I also wrote biotech stocks could be expected to outperform the market average until the correction. Aging Baby Boomers are expected to drive volume in prescription drugs.

"Core products from large-cap biotech firms, like Amgen, are based on technology that was developed decades ago. The major biotechnology firms face patent expirations, the same problem that has been faced by the pharmaceutical drug industry. The loss of core products to patent expirations is a signal that innovation needs to be accelerated...

The ETFs SPDR S&P Biotech ETF (NYSEARCA:XBI) and iShares Nasdaq Biotechnology (NASDAQ:IBB) cover almost all of the publicly traded firms in the sector."

The section: "Agenda: People, Companies and Ideas that Move Markets" in the October 2015 issue of Bloomberg Markets was titled, "Why Drugmakers Are Buying Each Other." It found the M&A boom is driven by companies looking to replace blockbuster medications which have patents that will soon expire. Tax advantages are also a factor as drugmakers seek to merge with others in lower-tax domiciles.

In "The Golden Age for Biotech Stocks Could be Nearing an End" (Sept. 17) the Wall Street Journal's Maureen Farrell found spending among drugmakers has shifted from business investment to financial engineering. By comparison, consumer staples are sound. On September 16, an article by David Harrison appeared in the Wall Street Journal titled, "Consumers Bolster Economy." The title says it all.

Warren Buffett and 3G Capital must try to wring efficiencies from the Kraft/Heinz merger. It is harder than achieving organic growth. Generation Y consumers prefer natural foods. Buffett was forced to buy large food companies. A conglomerate the size of Berkshire Hathaway (NYSE:BRK.A) must make large acquisitions to impact the bottom line. On November 9, 2013, I wrote:

Consumer staples are a defensive sector of the market. The relative stability of earnings makes the sector a haven in market downturns. This is relevant in today's market which will soon face two headwinds. The first headwind is reduced demand for stock as an investment vehicle from the diminutive Generation X. The Baby Boomer Generation, currently between the ages of 50 and 69, no longer has any more new members to enter the period of retirement saving that begins at age 50. The second headwind is reductions in Quantitative Easing, the program that has boosted share prices by providing inexpensive capital to companies that are well-positioned to repay the loans...

A reversal of sentiment will be shown when the momentum stocks top out or begin to decline. It will indicate investors think there are no longer some stocks that are much more attractive than others. A top in momentum stocks will indicate a change in sentiment from bullish to bearish."

from Switching from Consumer Discretionary to Consumer Staples

The individual investor can choose companies that focus on the taste of Generation Y. Hain Celestial (NASDAQ:HAIN) and White Wave Foods (NYSE:WWAV) are two. General Mills (NYSE:GIS) bought Annie Inc., a maker of organic foods, on September 9, 2014 for $820 million.

I cannot recommend investing in HAIN or WWAV because the market is in a downtrend. Companies with even the strongest fundamentals will have trouble bucking the trend.

Buffett compared the manufacturing sector to other sectors. By comparison, manufacturing had a low valuation. Demographics indicate an auto-parts manufacturer would have been preferable to an aerospace manufacturer. Generation Y is set to increase the market for new cars. A 47-year-old male is more likely to buy a new car than any other demographic (Gronbach, 2005). That demographic is set to expand.

I cannot recommend investing in the consumer staples or manufacturing sectors because I expect the market to trend down until the next recession. Manufacturing has a long runway, so it is an option when stock prices bottom during the recession. See the article "Car Makers Rev Up Industrial Production" by Eric Morath in the August 15 issue of the Wall Street Journal.

Auto manufacturers should hedge exposure to China. On July 11, an article by John D. Stoll appeared in the Wall Street Journal titled, "China's Auto Sales Slip Into Reverse After Long Slowdown."

It was followed by an article titled, "In China, Car Sales Slump Worsens." The second article was written by Rose Yu and Lilian Lin and appeared on September 11.

Demographics indicate China will continue to slow as I have wrote on Seeking Alpha and Quora.

References

Gronbach, Kenneth W. The Age Curve: How to Profit from the Coming Demographic Storm. New York: American Management Association, 2008. Print.

Disclosure: I am/we are long HAIN.