Consumer Defensive: Top-Shelf Picks for a Cautious Spending Environment

• The consumer defensive sector still trades roughly 1% above our fair value estimate, but we see a handful of undervalued industries and companies.
• Consolidation remains a theme in the consumer staples arena, with the Heinz-Kraft merger highlighting the opportunity for rationalizing brands and improving profitability.
• We don't think e-cigarettes present a substantial threat to tobacco companies' economic moats, because it could take 20 years for the product to gain full adoption, in our opinion.

The consumer defensive sector trades at a median price/fair value of 1.01, although it is slightly less overvalued than our overall coverage universe, which trades at a median price/fair value of 1.03. Investment opportunities remain, but many of the stocks we consider the most undervalued are seeing severe foreign currency headwinds from the strong U.S. dollar (including top pick

Overall, we remain cautious on global consumer spending, particularly in emerging and developing markets, and generally recommend focusing on companies in the sector with narrow or wide moats that enjoy strong brand intangible assets or sustainable cost advantages.

The consumer staples industry also continues to consolidate, most recently with the announced tie-up of

Beyond the consumer product manufacturers, we also see opportunity in some defensive retailers. In this space, we believe that a firm with a narrow economic moat should be able to charge material price premiums (it should exhibit pricing power) for comparable products or have the ability to drive more traffic and sell more products than its competitors (customer captivity). The latter case involving higher throughput tends to drive economies of scale based on cost advantage, which we view as more durable for retailers than pricing power alone. We assign wide moats to the small number of firms that have the strongest and potentially mutually reinforcing combinations of brand intangible assets and cost advantages, such as Wal-Mart, which we see as currently undervalued.

Finally, the tobacco industry is another in which we see a proliferation of wide economic moats. However, the emergence of e-cigarettes is one of the most controversial issues in the industry today and the single-most disruptive force since cigarettes were declared to be harmful to public health. Investors are concerned that e-cigs may threaten the competitive advantages and cash flows of the large tobacco manufacturers and accelerate the decline of cigarette volumes. That said, our analysis shows that not only are there significant risks to the current growth trajectory of e-cigs, but that only in the most bullish outcome for e-cig growth will they materially dent the cash flows and valuations of the Big Tobacco firms.

To reach this optimistic scenario, we believe that the products themselves will have to improve to better replicate the smoking ritual and that the regulatory and taxation environment will need to remain favorable, which we think is only likely should scientific evidence prove that e-cigs offer a reduced risk method of consuming nicotine. As such, we are reiterating our wide economic moat ratings for global tobacco players

Nestle

NSRGY

Although Nestle operates as the 800-pound gorilla in the consumer products landscape, it isn't immune to significant competition from both global peers and local players in emerging markets, which has pressured the firm's top line lately. However, in our view, the breadth of Nestle's product portfolio--which spans the coffee, bottled water, ice cream, confectionery, and pet-care aisles--and its low-cost global sales and distribution network (the basis for our wide moat) combined with continued brand investments should ensure that its competitive edge doesn't waver. The shares look undervalued at current levels, and for investors wishing to gain broad exposure to the consumer staples industry, Nestle may be an appropriate holding.

Procter & Gamble

PG

We contend that Procter & Gamble represents an attractive investment opportunity in the consumer products space. Like others in the industry, P&G has been challenged over the past several years by intense competitive pressures and muted consumer spending. However, we further surmise that lackluster innovation and an attempt to overextend its geographic reach has had a more pronounced negative impact on P&G's financial performance and subsequently its share price. Despite this, recent investments behind new products, a more disciplined expansion plan, and efforts to rightsize the brand mix while improving the efficiency of operations appear to be gaining traction. As such, we contend that P&G is poised to post accelerating top-line growth as well as improving profitability metrics over the next several years.

Philip Morris International

PM

Philip Morris International is our pick of the tobacco category both on business quality and valuation. We like the firm’s portfolio positioning, as it is in the premium segment where brand loyalty is strongest, and it possesses a first-mover advantage in next generation heat-not-burn e-cigarettes. The stock has struggled over the last 12 months due to accelerated currency headwinds and some new challenges in Asia. However, with the bar set quite low for 2015, we think PM is poised for a better year, and we expect to see an improvement in growth in Indonesia, where price gaps to competitors have narrowed. Standardized packaging remains the greatest risk to PM, in our opinion, but generally, we regard the fundamentals of the global tobacco industry as being quite sound.

More Quarter-End Insights

• Stock Market Outlook: Pick Your Spots Carefully
• Economic Outlook: Stuck in Neutral as We Cling to Cash
• Credit Markets: Investment Grade Struggles, While High Yield Outperforms
• Basic Materials: China Slowdown Weighs on Commodities (With One Exception)
• Consumer Cyclical: Assessing Disruptions in Restaurant, Retail, and Travel
• Energy: No Rapid Rebound for Oil Prices
• Financial Services: A Favorable Outlook for Insurance
• Health Care: A Few Stocks Still Offer Upside
• Industrials: Stronger U.S. Dollar, Weaker Energy Activity Weigh
• Real Estate: Rising Interest Rates Wreak Havoc on REITs
• Tech & Telecom: M&A Heats Up, and the Cloud Changes the Landscape
• Utilities: Starting to Look Attractive After a Woeful 2015 Start