Slow and Steady Wins the Race

<b>Tanya Stavreva, CFA</b><br> Senior Vice President, Portfolio Manager

Tanya Stavreva, CFA
Senior Vice President, Portfolio Manager

January 7, 2021

Economy & Investing


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Historically, Consumer Staples has been a stock market sector known for its all-weather attractiveness and resilience in different economic environments. Its name reflects the fact that these products are ingrained in the average consumer’s day-to-day life and thus less affected by changing tastes or macro volatility. Over the last three decades, the sector has provided an annualized total return of 9%, inclusive of dividend reinvestment. Its defensive nature offers a natural hedge during macro weakness and downside protection in times of high volatility. Conversely, in a robust economic scenario, the sector usually lags relative to its more cyclically skewed peers. In a way, the Staples sector serves the purpose of an airbag for markets—it is not much needed or talked about when the ride is going smoothly; however, it is quite useful when the big bumps come. In recent years of historically low real rates, the Staples sector has also earned points as a bond proxy for its stable yield relative to other sectors.



The sector makes up ~7% of the S&P 500 Index and is mainly comprised of large, well-established, slow-growing companies. In a world of doubling technology returns, a piping hot IPO market, and seemingly unlimited monetary stimulus, this strikes as a tad underwhelming. So why talk about it?

The Staples sector makes up for a lack of attractive growth characteristics with reliable profits, steady cash flow generation, and by having conservative balance sheets with stable dividends. The annualized total return for Staples puts it among the best performing sectors over the long term. In addition, during periods of turmoil, Staples has offered the lowest drawdown and has preserved the most capital versus peers.



Unprecedented circumstances in recent times have led to heightened global uncertainty and a macro-market disconnect that across most key indicators dwarfs the one experienced during the Global Financial Crisis. As a result, asset prices may not be fully, or accurately, reflective of intrinsic value and are likely amplified by the substantial central bank liquidity that has been added to the system. This is particularly relevant at the tail ends of the curve, whether for winners or losers. Thus, the relative resilience of Staples can be an attractive feature as the pendulum swings accelerate in magnitude.  


A Bird in the Hand is Worth Two in the Bush

An effect of the typical low-growth that most Staples companies exhibit is that most are stable dividend payers, and many have a long history of consistent dividend growth. As of December 2020, the Staples sector dividend yield was 2.7% versus the S&P 500 at 1.5%.



A steepening government yield curve is a potential headwind for the space in that it is likely to drive outflows for more interest rate-levered sectors. However, with economic and business pressures posed by the current environment, the Fed has implied that short rates are not going to increase for at least two years. While a steeper yield curve could make cyclicals more attractive, it is unlikely that the steepening is material enough to drive outflows from Staples.
 

Global Pandemic Paradigm Shift

The ongoing global pandemic has triggered a major shift within the Staples space, creating near-term tailwinds, fueled by stay-at-home orders and heightened cleaning/sanitation protocols. Organic growth rates, particularly in Food and HPC (household and personal care), have skyrocketed to levels not seen before in most companies’ histories. And, despite a step up in costs, a lot of benefit has been passed right to bottom line earnings.

Prior to the global pandemic, some observable themes had been in place. These included: (i) small pioneer brands driving major disruption and taking share from big established brands, (ii) private label gaining share at the expense of brand, as consumers shifted focus away from brand names and into ingredients, and (iii) periphery of store foods like perishables, as well as Organic/BFY (better-for-you)/Natural, driving growth in consumer spend to the detriment of center of store non-perishables.
 
As the more severe restrictions of the pandemic hit in March of 2020, consumers were noticeably affected by the unprecedented circumstances, ongoing media coverage, and social media photo stream of empty grocery store shelves. This caused a meaningful shift in the long-standing trends mentioned above. Big, established brands saw a sales lift driven by higher household penetration rates and higher repeat purchases at the expense of smaller, less well-proven innovators. Pantry stocking proved a major tailwind for the more shelf-stable, center of store food products at the expense of produce/perishables/ fresh food as consumers minimized grocery trips. Private label sales ground to a halt and reversed to share losses as consumers reverted to familiar and tested products. Finally, a big part of the benefit seen by these large, well-established players was due to sophisticated supply chains and better retail relationships, which enabled them to get products to shelf faster versus their smaller, more nascent peers.
 
It is hard to forecast the staying power of some of the changes in consumer behavior that we have witnessed this year. Will the consumer permanently adopt some of these newly formed habits like at-home-meals, stepped up cleaning and sanitation protocols, lower proclivity for travel, entertainment, and dining out? Or conversely, will pent up demand serve to ditch these new habits as soon as permissible and make up for lost time on the fun and leisure front.
 
We suspect the answer probably lies somewhere in the middle, with different cohorts of consumers taking different approaches depending on health tolerances and vulnerabilities. We also believe that some of the pre-pandemic themes, like preferences for organic, healthier products will return. Over the long run, pandemic-related benefits are likely to dissipate, and we do not consider these to be a key pillar in the investment case for Staples.
 

A Word of Caution

Despite its relatively low volatility, all the standard investing risks and caveats apply to Staples, and here as well, there are no guarantees for future returns. Companies have defaulted on their debt, gone out of business, and investors have lost money. While most of these risks can be largely mitigated by good portfolio diversification, it is worth spending a moment on some more sector-specific headwinds.

As the outsized growth seen during the global pandemic comes to an end and the consumer reverts to a more balanced consumption pattern, some of the share gains will dissipate, and growth will return to normal. Because the timing of this remains unknown, some of the excess capacity that has been kicked into gear may result in inventory build ups and heavy discounting. Commodity inputs are the main cost of sale components for most of Staples companies, and as commodity costs increase, gross margins will suffer, at least temporarily. Consumer Staples are one of the major offenders when it comes to carbon impact, water waste, emissions, and environmental sustainability, because most products require complex manufacturing, heavy packaging, plastics, and transportation. As awareness and socially responsible investing grows, the sector will need to reinvent itself to reduce its impact. Fortunately, most large players have detailed plans of carbon neutrality, among many other ESG considerations all within the foreseeable future. Lastly, and even though Staples tends to be more insulated from macro weakness, it is not fully insured against a broader consumer and macroeconomic slowdown.
 

Conclusion

Purely based on its own fundamental merits, it is hard to ignore the benefits offered by the Staples sector to portfolio diversification. It is rare to see a big single session, single week, or even single month moves in the space. The upside potential may not be as high as certain other sectors. Instead, returns compound over time in a slow and steady pattern. All aspects considered, the defensive properties of the space, supported by strong cash returns, well-covered dividends, stable credit profiles, and solid balance sheets are highly coveted attributes to any diversified investment portfolio.