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Beaten Down Consumer Staples Stocks Might Look Cheap Compared to Broader Market

Consumer staples stocks used to be considered a port in the storm. Like utilities, traditionally a defensive play for investors seeking a shield from volatility, these stocks generally also offer income potential in the form of dividends.

This year, though, the consumer staples sector has been punished, particularly as long-standing trends, namely margin compression, and recent emerging macroeconomic trends related to higher interest rates and inflationary pressures, have combined to result in significant under-performance. Year-to-date through May 21, the S&P 500 Consumer Staples sector of 34 stocks is down 13.3%, compared to a gain of 2.2% for the broader S&P 500 index.

This earnings season has proven to be a tough one. More companies are citing cost inflation and higher supply chain costs, cutting into profit margins, which have already been under pressure in recent years.

“The consumer staples sector has struggled recently and is now the worst-performing group of the year to date, as concerns about increased competition and tight margins appear to be combining with good global economic growth to dampen enthusiasm for the staples sector,” Brad Sorenson, managing director of market & sector analysis for the Schwab Center for Financial Research, wrote in a May 10 Sector Views article.

Still, the weakness in these companies share prices may present a buying opportunity for investors willing to withstand the time it could take for the sector’s big names to address slowing sales and consumers’ shifting tastes and preferences for natural and local foods.

As well, several companies within the sector are in the midst of absorbing relatively large acquisitions and restructuring their operations to remain competitive and maintain key debt to income ratios given the amount of money they’ve borrowed and spent in recent years to repurchase their shares.

Consumer Staples Sector’s Strong Relationship with 10-Year Note’s Yield

Based on where the 10-year Treasury note has been trading in 2018 – it closed May 21 at 3.06% up from about 2.41% at year-end 2017 – it’s no wonder that the consumer staples sector has underperformed.

As bond yields rise, investors are less incentivized to own a dividend paying stock versus a safer bond. This is why the relative valuations of these stocks tend to fall as rates rise, according to an April 27 blog by Russ Koesterich, portfolio manager for BlackRock’s Global Allocation team.

But the relationship has grown stronger in the yield-starved environment that has been the major backdrop for investors following the global financial crisis. Since 2010, Koesterich says, the level of the 10-year Treasury note’s yield has explained approximately 63% of the variation in the relative valuation (defined as the valuation of the sector versus the broader market) for consumer staples.

This relationship, he says, explains why defensive sectors like utilities and consumer staples have performed so poorly as of late. Yet, given the degree of underperformance, consumer staples stocks are starting to look reasonably priced compared to the broader market. “Large-cap consumer staples companies are trading at an 11% discount to the S&P 500. This represents the cheapest relative valuation the sector has possessed since 2010,” BlackRock’s Koesterich writes.

The sector is also trading at around an 8% discount to what long-term rates would indicate is fair value. “While not a particularly large discount, it has been years since the sector appeared undervalued based on this metric,” Koesterich said in the BlackRock blog post.

 

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Sources:

https://www.schwab.com/resource-center/insights/content/consumer-staples-sector

https://www.blackrockblog.com/2018/04/27/defensive-stocks/

Sources for market data:

http://bigcharts.marketwatch.com/historical/default.asp?symb=gsps&closeDate=5%2F21%2F18&x=0&y=0                       

http://bigcharts.marketwatch.com/historical/default.asp?symb=gsps&closeDate=12%2F29%2F17&x=27&y=22               

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPX&closeDate=12%2F29%2F17&x=19&y=26                 

http://bigcharts.marketwatch.com/historical/default.asp?symb=SPX&closeDate=5%2F21%2F18&x=19&y=22                   

https://www.cnbc.com/quotes/?symbol=US10Y

https://ycharts.com/indicators/10_year_treasury_rate       

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