Consumer Defensives: Firms Must Adapt to Win at the Shelf Amid Intense Macro Uncertainty

The Morningstar US Consumer Defensive Index materially lagged the broader market’s gain during the second quarter. As a result, the median consumer defensive stock now trades at a 14% discount to our intrinsic value (versus just 1% three months ago), rendering over half of our coverage in 4- or 5-star territory (compared with about a third prior).

We see opportunities in consumer packaged goods and alcoholic beverages, which sit 25%-30% below our fair value estimates. While we surmise concerns about tepid consumer spending, elevated inflation, and an uncertain geopolitical backdrop are tangible, we think competitively advantaged operators that prioritize investments in innovative products will ultimately withstand these headwinds.

In periods of pronounced uncertainty and economic malaise, consumers tend to add more private-label products to their baskets. However, since the onset of the pandemic, private-label share across a host of CPG categories has generally remained stable (though at vastly different levels). Lower-priced products maintain the highest share in more commoditized categories, like edible oils (42% on average) and dairy (31%), and in categories where differentiation tends to be lacking, such as tissue and hygiene (31%). Conversely, aisles like confectionery and home insecticides have negligible private-label penetration (low single digits), which we attribute to the importance of taste, and safety and efficacy, respectively. To counter the encroachment of value fare, we expect competitively advantaged operators to funnel resources toward consumer-valued innovation to win at the shelf, defend market share positions, and ultimately drive traffic to physical retail outlets and online platforms.

Despite macroeconomic and geopolitical angst, consumers have continued to embrace e-commerce for CPG products. Before the covid-19 pandemic, quality concerns and product size inhibited online purchases. However, predictable purchase patterns and convenience from not having to transport bulky items have driven penetration to over 30% for household and personal care products. To benefit from rising e-commerce adoption, firms must innovate products to maintain consumer appeal while ensuring consistent availability across channels.

Top Consumer Defensive Sector Picks

Campbell’s CPB

• Fair Value Estimate: $56.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

Trading around a 60% discount to our $56 fair value estimate and offering a 7.4% dividend yield, wide-moat Campbell’s offers an attractive investment opportunity. In our view, the market is pricing in elevated cost inflation and lagging profitability as structural. However, we expect inflationary headwinds to moderate and the firm to unlock efficiencies through distribution and manufacturing optimization, supporting improved profitability. As such, we forecast operating margins to reach approximately 18% over the next decade, slightly ahead of the 17% average operating margin between 2013 and 2022.

Kraft Heinz KHC

• Fair Value Estimate: $42.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: Medium

Narrow-moat Kraft Heinz trades close to a 50% discount to our intrinsic value. We view the $600 million earmarked for research, development, and marketing investments as a prudent means to juice volumes even against a tepid consumer spending backdrop. This course should support greater product relevance among cash-constrained consumers following a period of inflation-driven price increases. We surmise the firm’s strategic playbook, centered on increasing brand spending and enhancing its competitive standing, should enable 2% average annual sales growth over our long-term forecast.

Clorox CLX

• Fair Value Estimate: $163.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

Wide-moat Clorox trades at bargain prices, with shares sitting at about a 40% discount to our $163 fair value estimate while offering a 5.1% dividend yield. The firm has faced multiple headwinds, including a pullback in demand after the pandemic surge, a rout in profitability amid rising inflation, and a cybersecurity attack. But through it all, Clorox has continued to invest in consumer-oriented innovation, advertising, and its capabilities, which we think supports its stalwart competitive edge. This underpins our forecast for 3%-4% top-line growth and high-teens operating margins over the long term.