Matt Coffina: For Morningstar StockInvestor, I’m Matt Coffina. I’m joined today by R.J. Hottovy and Erin Lash from Morningstar’s consumer team, and we’re going to talk about the consumer defensive sector.
Thanks for joining me.
R.J. Hottovy: Thanks, Matt.
Erin Lash: Thanks for having us.
Coffina: Consumer defensive led the market earlier this year. In recent months, the sector has been lagging the broader market. R.J., what do you think is driving this, and how do you see the sector’s valuation right now?
Hottovy: It really is a twofold function. I think for the first half of the year, really up until the beginning of June, we saw that the consumer defensive space on average is about 5% to 10% overvalued. I think what we saw is a lot of investors using the consumer defensive space as a fixed-income proxy. Most of the names in the space are nice dividend payers. Typically, you find yields north of 3%, in some cases north of 4%. I think a lot of investors were really using that as a fixed-income proxy.
As soon as June rolled around, and we saw the Fed hint at potentially tapering quantitative easing programs, potentially an increase in interest rates, we saw a lot of rotation on the consumer defensive names and people getting back into fixed-income vehicles. I think that also might have led to pressure there.
Secondarily, too, we also started to see some cracks in the overall U.S. consumer as well, particularly among the lower- to middle-income consumer that remains extremely cash strapped and looking to stretch household budgets at the same time. So some potential downside guidance as well that led to some of the pressures in the space. Right now, we view the space as about fairly valued, slightly above 1 times under the price/fair value basis, but relative to other sectors certainly cheaper than most other sectors we cover.
Coffina: Erin, as we look across the consumer defensive sector, we find that some industries are more conducive to moats than others. One sector that has a lot of wide-moat companies in it would be tobacco. What makes tobacco especially conducive to moats?
Lash: There’s a few factors, Matt. One would be the addictive nature of the product. Obviously, that’s part of it, and consumers are subsequently very brand-loyal in the tobacco space. The industry is highly consolidated, and as such, there hasn’t been as much private-label penetration within the tobacco sector, and that’s led to excess returns on invested capital and subsequently outsize penetration of wide moats relative to other consumer defensive sectors.
Coffina: How about beverages, both alcoholic and nonalcoholic? We also see relatively moaty companies in this industry. What can you tell me about the beverage industry?
Lash: The beverage industry depends on category to a certain extent. Obviously, for companies nonalcoholic, like Coke and Pepsi, they’ve been consolidating the market, expanding beyond that carbonated beverage for some time, and that’s enhanced their competitive advantages relative to retailers in the spaces that they play. For alcoholic beverages, it’s a little bit more diversified. For brewers, if they operate in a geography where it’s consolidated and they’re one of the top players in the market, they tend to have more competitive advantages than brewers that operate in fragmented markets. For distillers, you see that those that deal with age-distilled products, like aged brown liquors, those tend to have stronger competitive advantages, given the lead time that’s necessary to age the actual product. So we see that those players have stronger competitive advantages and subsequently returns on invested capital, as well.
Coffina: Both tobacco, nonalcoholic beverages, and also distilleries, they all have relatively low degrees of private-label penetration and they’re also relatively consolidated markets. We find that to be less true with household and personal-care products. What’s your outlook for that industry?
Lash: Obviously, retailers have taken the opportunity during the economic downturn to really invest behind their own store brands, and subsequently competing more against household and personal-care names. But it has been a divergent tale. I would say that there are certain categories where consumers are more apt to trade down within the household and personal-care space than others: food storage, laundry being two that consumers maybe have opted to trade down more. But beauty care still tends to be an area of the household and personal-care space where trade-down is less noticeable, even though the products are actually priced at a greater premium relative to private-label offerings. Some of that’s due to the advertising and research and development budget that companies invest behind those products and the cachet that consumers associate with those levels of investment.
In addition, I would say that household and personal-care names have been doing their fair share in terms of trying to keep consumers loyal to the brand: launching particular brands at exclusive outlets to create excitement for the product or the brand and ensuring that their brands are driving traffic in consumer stores.
Coffina: Lastly, packaged food is one area that we think has relatively weaker competitive positions, but there are some exceptions. What do you think about the packaged-food space?
Lash: Yeah, it definitely depends on the category in which you play. Firms that play in advantaged categories, like confectionery and spices and seasonings, tend to have stronger competitive advantages than other firms. These firms also tend to have more expansive global footprints, and their brands drive store traffic. Conversely, firms that play in categories that are maybe faster-turning or perishable, like fresh meat and dairy, tend to have less brand power, pricing power in the eyes of consumers. Consumers might be more apt to consider price rather than brand, and retailers have subsequently taken advantage of that positioning.
Coffina: R.J., as we look across our consumer coverage, what would be some of your top picks, in particular wide-moat companies that we think are trading at reasonable valuations?
Hottovy: I’ll start with just mentioning some of the themes that we’ve identified and really been keeping a close eye on. We’ve been monitoring the balance of bargaining power between the large CPG companies and the retail outlets that they distribute their products through a lot more closely ever since the recession. What we’ve seen is that there has been a consolidation among the large retailers and that they had gained some ground in terms of bargaining power in the last couple of years.
That being said, we do think a couple of categories, particularly tobacco and beverage, that there are some opportunities in valuation there, particularly because those companies don’t face a lot of private-label competition, do have large brand portfolios, and do have cost advantages. Names like Philip Morris, we think, right now is a pretty attractive name; Coke is another name that we think is also particularly attractive in this environment. Both are very strong players within fairly consolidated industries, dominant market share positions, and still some emerging-market growth potential, as well. Both pay pretty strong dividends, certainly above 2%, and so you get that part of the story as well.
Looking further down the consumer defensive space, a name like Unilever is also a name that we think is particularly attractive in this environment. I think that’s a situation where they’re harnessing the potential of the emerging markets a lot better than they had in the previous years, and I think that will show in results over the next 12 to 18 months as well.
Coffina: Thanks for joining me, R.J. and Erin.
Lash: Thank you.
Hottovy: Thanks, Matt.
Coffina: I’ll just mention that Morningstar StockInvestor’s Tortoise and Hare portfolios own Coca-Cola and Philip Morris International.
In conclusion, I think this is a time that greed is really winning out over fear in the marketplace. Consumer defensive names, which tend to be very high quality, a lot of wide moats to be found, are trading at relatively reasonable valuations, and I think this is a good time to take a look at this space.
For Morningstar StockInvestor, I’m Matt Coffina.
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