Consumer defensive stocks, though fairly valued, still offer opportunities for investors concerned about safety.
In the face of commodity cost pressures and weak economies worldwide, consumer defensive companies continue to press on through the ups and downs of the business cycle. Investors, searching for yield and safety, have rotated into the sector, pushing up values. Still, Morningstar’s equity analysts think that the long-term fundamentals of the sector are strong and that opportunities exist for patient investors. To learn more about consumer defensive stocks, I sat down with R.J. Hottovy, Thomas Mullarkey, Erin Lash, and Ken Perkins, who Morningstar equity analysts who cover the sector. Our discussion took place Feb. 25.
Philip Guziec: The consumer defensive sector is supposed to hold some value through an entire business cycle. How well did these stocks hold up through the our latest cycle?
R.J. Hottovy: Through 2008 and 2009, consumer defensive stocks outperformed the broader market. What we saw was a lot of rotation into high-quality names. Consumer defensive is one of the more-concentrated categories in terms of economic moats. Roughly two thirds of the 100 consumer defensive companies that we cover have either a wide or narrow Morningstar Economic Moat Rating. That makes them attractive in times of difficulties. These are the brands that people buy, regardless of the economic backdrop. And while shoppers may trade down to private-label and lower-priced items, these products are still produced by consumer defensive firms.
Now, as we started to see a bit more recovery, the bounce back among the consumer defensive stocks wasn’t as pronounced as it was in the higher-risk consumer cyclical space. Still, over the past six to nine months, consumer defensive stocks outperformed cyclical stocks. A lot of that had to do with investors’ preference for higher-yielding stocks. That’s another feature of the consumer defensive sector. It is full of dividend-payers. The average consumer defensive stocks pays a dividend yield of 3.5%. So, it’s a good category for investors chasing yield.
Guziec: In terms of operating performance, did they exhibit stable earnings as expected?
Hottovy: For the most part. There was more stability on the revenue line than anything else. You’re always going to have low-single digit volume growth with these companies, but pricing was a wild card. We did see a spike in commodity costs, particularly in the latter part of 2011, early part of 2012, which had a lot of consumer companies rethinking things. As a result, we saw more margin pressure than we had seen in past economic downturns, particularly in terms of food-related commodity costs, which were so severe that it ate away at profitability for a lot of these companies.
Another thing we see in the retail side of the sector is a lot of consolidation. Big players such as Wal-Mart WMT and Costco COST are now commanding a lot more bargaining power with consumer staples companies. But all things considered, consumer defensive stocks were able to better preserve their margins when things were getting worse than what consumer cyclicals were able to do. But they may not bounce back as quickly as some of the other categories once we get higher revenue growth.
Guziec: Where are things valuation-wise? What looks interesting?