It May Be Time To Switch From Discretionary To Staples

November 8, 2016

It May Be Time To Switch From Discretionary To Staples

  • Consumer staples and discretionary stocks have similar valuations, but rising consumer debt suggests rebalancing towards staples is less risky.
  • Staples have better earnings to revenue growth which indicates higher competitiveness and M&A activity in the discretionary sector.
  • In the case of an economic pullback, discretionary stocks would be hit harder as M&A activity will prove too expensive at valuations above 24.

Introduction

With most of the earnings in and the S&P 500 down in the last two weeks, it’s good to take a look at the consumer goods sector to find potential defensive investments. The iShares Consumer Goods ETF (NYSEARCA: IYK) has enjoyed a wonderful run in the past 7 years.

figure-1-iyk-etf
Figure 1: iShares Consumer Goods ETF over the last 10 years. Source: iShares.

However, the sector has shown some concerning weakness in the last 6 months and it is now time to look at fundamentals, competitiveness and sector economics to see if it’s time to lock in the gains as the negative trend could continue.

figure-2-iyk-6-months
Figure 2: iShares Consumer Goods ETF in the last 6 months. Source: iShares.

After such a run over the last 10 years, it’s also time to differentiate between consumer staples and discretionary goods as an eventual recession would severely hit consumer discretionary. The consumer goods sector is is made up of the biggest companies in the consumer discretionary and consumer staples sectors. Essential products like food, beverages, tobacco and household items fall under consumer staples while consumer discretionary contains not essentials like automobiles, high-end clothing, restaurants, hotels, and luxury goods.

Fundamentals & Economics

A quick look at PE ratios tells us immediately that most companies in the sector are similarly priced with PE ratios close to the S&P 500 average of 23.99. Some companies, like Newell Brands (NYSE: NWL), have higher PE ratios but by normalizing earnings and excluding one-off events, those PE ratios fall into the 20 to 30 range.

TickerCompanyPE RatioDividendSector
PGProcter & Gamble23.673.15%Consumer Staples
KOCoca-Cola25.273.36%Consumer Staples
PEPPepsico Inc.23.23.01%Consumer Staples
PMPhilip Morris International Inc.22.844.36%Consumer Staples
MOAltria Group Inc.24.23.79%Consumer Staples
MDLZMondelez International Inc. Class A84.531.78%Consumer Staples
NKENike Inc. Class B22.51.28%Consumer Discretionary
CLColgate-Palmolive45.472.24%Consumer Staples
KHCKraft Heinz36.862.86%Consumer Staples
RAIReynolds American Inc14.181.84%Consumer Staples
FFord Motor5.665.29%Consumer Discretionary
GMGeneral Motors8.734.88%Consumer Discretionary
KMBKimberly Clark Corp20.463.28%Consumer Staples
GISGeneral Mills Inc.22.053.17%Consumer Staples
ATVIActivision Blizzard Inc.41.70.62%Information Technology
STZConstellation Brands Inc. Class A29.031%Consumer Staples
ADMArcher Daniels Midland17.72.56%Consumer Staples
EAElectronic Arts Inc.20.460.00%Information Technology
NWLNewell Brands Inc.91.31.60%Consumer Discretionary
Table 1: Top 20 consumer goods sector holdings. Source: Morningstar.

Of the top 20 holdings of the consumer goods sector, only two companies have relatively low PE ratios of 5.66 and 8.73, the Ford Motor Company (NYSE: F) and General Motors (NYSE: GM), respectively. Both companies have sold a record number of cars in the last few years and it seems that the market finds this growth unsustainable which helps explain the low PE ratios.

Automotive sales slow down when the economy enters into the deleveraging part of the business cycle. In October 2016, U.S. passenger car sales fell 14.8% compared to October 2015 while light trucks sales increased 0.8% for a total light vehicle sales decline of 5.8% in October. Car sales year-to-data are still holding and are just 0.2% lower than they were in 2015. Truck orders fell 50% in October as the expected freight load growth didn’t materialize and there exists an oversupply of trucking. This isn’t good news for automotive manufacturers who will get hit first, but it’s also bad news for the general consumer goods sector as less trucking means less demand.

For Q3 2015, the latest GDP data showed spending on durable goods increased 9.5% while spending on nondurables decreased by 1.4%. From the reported earnings, consumer discretionary revenue grew by 8% while consumer staples revenue grew by only 2%.

figure-3-revenue-q3
Figure 3: S&P 500 Q3 2016 revenue growth per sector. Source: FACTSET.

However, earnings growth was almost the same with 5.9% for consumer discretionary and 5.1% for consumer staples.

figure-4-earnings-growth
Figure 4: S&P 500 Q3 2016 earnings growth per sector. Source: FACTSET.

The difference between revenue and earnings growth suggests consumer discretionary stocks operate in a more competitive environment while staples have more opportunity to grow earnings despite slower revenue growth.

In order to see which will fare better, staples or discretionary, it is necessary to look at the credit cycle and economic growth. Consumer credit has been consistently growing with some slowdowns during recessions while consumer debt service payments as a percentage of disposable personal income shows clear cyclical patterns.

figure-5-consumer-credit
Figure 5: Total consumer credit outstanding (blue, left) and consumer debt service payments as percentage of disposable personal income (red, right). Source: FRED.

Even if income is rising, consumer credit is rising faster. The level of consumer debt service payments as percentage of income is getting close to the level reached in 2007.

Conclusion

As debt service payments increase in relation to income, it becomes riskier to hold consumer discretionary stocks in relation to consumer staples. Not only that, but the increased competitiveness in the consumer discretionary sector indicates higher revenue growth as a result of acquisitions that rarely increase shareholder value when done 7 years into a positive economic cycle. At average valuations of above 24, it is very easy to overpay for something.

Given that discretionary and staples stocks have similar valuations, it might be a good idea to rebalance your portfolio to be overweight staples as debt service payments as a percentage of income grows.

Consumer discretionary would be severely hit by an economic pullback. We already see this happening in the automotive sector where companies have ridiculous valuations in expectation of future lower sales.

By selling the discretionary, you renounce the future potential growth but also avoid the risk of severe recession or slowdown damage. On the other hand, in the case of a recession, the total consumer sector would be hit as PE ratios above 20 offer you a meagre 4% to 5% earnings yield. While, in the case of a market panic or a much stronger dollar, the whole sector could see a 50% decline as required earnings yields increase to 8% or 10%.

Perhaps it is better to avoid the sector altogether. There are better risk reward options out there, follow along with Investiv Daily for more insight and better risk reward stock picks.

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