Shop for Moats in Consumer Defensive Stocks

• The consumer defensive sector still trades at a premium to our fair value estimate, on average, but valuation opportunities exist given an abundance of companies with economic moats.
• Severe price competition is still the norm for U.K. grocers, but market leader Tesco is aiming to buck the trend, which could help its long-term story.
• With more-limited organic growth opportunities at present, acquisition spending and potential break-ups continue to fill the headlines in consumer staples.

We continue to believe that the consumer defensive sector is overvalued, with a median price/fair value estimate ratio of 1.04. Although we've seen some share price volatility among consumer defensive names the past few months due to questions about the timing of quantitative easing changes in the U.S. (with many fixed-income investors using consumer staples dividends to augment total returns in a low-rate environment), valuations from this category have been relatively stable. Still, with roughly two thirds of the category enjoying a narrow or wide economic moat, we continue to find pockets of valuation opportunity when short-term concerns outweigh our forecasted long-term growth trajectories.

Pricing is typically a key long-run strategy for many firms in this sector given this proliferation of competitive advantages, but we've seen volume weakness offset pricing gains in recent quarters owing to uncertainty surrounding the global economy. In some cases, we've also seen pricing suffer, perhaps most notably in the U.K. grocery space. Continuing the theme seen in the last quarter, we expect intense industry competition and price deflation to harm near-term results, but we're encouraged by industry leader  Tesco (TSCO), which recently decided to reduce promotional activity substantially. Despite the near-term challenges, we think more focused price investments on core items will help Tesco keep its most loyal customers coming back over the long term. While nonexistent switching costs constrain our moat rating for the firm, we nonetheless identify the company as one of our top picks in the sector given a decent discount to our fair value estimate.

Given the limited current growth environment, we've also seen renewed interest in M&A activity. Following  Hillshire Brands' own plans to acquire Pinnacle Foods (originally announced in May), both  Tyson Foods (TSN) and Pilgrim's Pride (PPC) launched bids for Hillshire, with Tyson eventually triumphing at a $63 per share offer. We view this acquisition as rich, given our prior $32 per share fair value estimate for Hillshire, though expected synergies somewhat ease our qualms. With our growth expectations remaining relatively muted for the overall sector, and cheap credit seemingly available for many potential acquirers, we wouldn't be surprised to see additional purchases announced over the course of the year.

Similarly, several consumer staples companies have faced pressure to split apart, in an effort to drive better focus, share gains, and ultimately earnings growth. While continued price appreciation among these companies' shares prevents a great deal of value from being unlocked, in our opinion, we think that  Unilever in particular could enjoy upside by breaking apart its food/beverage and home health/personal care businesses. That said, we believe that of the four firms often cited as breakup candidates (which also include  Nestle (NSRGY),  Procter & Gamble (PG), and  PepsiCo (PEP)), P&G enjoys the greatest current discount to our fair value estimate.

Top Consumer Defensive Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Tesco		GBX 380.00	None	Medium	GBX 266.00
Procter & Gamble		$89.00	Wide	Low	$71.20
Sysco		$43.00	Wide	Medium	$30.10
Data as of 6-23-2014

 Tesco (TSCO)
Tesco is a retail company that sells groceries, clothing, and general merchandise. Through its subsidiaries, the company also offers services such as telecom, digital entertainment, and banking. The relationship between food prices and consumer incomes is returning to a more normalized level (food inflation has outpaced wage growth over the past several years), and hard discounters Aldi and Lidl have capitalized on the opportunity to capture share of cost-conscious consumers' spending. However, we still think Tesco will remain a dominant player in the U.K. market, and for those looking for exposure to the U.K. grocery space, we think Tesco's valuation remains the most attractive.

 Procter & Gamble (PG)
Procter & Gamble provides branded consumer packaged goods. It markets its products in about 180 countries through mass merchandisers, grocery stores, membership club stores, drugstores, and department stores, among others. The consumer product industry remains highly competitive, but we're encouraged by P&G's repeated references to its successful new products in its most recent quarter, particularly since we've been concerned that product innovation had languished at the leading household and personal-care giant over the past several years. We still regard Proctor & Gamble as a wide-moat giant that enjoys the benefits of scale and unprecedented brand reach.

 Sysco (SYY)
Sysco, through its subsidiaries and divisions, is a distributor of food and related products to the food-service, or "food away from home," industry. The firm's vast distribution platform allows the company to be the low-cost leader in a capital-intensive industry, but intense competitive pressure and sluggish restaurant traffic continue to take a toll. Market concerns over these near-term negative trends, and uncertainty surrounding regulatory approval of the firm's acquisition of U.S. Foods, offer a compelling discount to our fair value estimate, in our opinion.

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