The consumer staples sector has been one of the best-performing sectors during the prior 10-year period, which encompasses a year or so before the great recession and then the ensuing period up until now. Indeed, as measured by the SPDR Consumer Staples ETF (XLP, Financial) the sector has almost doubled the return of the Standard & Poor's 500.
Even after this stellar performance the sector remains popular. Yields on the 10-year Treasury bond are around 1.5%, and the combination of a (perceived) safe business and solid dividends is generally the agreed upon reason that consumer staples have performed well. The consensus seems to be that investors are viewing them as a stable, income-generating partial substitute for bonds.
Add in the facts that this has been one of the most hated bull markets in history and investors and the media are constantly searching for the next crash, and we can see why consumer staples have remained popular.
The chart below shows the characteristics of the consumer staples sector. I’ve highlighted in red two important things, the price-earnings (P/E) ratio of 24.6 and the earnings growth rate of 3%.
With the consumer staples sector we have a situation where a slow-growing sector is trading at a premium valuation. It’s worth noting that the P/E ratio for the sector is roughly in line with the market. However, the P/E for the entire market is a bit distorted by the collapse in income (and accounting write-downs of assets) of the energy and materials sector. When we look at forward P/Es which will lap some of the large write-downs in the energy sector, the stock market is trading at around 17 times forward earnings while the consumer staples sector is trading at around 20.5 times forward earnings.
The biggest problem I see for the consumer staples sector is one of low growth and high valuations. I looked at XLP's top five largest holdings –Â Procter & Gamble (PG, Financial), Coca-Cola (KO, Financial), Philip Morris International (PM, Financial), Pepsico (PEP, Financial) and Altria (MO, Financial). For Procter & Gamble I excluded fiscal year 2015 from any calculations due to the sale of its Coty division for $12.5 billion.
We can see that over the past five years average revenue growth has been negative and average operating income growth has also been negative. Yet consumer staples stocks are reaching all-time highs.
High valuations and low growth is not a recipe for success. The consumer staples sector is not going to suffer an epic collapse like the technology bubble or the subprime housing bubble. The most likely scenario is that at some point, once the sector loses its popularity, it will begin to suffer multiple compression, and we will see the returns for the sector go nowhere over almost a decade as it “works off” its high valuation. So what should investors do?
What to do
Here are a few things investors can do to address the high valuation in the sector.
1. The most important thing to remember is that stocks are not bonds. Bonds are bonds. If you are using consumer staples stock as some sort of bond substitute in your portfolio, stop. Immediately.
2. Don’t panic. Don’t wake up on Monday and sell every single consumer staples stock you own. Earnings are projected to rise for the sector, and the dollar has fallen by 2% to 4% this year which will help earnings for many of the U.S.-based multinational consumer stocks.
Additionally, interest rates are unlikely to skyrocket any time soon. We are perhaps looking at one interest rate increase this year so the narrative of staples stocks as bond replacements is unlikely to unravel immediately.
You’ll see in the disclosure below which consumer staples stocks we own. Over the past few years we’ve been selectively reducing our exposure to the sector as some of our other holdings have risen in value. For instance we’ve previously sold Kimberly-Clark (KMB, Financial) and Unilever (UL, Financial) and as you’ll read in the disclosure we are also planning on selling our holdings in Anheuser-Busch InBev (BUD, Financial). As valuations in the sector get stretched consider selling or at least trimming positions.
3. Because the sector as a whole is overvalued doesn’t mean that individual stocks can’t be fairly valued or even undervalued. Look at the chart about the top five above. Altria has posted steady revenue and earnings growth. In an environment characterized by extreme uncertainty steady growth should be rewarded with above-market multiples. While Philip Morris hasn’t seen growth it is poised to benefit from better foreign exchange rates over the coming years (the stock saw earnings hit hard by the decline in the values of the currencies of some of its major markets). So even though the sector as a whole is overvalued it doesn’t mean that there can’t be some consumer staple stocks worth holding.
4. Value stocks using absolute rather than relative metrics. One of the things we like to do is value all of our holdings using a DCF model that uses a 9% to 11% discount rate. Over the long term the annual returns of the stock market have been somewhere around 10%. Traditional financial theory says you need to incorporate all sorts of variables such as interest rates, equity risk premiums, cost of capital and more into calculating the appropriate discount rate. However, this runs the risk of drawing you into traps by valuing companies using relative metrics like prevailing interest rates or stock market volatility (beta).
We prefer to just use a static rate for our valuations. We want to earn at least the average market return so plugging that in our model lets us see what kind of cash flow growth a company needs to generate in order to justify its current stock price. Using a static discount rate prevents you from falling into the trap of playing around with betas and interest rates and the like in order to justify a valuation.
Disclosure: We own PM, MO, RAI, IMBBY, BTI, NSRGY, and BUD. We are planning to sell BUD in the near future, but this may change.
Start a free seven-day trial of Premium Membership to GuruFocus.
