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Our Outlook for the Consumer Sector

A handful of high-quality 5-star stocks are scattered across the sector.

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Despite the ongoing slowdown in the housing market and the resurgence of high gasoline prices, consumer spending has remained strong. As a result, consumer goods and services stocks have held up quite well (on average) despite fears of an eventual consumer spending downturn. Average star ratings of the industries that constitute the consumer goods and services sectors are between 2.0 and 4.0, and the average price/fair-value ratios of these industries are between 0.9 and 1.2. This suggests to us that the sector, as a whole, is fairly valued.

Aside from the homebuilders, we don't see any large pockets of value. However, a handful of high-quality 5-star stocks are scattered across the sector, and some are made especially attractive by the fact that we think they are somewhat insulated from any weakness in consumer spending. And, of course, for more risk-tolerant investors, there are also a significant number of cheap homebuilders.

Valuations by Industry
Within the consumer goods and services sectors, the most overvalued groups are the hotel industry and the food manufacturers. Most of the stocks we cover in the food manufacturing industry are fairly valued, with a couple of overvalued outliers ( Diamond Foods (DMND) and  Bunge (BG)) dragging the average star rating downward. But overvaluation in the hotel industry is widespread. The most undervalued companies in the consumer goods and services sectors are the homebuilders and the home supply companies ( Home Depot (HD) and  Lowe's (LOW)).

 Consumer Goods/Services Industry Valuations
Segment

Average
Star Rating

Median
Price/Fair Value
Stocks Covered
Apparel Makers 2.6 1.2 10
Clothing Store 2.7 1.1 21
Department Stores 2.7 1.1 6
Discount Stores 2.8 1.1 13
Food Manufact 2.5 1.1 27
Groceries 2.9 1.0 14
Home Building 3.9 0.8 20
Home Supply 4.0 0.9 2
Hotels 2.4 1.2 10
Online Retail 2.6 1.2 11
Restaurants 3.4 0.9 18
Specialty Retail 3.5 0.9 17
Data as of 06-15-07.

The hotel industry (including  Marriott International (MAR),  Hilton (HLT),  Starwood (HOT),  Orient-Express (OEH), and  Wyndham Worldwide (WYN)) looks expensive. Its strong run over the last 12 months has outstripped the fundamentals of the business, in our opinion. Room rate growth has already started to slow, and occupancies are flat. New supply is starting to come online in several suburban markets and Las Vegas, which will depress results. The timeshare sales business (which is a substantial part of Marriott's, Hilton's, and Wyndham's business) has shown signs of cooling down as well. Orient-Express has been by far the most overvalued due to its luxury exposure and constant buyout rumors, while Wyndham is slightly undervalued.

With a large number of 4- and 5-star stocks, the homebuilding industry looks cheap. We recognize that the industry is in dire straits currently, and we do not believe that the worst has yet been realized. However, our investment philosophy looks past the daily rumor buzz and doomsday scenarios that the market seems to be using to value these stocks. The 5-star price associated with many of our homebuilders is less than the tangible book value of their assets, primarily their land holdings. While the near-term business outlook remains bleak, the discount associated with these stocks makes them worth a look for the long-term value investor.

Another group that looks inexpensive, but perhaps not so volatile, is the home supply industry. Both Home Depot and Lowe's are inexpensive, and both are wide-moat companies.

Consumer Goods/Services Stocks for Your Radar
The following table presents several consumer stocks to consider:

 Stocks to Watch--Consumer Goods and Services
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

Molson Coors  $120 Narrow Average 0.76
P&G  $77 Wide Below Avg 0.79
Lowe's  $39 Wide Below Avg 0.80
eBay  $49 Wide Below Avg 0.65
Lennar  $57 Narrow Average 0.70
Data as of 06-22-07.

 Molson Coors (TAP)
Senior analyst Matt Reilly recently boosted his fair value estimate on Molson Coors after attending the company's analyst conference. The integration of Molson and Coors, which merged in 2005, went very smoothly, and the combined company has over-delivered on the synergies that it promised (which is a rare case among large mergers). Moreover, the European business has stabilized, and Molson's duopoly position in Canada provides the firm with a narrow economic moat. The beer industry tends to hold up well in a consumer spending slowdown, so Molson Coors could also be viewed as a defensive stock.

 Procter & Gamble (PG)
Like Molson Coors, P&G successfully integrated a large acquisition (Gillette), and this gave analyst Lauren DeSanto cause to boost her fair value estimate on the company. Weak third-quarter results weighed on the stock, but she thinks that the company's long-term competitive advantages remain intact, and that this provides a nice entry point for a stock that doesn't get cheap very often. This would be one of our favorite consumer stocks to hold during a consumer downturn, given the everyday nature of its products.

 Lowe's (LOW)
Although Lowe's has some exposure to the housing market, analyst Brady Lemos thinks that the worst is already priced into the stock. The company isn't as exposed to the contracting business as Home Depot, and thus isn't as exposed to new housing starts. It has been gaining share in markets where it competes with Home Depot, and we think that the firm's culture of strong customer service will help it also compete with smaller neighborhood stores.

 eBay (EBAY)
Shares of eBay still look cheap. The company has fallen out of favor, but analyst John Owens thinks that the fundamentals of the business remain strong. In addition to the auctions business (which boasts one of the widest moats of any company we cover), PayPal continues to grow, and Skype has recently turned profitable. EBay has had to fine-tune its auction strategy outside of the U.S., but the recent exit of  Yahoo (YHOO) from the auctions business underscores the enormous lead that eBay has over the competition.

 Lennar (LEN)
For investors with a higher appetite for risk, Lennar is our top pick in the homebuilding industry. Senior analyst Eric Landry believes that Lennar will benefit from its holdings in land-constrained areas once the housing market improves. He also thinks that it has one of the top two or three most liquid balance sheets in the business, and that it has the infrastructure in place to absorb and manage large amounts of land as weaker homebuilders are forced to sell off their own land holdings.

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Joseph Beaulieu does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.