Defenseless Defensives: Look Beyond Consumer Staples for Stability
Portfolio Managers Brian Demain and Cody Wheaton discuss why the consumer staples sector has lost many of the defensive characteristics it once possessed.
- Traditionally, when concerns about the economy surface, investors’ knee-jerk reaction has been to pile into consumer staples stocks. This reaction could be misguided.
- A changing marketing and distribution landscape has eroded the competitive advantages that consumer staples companies once enjoyed. But valuations in the sector remain high.
- We believe other pockets of the market including information services businesses and medical device companies will provide more durable earnings growth.
With market volatility returning, many investors are evaluating how defensive their portfolios may be. We offer a word of caution: Yesterday’s “defensive” stocks don’t possess the same resilient characteristics they did in previous downturns.
Traditionally, when concerns about the economy surface, investors’ knee-jerk reaction has been to pile into consumer staples stocks. The revenues tied to selling these basic goods and services is thought to be a source of stability when consumers and businesses cut spending elsewhere. We saw this investment trend play out again in the fourth quarter, with consumer staples stocks broadly outperforming the rest of the market.
The notion that these stocks still provide safety may, however, be misguided. A changing marketing and distribution landscape has eroded the competitive advantages that underpinned the stable earnings growth of many consumer staples companies … and relatively demanding multiples for consumer staples stocks leave little valuation support.
The Death of a Distribution Advantage
When evaluating stocks, three of the most important criteria to consider include the strength of a company’s competitive advantages, confidence in its management team and the stock’s valuation. Most consumer staples stocks fail on all three factors.
The first is perhaps most important. For decades, the main competitive advantage that consumer staples companies enjoyed was a strong brand name. A strong brand commanded the best shelf space at the few big box retailers where most consumers shopped. Better brand recognition prompted greater sales, which allowed established staples companies to spend more advertising dollars in the few advertising channels that existed (television, radio, print media) to further reinforce already strong brand recognition.
That self-reinforcing competitive advantage has broken down. E-commerce gives shoppers more avenues to discover new, upstart brands. And digital media allows these competitors ways to more effectively reach a target audience. Both changes chip away at the incumbent company’s customer base. Changing consumer preferences toward more authentic, local, organic or natural products create further headwinds for many staples companies, and allow niche entrants into the market.
Consider how the present landscape threatens these old-line companies: Today, a new business can advertise to a select, targeted audience on Facebook, set up an online store with Shopify in minutes, and quickly grow through word of mouth.
Despite their eroding competitive advantages, many consumer staples stocks trade at a high-teens to low 20s price/earnings multiple. In our view, that’s a high multiple for those companies with low-single-digit sales growth or no growth at all.
The final factor – strength of management teams – is harder to quantify. While we do find solid leadership at some consumer staples companies, we generally find few strong management teams within the sector that seem forward-thinking enough to lead their respective companies through a period of great change in consumer shopping habits and preferences. Much of the industry is focused on cost cutting or gaining scale through fully-priced, merger and acquisition transactions, but neither strategy creates an obvious path to sustainable growth.
The New Defensives
We see both better stability – and better growth – in other pockets outside the consumer staples sector. For example, we see durable, long-term growth potential for many financial technology and “information services” companies. These companies provide data, analytics or business process software that is absolutely vital to the businesses that depend on it. The mission-critical nature of these data and services give these companies a high degree of pricing power and, in our view, make their revenue streams less cyclical.
Another area where we see opportunity is in medical device companies. A convergence of factors including innovation, a rising global middle class that demands better health care and a rising older population in need of it all underpin strong demand in the coming decades. And similar to information services companies, the critical nature of medical devices to someone’s survival removes cyclicality from their revenue streams. A surgery to install a new heart valve, for example, can’t wait until the economy improves.
Both the information services and medical device stocks generally trade at a slight premium to consumer staples companies, but in our view they have similar defensive characteristics, stronger competitive advantages and ultimately, better growth prospects. If volatility persists, we believe investors may be in a better position holding these companies than consumer staples stocks.
Investments in a single sector will be more susceptible to factors affecting that sector and may be more volatile than less concentrated investments or the market as a whole.