INSIGHTS

Consumer staples have a place in any diversified investment portfolio. They provide the essential items you often find in a household – from toothpaste and toilet paper to petfood and pasta. They’re defensive, strong cash generators and have impressive dividend growth history – all signs of a quality company.

Why we like consumer staples

As long-term investors, we believe the core of an investment portfolio should be made up of high quality, defensive stocks. A quality stock tends to be a large capitalised company with a strong balance sheet, that generates strong cash flows, is well managed and has a track record of earnings and dividend growth. Consumer staples like Unilever, Coca-Cola, Mars and Nestle fit the bill perfectly.

Their competitive advantage lies in the value of their brands, the scale of their operations and their ability to continuously innovate new products in an effort to move with consumer trends; all of which have created strong barriers to entry.

What makes them so defensive?

Consumer staples are defensive because of their low economic sensitivity. Think of all the products found in your kitchen, laundry and bathroom that you would be hard pressed to live without. This means that sales volumes of consumer staples products are typically very resilient during periods of slow economic growth.

The chart below shows the sector’s strong financial position and defensiveness. Over the last 13 years, earnings generated by the consumer staples sector have been very steady, particularly through the global financial crisis where earnings declined by just 1.7% in 2009. This compares to a 50.8% decline from the broader market.

Not only have consumer staples provided the highest dividend growth over the past 13 years but the sector was one of the few to grow its dividend in 2009 during the financial crisis, as seen in the chart.

A focus on research & development

Consumer staples companies have continued to invest in their brands over the decades and are now sitting on some of the most valuable and well-known brand names in the world. This creates brand loyalty, helps to grow their products’ market share, and builds pricing power. An example is L’Oréal who invested 32.8% of sales in 2017 into refining its product offerings and building its brands.

Companies with strong pricing power have the ability to raise their product prices, which is important for sales growth and as a hedge against inflation.

The emerging market opportunity

Emerging markets offer a long term growth opportunity, primarily due to their demographics. Countries in the developing world generally have much younger populations than those in developed regions.

Around 90% of the world’s population under the age of 30 are living in emerging markets. Consider that as these economies grow and more people enter the workforce, disposable incomes will follow. This should lead to greater consumption of consumer staples products.

Opportunities in the emerging markets are not new for this sector. Unilever, for example, already generates an impressive 58% of its sales from emerging markets. They aspire to have 75% of revenue generated from emerging markets.

Underperformance as growth accelerates

From mid-2016, we have seen a sharp acceleration in economic growth. The cyclical sectors (such as financials or industrials) have benefited from this at the expense of defensive stocks (such as the consumer staples sector). This can be seen in its valuation relative to the broader market – it’s sitting at its largest discount since 2010, as shown in the chart below. This is significantly below its long-run average premium.

So why now?

We believe recent underperformance has created an attractive buying opportunity. Currently, investor sentiment towards the consumer staples sector is particularly low and expectations seem rather conservative. In our view, sentiment is unlikely to get much worse from here. In the event we see risks emerge, such as a meaningful deceleration in global economic growth, a step up in inflation or a rise in geopolitical tensions, we would expect consumer staples to outperform.

Please note: This article was first published in the April 2018 edition of News & Views. Craigs Investment Partners clients can view the latest edition of News & Views, which includes the full version of this article, by logging in to Client Portal.