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19.08.2016

Giselle Roux: The two choices you have when it comes to global consumer stocks

Household consumption is the largest contributor to economic growth, well outspending business and governments. So equity markets are replete with companies representing the whole gamut of consumption patterns around the world.

At the heart are consumer staples, comprising 11 per cent of the MSCI All Country Index, and consumer discretionary stocks, a touch bigger at 12 per cent of the equity market. From that point on the segments could hardly be more different. Staples equities are mainly food, beverage and tobacco companies, along with household products and associated retailers.

The largest global names in the index are familiar to investors – who does not know British American Tobacco, Coca-Cola, Procter and Gamble or Nestlé? As the profitability and cash flow of most of these businesses is relatively predictable, the stocks are generally valued well above the market, at a weighted average of 24.5 times current earnings.

In an uncertain world they have formed a bulwark for global funds willing to tolerate the high valuations to capture the low volatility. The investment market measure of standard deviation (as a proxy for volatility) for consumer staples has been 10.6 per cent a year over 10 years compared with the MSCI AWCI stock index of 13 per cent. This is reinforced by the sector beta, the measure of its behaviour relative to the market, of 0.7. Staples will therefore tend to outperform a falling market and vice versa.

Wider range

Discretionary companies have a wider range of operations. Retailing is the largest component with, perhaps unsurprisingly, Amazon being the highest market cap stock in the industry. Home Depot and Lowe’s, the Bunnings of the US, are in the top mix, easily overtaking department stores. Luxury brand companies are also right up there.

Given their global size, auto companies are in the large-cap end and the media sub-segment is dominated by US names, such as Walt Disney and Comcast, while consumer services takes in leisure, hotels and restaurants. For this sector the P/E averages 17 times and the standard deviation is in line with the equity market in general.

Their performance is variable over time and echoes the array of choices consumers make. High growth can be matched by very high valuations, while those considered on the wane fall into the “value” category. Fund managers have distinct views on discretionary stocks and their judgment can make a considerable difference to performance.

Consumer staples have been the winner in the long term, with return of 10 per cent a year over 10 years compared with 7 per cent from discretionary companies, though over five years the race is more evenly balanced.

Seeking comfort

In many ways, these two market segments reflect current conditions. Funds and their investors are seeking as much comfort as they can get from companies with predictable characteristics, but the price of that privilege may require turning a blind eye to valuation.

To justify the valuation, consumer staples companies cannot waste a penny of cash flow on expansion or acquisitions that may jeopardise their relationship with their equity holders. The premium is built on a low bond rate (therefore discounted value of future earnings) and modest economic growth.

For many, the consumer in emerging economies is critical to their growth, yet occasionally regulation, discomfort with the global reach of the organisation and local markets can prove unfriendly to their outlook.

Discretionary stocks sit between two worlds of those that have adapted to, or are in a position to take advantage of, change – Amazon, Starbucks, Walt Disney, Netflix or Nike. On the other side are those that have struggled to adapt, including old media, department stores and car companies without consumer cachet.

The relative valuation is bifurcated by this winners and losers circle. Once again, an investor is faced with the choice of a highly valued company that has shown its capacity to change versus the deep value that can apply to those left behind.

Equities are rarely a simple decision: anchoring on the past meets excess confidence in the future. But out of it all comes the best asset class for the long term.

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