UBS Group (UBS, Financial) recently announced its plans to tilt its portfolio toward beverages, believing the category could outperform the consumer staples sector and the broader market. UBS followed a style-based investment approach in 2022, leading it to a high conviction on risk-off stocks such as consumer staples. However, the firm now believes the market could pivot due to possible stagflation.
I believe the bank's bullish call on beverages makes theoretical sense; here's why.
Why beverages could outperform
UBS' emphasis on beverages isn't a nit-picky argument, nor is it product-focused. In fact, the bank's discovery is based on factor investing. Factor investing summarizes stock returns through regression analysis, identifying which stocks outperform others during various macroeconomic climates.
The firm's emphasis on "pricing power and high quality" suggests it believes quality stocks could outperform during challenging economic circumstances. "Quality stocks" is a market segment that refers to equities with robust balance sheets and unparalleled market shares, thus providing them with the attributes to sustain profits while smaller companies suffer from cyclicality.
Furthermore, UBS secures its high quality argument by adding low volatility into the mix. Consumer staples are generally considered low volatility bets due to their countercyclical nature. Thus, by combining quality and low volatility in its screening process, UBS discovered the beverage space as a potential breadwinner during today's trying economic circumstances.
In light of UBS' strong bullish case for beverage stocks, let's take a look at two leaders in the industry.
Constellation Brands
Constellation Brands' (STZ, Financial) horizontally-integrated business model has allowed it to garner a substantial market share across the alcoholic beverages spectrum. According to CSI Market, the company hosts 6.33% of the cross-segment market share, explaining why it has a 52.31% gross profit margin. Constellation Brands' economies of scale allow it to exercise pricing power over its consumers and bargaining power over its suppliers. Therefore, the company exhibits a non-cyclical earnings pattern.
Constellation Brands recently released its second-quarter results, revealing a revenue beat of $147.01 million at a 12% year-over-year growth rate. More importantly, the alcoholic beverage giant managed its income statement effectively with 10% in year-over-year operating income growth and an earnings per share beat of 29 cents.
Much of Constellation Brands' current success stems from beer sales, with Modelo experiencing hypergrowth. Additionally, Corona is resuming a constant growth trajectory at 6% year-over-year.
Despite its robust organic growth, Constellation Brands recently suffered a $1.1 billion impairment loss on Canopy Growth as the holding's market value collapsed. Constellation Brands still owns approximately 35% of Canopy Growth, meaning it possesses the asset as an investment in associates, which adds volatility to Constellation Brands' income statement. Despite the investment's excess risk, the integration of Canopy might provide Constellation Brands with valuable synergies.
Constellation Brands looks like a highly lucrative investment in my view becasue GuruFocus' free cash flow-based discounted cash flow calculator suggests the stock is undervalued. For this calculation, I predicted a 10-year growth rate of 16.4% and a discount rate of 10%, which resulted in a 6.09% margin of safety. The stock also has a dividend yield of 1.36%, which adds to its total return prospects.
Coca-Cola
Coca-Cola (KO, Financial) is at the apex of the non-alcoholic beverage space. The company is a powerhouse with high customer loyalty, "best-in-class" products and iconic branding, setting it apart from its peers. It's easy to see why Coca-Cola is one of Warren Buffet's long-term top holdings.
Coca-Cola's core product sales remain robust. However, the company recognizes that consumer trends might change. Thus, it recently invested in acquiring brands such as Costa, Innocent, Ades and BodyArmor. More crucially, the company holds a global footprint with significant exposure outside the U.S., allowing it to hedge geographic consumer trends.
Furthermore, investment bank Evercore believes Coca-Cola's next move might be into the alcohol space. According to one of the bank's analysts, Robert Ottenstein, Coca-Cola's top line could grow by 4% to 6% if it entered the alcoholic beverages industry. Whether Coca-Cola would be open to a pivot is debatable; however, the company's recent acquisitions suggest a strong possibility.
Although Coca-Cola trades at 27.87 times its earnings, the stock's intrinsic worth is still high in my view. Coca-Cola's return on equity of 42.84% is better than 96.30% of its sector peers. Moreover, the company's return on invested capital (ROIC) figure eclipses its weighted average cost of capital (WACC), suggesting that shareholders' risk-return demands are being met.
Lastly, Coca-Cola's dividend yield of 2.76% is considered lucrative and stable, thus providing investors with sound total return prospects.
Potential risks
Despite all the positives related to beverages and the stocks mentioned above, risks remain amid uncertain investor sentiment. For example, a recent survey by Goldman Sachs (GS, Financial) found that most fund managers are invested in cyclical stocks instead of consumer staples.
Furthermore, both Constellation Brands and Coca-Cola are trading at elevated price multiples. Thus, an extended bear market could result in a sell-off of both stocks.
Concluding thoughts
UBS has decided to emphasize beverage stocks as their high quality and low volatility features provide substantial risk-off benefits. The global economy has yet to stabilize, which could see beverages outperform the broader market. Based on key metrics, I believe the likes of Constellation Brands and Coca-Cola provide favorable risk-adjusted return options.
