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Morningstar
Quarter-End Insights

Consumer Cyclical Picks for a Slower-Growth World

Amid global uncertainty, consumer cyclical companies with moats will fare the best, in our opinion.

RJ Hottovy
  • Despite some global economic uncertainty, consumer cyclical companies with economic moats thanks to brand, technology, or product differentiation are likely to outperform their less competitive peers.
  • The consumer cyclical sector looks fairly valued on the whole, but several sectors and individual companies offer compelling opportunities.     
  • U.S. retail spending continued to tick up at a low-single-digit pace through the second quarter, and European demand appears to be enjoying stable and increasing trends.
  • Consumers' tastes are becoming increasingly discerning, benefiting companies with differentiated products and economic moats, making it more difficult for outperformance of no-moat companies.
  • After a weather-plagued first quarter and subsequent recovery of demand, inventory should be in decent shape for apparel and home improvement retailers.

 

The consumer cyclical sector currently looks fairly valued, in our opinion, trading at a median price/fair value estimate of about 1.01. That said, we think several industries offer relative attractiveness, including resorts and casinos (with a ratio of 0.80), recreational vehicles (0.93), and leisure (0.94). Moreover, several companies outside these areas (as highlighted later in this article) look especially attractive given recent concerns that we don't believe will negatively affect the firms' long-run investment theses. In all, although the broader consumer cyclical end markets have showed improving trends in recent months, we'd still generally point investors toward companies with economic moats, as the larger retail spending environment remains uncertain around the world.

Domestic retail sales continue to rise at a modest clip, and we believe the persistence of rising equity prices and home prices has allowed a positive wealth effect to prevail, increasing consumers' willingness to spend. With quantitative easing winding down domestically and former high-growth countries (Brazil, China) moderating to more rational long-term growth levels internationally, we could see some headwinds for both equity markets and global consumer spending ahead. 

To this point, we view consumer tastes as becoming increasingly discerning, and think those companies offering differentiated products, better technical aspects, or garnering brand cachet will continue to outperform substitutes with lower quality or name recognition. This is a cross-industry phenomenon, affecting businesses from power sports to fast-casual dining.  

The silver lining here is that in response to evolving consumer preferences and spending, many companies have rightsized both their footprint and inventory levels in recent periods, positioning those with economic moats to perform well relative to their less competitive peers over the remainder of the year, which could lead to excess economic returns.

Top Consumer Cyclical Sector Picks
Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Kingfisher PLC $14.00
 		Narrow Medium $9.80
Swatch CHF 640 Wide High CHF 384
Coach $50.00 Narrow High $30
Data as of 09-12-2014

 Kingfisher PLC (KGFHY)
Kingfisher is Europe's largest home improvement retail group, with 1,134 stores in nine countries in Europe and Asia. Performance of the French business has depressed overall performance, but recent comments by President Francois Hollande indicating that it will take measures to kick-start the construction industry should provide some support to Kingfisher's Brico Depot business. We think a return to positive housing-price growth in France would be the true catalyst for the stock, which we view as undervalued at current levels.

 Swatch Group (()UHR)
Swatch Group is one of the largest manufacturers and distributors of timepieces. With 20 different brands, Swatch is as much about fashion and design as it is about accuracy and dependability. Despite current exchange rate headwinds, production issues after the December 2013 fire at its ETA factory, and fears over China demand and coming smartwatches, we continue to believe shares are undervalued. We believe that Swatch still has long-run margin improvement opportunities, and that Swiss mechanical watches will further capture consumers' imagination in an increasingly digital world.

 Coach (COH)
Coach is a manufacturer, distributor, and retailer of handbags and accessories, offering the quality of higher-luxury brands at more attractive price points. We view shares as undervalued, but recognize that patience is needed as new strategies are implemented. For now, solid growth internationally--including double-digit comparable-store sales in China, expansion in new markets, and traction in Europe--should continue to partially offset North American comparable-store sales declines and store closings. We believe a return to higher-priced leather goods offerings and increased full-price selling should solidify the brand in the long run.

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