Our Outlook for Consumer Stocks

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The consumer goods and services sectors have been a roller-coaster ride over the past quarter, and we don't expect the ride to end soon. Even as inflationary trends appeared to be softening, extreme turmoil in the financial services industry (including the failures of  Fannie Mae  (FNM),  Freddie Mac  (FRE),  American International Group (AIG), and Lehman Brothers) once again cast a pall over most of the U.S. stock market. 

Even if we set aside the crisis that is roiling Wall Street, Main Street still has its own set of problems. Consumers are facing many head winds: declining home prices, tightening credit standards, fuel and food inflation, minimal wage growth, and higher (yet still moderate on a historical basis) unemployment rates. Consumer products companies are hoping they can continue to raise prices to cover escalating input costs without incurring a consumer backlash. Retailers are preparing for a very disappointing holiday season.

Looking across the consumer landscape, we see many undervalued stocks with the potential for substantial appreciation. However, given that nobody can be certain how deep the banking crisis will go, or how much it will infect the overall economy, we think that many of our most-undervalued companies could carry substantial near-term risks if the banking crisis continues to accelerate. Some of them have highly leveraged balance sheets; others have a lot of exposure to the housing market; and some are merely undifferentiated competitors in crowded markets. However, there are a few examples of high-quality firms with strong balance sheets that have dipped into bargain territory. These include  PetSmart  and  Best Buy (BBY).

Valuations by Industry
There are a few pockets of value in the consumer products and services sector, some riskier than others. Some of the alcoholic beverages companies look good to us right about now, for several reasons. Consolidation and higher commodity costs have pressured smaller players (such as craft brewers) in both procurement and distribution. This has been exacerbated by a weak macroeconomic environment, which has led to trading down. Longer term, however, we think the direction of consumer trends will remain unchanged--consumers will still demand affordable luxury. Because of this trend and the benefits of consolidation, we remain positive on  MolsonCoors (TAP),  Diageo (DEO),  Brown-Forman (BF.B), and  Constellation Brands (STZ).

The home supply companies are trading at a deep discount to what we think they are worth, primarily due to fears that the housing  market will remain stagnant. We think Home Depot and Lowe's are compelling values for patient investors because each should emerge from the current housing crisis as stronger retailers. The home improvement industry is still highly fragmented and smaller, less capitalized rivals are at a competitive disadvantage during economic downturns. Consolidation should accelerate and Home Depot and Lowe's should gain market share. The housing market isn't showing any signs of a turnaround, and we think the current share prices already reflect that, and then some. Our valuation is based on the assumption that the housing market remains weak through 2009 and then begins to rebound in 2010.

The restaurant industry looks inexpensive as well. In our view, casual and fine dining restaurant companies will continue to struggle for the remainder of this year and for next year, due to the very challenging consumer environment. This will result in weak same-store sales and deteriorating profit margins for these companies. We also do not anticipate a strong recovery, so the profitability of these companies in future years will likely remain well below historic levels. That being said, the market's view appears much more dire and altogether ignores growth prospects for high-quality restaurant companies (such as  Darden (DRI) and  Cheesecake Factory (CAKE)), which should not only be able to survive this downturn, but emerge in a stronger position. We also believe the market is too pessimistic on  Starbucks (SBUX) and  Chipotle (CMG).

Consumer Goods/Services Stocks for Your Radar
In accordance with the themes described above, we are featuring two alcoholic beverage stocks, a home supply firm, and a casual dining company.

Stocks to Watch--Consumer
Company	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
Darden		$52	Narrow	High	0.58
Diageo		$112	Wide	Low	0.65
Lowe's		$39	Wide	Low	0.62
MolsonCoors		$70	Narrow	Medium	0.68
Data as of 09-22-08.

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