How easy or difficult is it to earn returns by investing in the consumer staples sector. The manager of a fund at a UK fund manager examines the territory.

This article, which looks at whether investing in consumer staples companies is all it’s cracked up to be, is written by Bettina Edmondston, co-manager of the Saracen Global Income and Growth fund, at Edinburgh-based Saracen Fund Managers. Those who wish to respond with comments can email tom.burroughes@wealthbriefing.com

Comments of guest contributors are not necessarily endorsed by the editorial team.
     

Conventional wisdom says investing in consumer staples companies such as Pepsi, Nestle, and Coca-Cola is safe and defensive, but it is not necessarily the case.

The argument is that you should stick with ‘quality’ and consumer defensives as they are, by their nature, low risk investments. Consumer staples companies are considered defensive as consumers often don’t have a choice but to buy food, beverages and household products. Equally, these companies are viewed as high quality, which means high and stable margins and returns on capital. While there is some logic in screening for these attributes, there is surely a missing piece in the jigsaw, which is valuation. 

Edmondston thinks that many of these staples companies have delivered pedestrian levels of growth in sales and profits. Yet they continue to be rewarded with earnings multiples that price in unrealistic expectations.

Since the financial crisis, consumer staples companies benefitted from a low to zero interest rate environment. Income investors were very happy to receive 2-3 per cent dividend yields when there was not much return from treasuries or bonds. However, as we now all know too well, the environment has changed. Today, yields of between 2-3 per cent seem mediocre. Perhaps due to their previous bond proxy status, consumer staples’ earnings multiples expanded since 2009. However, they have continued to be highly valued and appear to have detached themselves from the rest of the market.

This sector also has a reputation of strong returns on invested capital. However, these have generally been in decline across the space in the last 15 years. For instance, Coca Cola’s 1Y forward price/earnings ratio (PE) increased from 13.7 times earnings in 2009 to 23.1x today. Yet Coca Cola only delivered 2.5 per cent compound annual growth in revenues and a decline in operating margin by 1.2 per cent. Growth in earnings per share of 3.1 per cent per year was helped by substantial share buybacks. Not only did Coca Cola’s net debt/EBITDA increase from 0.4x to 1.5x, but return on invested capital declined from 21 per cent to 15.4 per cent. 

Furthermore, if global economic growth does slow further and mortgage rates increase, the consumer will also come under increasing pressure. We do not expect consumer staples companies to be untouched. 

There’s another problem with so-called defensive consumer staples too. Over the last 20 years, there has been a real jump in both the variety and standards of private label products. In previous recessions, consumers “traded down” when times got tough and moved away from the branded products offered by the likes of Pepsi, Nestle etc. This hasn’t happened yet in this cost-of-living-crisis. Edmondston believes there are a few reasons why this down-trade has been delayed but not cancelled:

1) There is a general depletion of COVID-era excess savings which seems to be coming to an end; 

2) In the US, as many as 42 million low-income households are currently enrolled in the “Supplemental Nutrition Assistance Program”, a benefits scheme that is only now rolling off; 

3) The biggest price increases have only recently come through. According to the UK Office for National statistics, the average basket size of groceries was up 15 per cent y/y in March, driven by milk (+38 per cent), white sliced bread (+29 per cent), yoghurt (+28 per cent), pork sausage (+21 per cent), coffee pods (+21 per cent). The list goes on. However, staples companies mention further price increases to come: some say they are only 1/3 or ½ way through; and  

4) Shrinkflation: A hidden, gradual and all too easy driver of improved margins. Not only have many products reduced in size for the same price, but in many categories, ingredients have been swapped or reduced for cheaper alternatives. Some well-known chocolate bars just don’t taste the same anymore! This can only continue for so long before a value proposition is completely eroded, accelerating the loss to private label.

Downtrading may come through in earnest over the summer and into the second half of 2023. 

For example, Essity, owner of brands like Plenty, Tempo, Cushelle and Bodyform, reported Q2 results below expectations. Part of the miss was due to the continued down-trading in many places. Europe is one area where there has been some down-trading to private label and to lower-value products. At the same time, the company points to increased promotional activity, i.e. price cuts, in order to get volumes back. 

The share of discounters has increased in the UK and globally and consumers might be pleasantly surprised by the quality of the own brand offering. Supermarkets and consumers are also pushing back on further price increases. This could be a double whammy for consumer companies, in that it will not just hurt top line revenues, but also margins.

Many companies have hedged more than is usual, and will still face rising costs as these hedges roll off. If history is a guide, at some point valuations and cash earnings return to equilibrium. If both high earnings multiples and fundamental prospects decline, it can be particularly painful for share prices.