Time to Buy the Staples?

The industry sectors in the S&P 500 have displayed widely divergent performance since the US presidential election on November 8, 2016. While the Technology sector is up over 56% and the S&P 500 is up nearly 29%, the Consumer Staples sector is down 3% (all excluding dividends). The FANG stock contribution (Facebook, Amazon, Alphabet, Apple, and Netflex) toward the strong performance in the Technology sector and the broader market has been well documented. But why have Consumer Staples companies suffered so mightily (on a relative basis) over the past 18 months? There are several factors:
    • Rising Interest Rates – It is no coincidence that the worst-performing sectors have been those that offer the highest dividend yields (Energy, Real Estate, Utilities, Consumer Staples and Telecom). Many investors use these sectors to generate income, and so the attractiveness of these sectors as a source of outsized dividend income has diminished as interest rates have risen. In fact, the yield on the 10-year Treasury bond is up more than 100 basis points (or 1%) since the election, making interest income on Treasuries more attractive relative to dividends.
    • Slowing Global Growth – In more recent months, we have received a lot of data that suggest economic growth outside the US may be slowing. Slowing growth is a double-whammy for the large multinational Consumer Staples companies that generate a big portion of revenue outside of the US. Slower economic growth will lead to weaker demand, and weaker demand will obviously pressure revenue growth. At the same time we are seeing slower growth outside the US, the domestic economy appears to be strengthening due to the tax cuts and the passage of a (profligate) spending bill. While good for domestic demand, the divergence in growth trajectories between the US and non-US economies has caused the dollar to strengthen. A stronger dollar makes it harder for US multinationals to compete with their foreign competitors.
    • Rising Commodity Costs – The rising cost of energy and other input prices in recent months has put pressure on margins at Consumer Staples companies. Raw materials are a big percentage of production cost for many Consumer Staples companies, and so rising input costs can and have affected profitability. This is especially true as many companies have been finding it hard to pass these rising costs onto consumers.
    • Rising Labor Costs – A huge drop in the unemployment rate is finally causing some wage pressure. While it is certainly not a foregone conclusion that the growth in wages will accelerate, rising wages are already having an effect on margins across multiple industries, including Consumer Staples.
    • The “Amazon Effect” – Many Consumer Staples companies sell their products through Amazon.com. And just as Wal-Mart has squeezed its suppliers for years by requiring sizeable price concessions in exchange for shelf space, Amazon is now doing the same thing in its quest for higher profits. Many purveyors of staples goods are finding they have no choice but to meet the demands of the e-commerce juggernaut.
    • Private-Label Competition – During and following the Great Recession, there has been an explosion in lower-priced, private-label offerings. These new products generally sell for much lower prices than many of the branded and premium products sold by the likes of P&G and Colgate. No doubt the “trade-down” effect was due to the precarious financial condition that many consumers suffered as a result of the financial crisis. And while many consumers are doing much better now, there remain a large percentage of consumers who have not benefited much from the economic recovery. This means the “trade-down” effect may have lasting consequences.

Source: Bloomberg

 

Source: Bloomberg

 

At the very least, we think the dramatic variance in returns among the eleven S&P 500 industry sectors over the 18+ months creates opportunities for a rotation into more defensive sectors. To be sure, there is a confluence of highly credible reasons for Consumer Staples sector weakness of late. However, the massive underperformance, combined with the likelihood that all these issues should be well understood and priced in by now, argue for a long, hard look at the sector. In a research note published this morning, analysts at JP Morgan had this to say about the weakness in Consumer Staples stocks: “The extended period of underperformance resulted in a severe multiple compression with forward P/E declining by ~5x from 21.9x to 17.6x. Similarly, the dividend yield has risen from 2.6% in 2016 to 3.2% (relative to S&P 500, dividend yield has risen to a record wide of 120bps). We believe Staples carry [the spread between dividend yield and borrowing costs] should be attractive in a world where $8.8t of government debt is still trading at sub-zero, Euro/EM economic growth is being revised down, and inflation prints remain softer than expected.” We agree.