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By Matthew Coffina, CFA and R.J. Hottovy, CFA | 11-05-2013 02:00 PM

Ideas for the Consumer Defensive Sector

Some categories in the sector are more conducive to moats than others, but Morningstar's Matt Coffina, R.J. Hottovy, and Erin Lash say opportunities exist among beverage and tobacco firms.

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.

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