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Comparison Shopping in Consumer Stocks

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

As the consumer takes the center stage in the economic recovery, investors might be sniffing around the consumer sector looking for some investment opportunities, but it pays to be picky.

Here to tell us why is, Morningstar's Paul Larson. He is an equity strategist and editor of Morningstar StockInvestor newsletter. Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So, you mentioned to me before that the market has enjoyed a pretty nice run here over the last few months, so it really is important to dig underneath the surface on any investments that you might be considering right now. You have some examples of some divergence of valuations in the consumer sector. Let's start on the overvalued side. You picked out a name that's looking pretty pricey right now. Tell us the story behind that?

Larson: The company that's looking a lot overvalued right now is Estée Lauder, ticker EL, and this is a women's consumer products company, making and selling make-up and shampoos, and other creams and lotions and such. This is a narrow moat company. It's a fairly high-quality company, relatively stable company. I can't say there is anything terribly wrong with the underlying business, but when you look at the underlying valuation, I think the stock is looking quite rich today.

Stipp: So, what's behind that? It has a narrow moat. It looks like a good business. You expect it would have a decent valuation, maybe a premium to some other consumer products companies, but it's beyond that. Why have investors bid up this company?

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Larson: When you look at just the simple P/E multiple, the stock is trading near 30 times earnings, both trailing and forward, because the growth rate really isn't all that high, and when you look at that growth rate, this is a company that had growth a little bit less than 4% in the last four years. We expect it to accelerate slightly coming out of the recession, close to 5%-6%.

What I think the market is seeing with Estée is, they are seeing a potential turnaround story. I don't know if I necessarily believe that it's going to be a turnaround story, nor do our analysts believe it's going to be a turnaround story, but I think the bigger driver here is, this is a company that just happens to be about the right size for a potential buyout, and I think that the stock has a very rich premium attached to it because of that potential. It would be just a nice, relatively simple bolt-on acquisition for a large consumer products company, and again it's that right size to be able to be bought fairly easily.

Stipp: So, certainly buying in right now would be a lot of a speculation that a deal would actually be proposed and would get done at some point at a valuation that looks as attractive or more attractive than the stock is priced today?

Larson: Right. Yeah. I mean I don't know how you make the numbers work on a stand-alone basis, with the company trading at roughly 30 times earnings growing at a 5% or 6% growth rate.

Stipp: So, Paul, staying in the consumer space and looking at some other opportunities, what would you see that might be well worth investors taking a closer look as a possible buy?

Larson: One possibility if you want to get into pair trading is a wide-moat women's consumer products from Avon. It has a little bit different business model than Estée Lauder. Estée is going into traditional department store channels, where Avon is more of the direct-sales, multi-level marketing model, but we think that Avon has a wider moat, and it actually garners our wide moat rating and has higher returns on capital, and is trading at a much more reasonable valuation. Our fair value is $36; the stock is a little bit under $30, so unlike Estée, which is trading above our fair value estimate by a fairly significant margin, Avon is trading at a moderate discount.

Stipp: You mentioned that you had another idea that has ... a much broader business, but it's also worth investors to take a look at, if they want to get some more exposure to the consumer. What's that company?

Larson: Sure. Procter & Gamble is another stock. One that I happen to own in the Tortoise Portfolio, I manage for StockInvestor as well as personally. This is another wide-moat consumer products firm that gets its moat from economies of scale. It's a massive company, and also from the brands that it has. It has over 20 brands that have over $1 billion in sales annually.

Our fair value for Procter & Gamble is $77. The stock is in the high $60s. So, it's not a massive discount to fair value. It's not a table-pounding buy, but it's trading at only about 16 times earnings, even though it has a very similar growth rate to Estée Lauder, which is trading at 30 times earnings. I think that P&G is a much better value.

Stipp: So, at 16 times with a wide moat versus 30 times with the narrow moat, it seems like P&G gets the nod on this one.

Larson: Indeed.

Stipp: Thanks for joining me, Paul.

Larson: Thanks for having me.

Stipp: For Morningstar I am Jason Stipp. Thanks for watching.