Consumer Staples & Discretionary Sector Report

Sector report by Jun Wei Seah, 29 January 2021

EXECUTIVE SUMMARY

The Consumer Staples & Discretionary sectors are 2 sectors that are closely related and yet have different characteristics. The Consumer Staples sector is often called the Consumer Defensive sector. Traditionally, investors turn to companies within the sector when they seek stable dividend pay-outs and resilient revenues during recessions. Companies that sell daily necessities belong in this sector, such as packaged food, food retail, toiletries, cleaning products and tobacco.

The Consumer Discretionary sector is a sector that is very loosely defined, with hotel chains, automobile manufacturers, luxury goods manufacturers and retailers among many others all belonging in this sector. Companies in this sector tend to sell goods that are more sensitive to economic conditions, meaning that demand tends to increase more than proportionately during times of economic prosperity and fall to a greater extent in times of recession.

In this report, we take a closer look at the subsectors within the Consumer Staples and Consumer Discretionary sectors, as well as the impact of COVID-19 on some of the subsectors. This is followed by more in-depth industry commentary, where we discuss subsectors that could see secular growth in the next few years. Finally, we take a look at some industry-specific ETFs and how these may be good choices for investing into.

OVERVIEW OF SECTOR

We look at the year-to-date performances of the S&P 500 Consumer Staples and Consumer Discretionary sectors in the graphs below.
Year-to-date performance (data from S&P):

5-year performance (data from S&P):

As we can see from the charts above, the Consumer Staples sector is less volatile than the S&P 500 Index and has a beta that is less than 1. The Consumer Discretionary sector is more volatile than the S&P 500 and has a beta larger than 1. Beta is a measure of volatility with respect to the entire market. For example, a beta of 1.50 would mean that if the market is up 10%, the stock or the sector is up by 15%.

To kick off 2021, the Consumer Staples sector saw losses while the Consumer Discretionary sector has slightly outperformed the S&P 500. The markets have started off a little more cautiously this year with the S&P 500 increasing by about 2.5%. It is interesting that the markets largely shrugged off the riots at the U.S. Capitol on January 6th, with the S&P 500 going up that day. This shows that investors believed that the storming of the U.S. Capitol did not pose a real threat to national security and was a one-off albeit scary incident.

Both the Consumer Staples and Consumer Discretionary sectors are huge sectors with a multitude of industries. For Consumer Staples, the subsectors include:

Food Retailing
This subsector includes supermarket and convenience store chains. Some companies in this subsector include Costco, Walgreens and Walmart.

Food products and beverages
This subsector includes soft drink manufacturers, packaged food manufacturers, distilleries and many more. Some companies in this subsector include General Mills, Coca-Cola, Conagra, Molson Coors and Kellogg.

Household & personal products
This subsector consists of manufacturers that produce a wide variety of products such as toiletries, detergent, tissue paper, etc. Some companies include Unilever, Procter & Gamble and Clorox.

Tobacco
This subsector is made up of companies that sell cigarettes and related products. Some companies include Altria, Phillip Morris International, Japan Tobacco and British American Tobacco.

The Consumer Discretionary sector consists of even more subsectors, as below:

Auto components & Automobiles
These companies include tyre manufacturers, spare parts manufacturers and car manufacturers. Some companies include Goodyear, Advance Auto Parts, Daimler, General Motors and Ford Motor Company.

Hotels, Restaurants & Leisure
Companies in this subsector range from hotel chains to casino operators to fast food chains. Some companies include Hilton, Las Vegas Sands, Restaurant Brands International, McDonald’s and Royal Caribbean Cruises.

Luxury Goods
These companies sell luxury items such as handbags and designer jewellery. Companies include LVMH and Estee Lauder.

Retail
These companies include any other retail companies that do not fall within the other subsectors. These range from sports retailers such as Foot Locker, Nike and Adidas to department stores such as Nordstrom and Macy’s to electronics retailers such as Best Buy and Home Depot.

In both the Consumer Staples and Consumer Discretionary sectors, there is often a lot of overlap between subsectors. For example, Unilever manufactures ice cream and also manufactures shampoo and beauty products. Many consumer goods companies are highly diversified and have a wide range of revenue streams and hundreds of different products, especially fast-moving consumer goods (FMCG) companies such as Unilever and P&G. Companies such as Walmart sell everything from sportswear to bicycles to groceries, and thus would overlap with Consumer Discretionary as well.

COVID-19 had mixed impacts on companies in the sector, and I highlight 2 key ones below.

  1. Switch back to packaged foods and increased demand for household goods
    As people are staying at home more, there has been an increase in demand for snacks and packaged foods. Companies such as General Mills reported earnings for the past 2 quarters that comfortably exceeded expectations, as there was an increase in demand for its cereals and snacks. Meanwhile, companies such as Coca-Cola reported poorer results as demand was adversely affected by the closures of bars, restaurants and cinemas.
    Companies that specialised in cleaning equipment and hygiene such as Clorox reported incredible Q3 earnings, with Clorox reporting its best earnings growth in more than a decade due to heightened demand for cleaning products.
  2. Acceleration of the shift to online retail, while retailers that are slow to adapt suffer
    The pandemic has accelerated the growth of online retail and the decline of brick-and-mortar retail. Companies that had strong online retailing capabilities or were able to transition quickly to online retailing such as Best Buy, Walmart and Lululemon Athletica have seen their share prices jump as they beat earnings expectations. Meanwhile, many department stores faced financial distress as they were unable to sell their products due to lockdowns and movement restrictions. Companies such as Macy’s and Nordstrom continue to struggle, with some retailers (Neiman Marcus) even filing for bankruptcy.

FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS

For the consumer discretionary and consumer staples sectors, key factors that typically drive long-term success would be:

  1. Macroeconomic conditions and population growth
  2. Adapting to consumer trends and preferences
  3. Cost efficiency and margins due to steep competition faced by companies in the sector.

In the last report, I highlighted some key trends in the sector, which were:

  1. Strong secular growth in quick-service restaurants
  2. Big Tobacco headwinds
  3. Recovery of travel-related stocks

In this report, I would like to highlight another trend (demand for luxury goods in China), provide an update on travel-related stocks and explain why gaming/consumer electronics could be an interesting subsector to focus on in the future.

Strong recovery of luxury goods demand in China
With Asia leading the global economic recovery as the world continues to battle coronavirus, many luxury goods companies have posted incredibly strong Q3 and Q4 results in Asia. For example, Burberry saw its share price jump 4% after giving an update on its fiscal quarter ending December 26th. Despite revenues decreasing 9% YoY, it saw strong double-digit growth in China and South Korea, leading to an 11% increase in revenues for the whole of Asia-Pacific. The overall decline in revenue was due to a 37% decline in Europe and an 8% decline in America. At the same time, Richemont, the parent company of jewellery brand Cartier, saw a whopping 80% YoY increase in revenue in China and an overall increase in revenue of 5%.

While some of it can be attributed to pent-up demand, there is no doubt that Asia has been the main driver of growth for luxury goods companies and will continue to be the main driver of growth due to strong economic recovery and increased purchasing power, particularly in China. China posted incredible GDP growth figures, with a 6.5% increase in Q4 2020. It is the world’s largest economy to record positive growth and stands out in a pack of Asian economies which dealt well with covid-19, with South Korea contracting 1.1% and other economies in Asia such as Singapore, Taiwan and Hong Kong expected to contract in the mid-single digits.

Also, a recent report by Bain & Co., the strategy consulting firm, estimated that China’s share of the global luxury market nearly doubled from 11% in 2019 to 20% in 2020, with luxury goods sales increase 48% to US$53.6 billion in 2020. This puts China on track to account for the largest proportion of luxury goods sales by 2025, and luxury goods companies are recognising this. For example, Burberry has focused much of its recent marketing efforts on its Lunar New Year campaign, enlisting the likes of Chinese A-listers Zhou Dongyu and Song Weilong to star in their promotional short film.

An update on travel-related stocks
In the previous report, I gave an overview on why travel-related stocks did not do well last year and the financial difficulties faced by companies in the sector. I then gave 3 reasons why I believed fears surrounding travel-related stocks were overstated and why the sector would recover, namely:

  1. Vaccinations
  2. Pent-up demand, and
  3. Economic recovery.

This year, we can observe that travel-related stocks have probably matched investors’ expectations with regards to the above 3 factors. As we can see from the chart below,

1 – month performance of Hotels, Restaurants & Leisure subsector vs. the S&P 500 (Chart taken from Fidelity website)

While the Hotels, Restaurants Leisure subsector is still lagging behind the S&P 500 slightly, there is no longer such a massive difference in price changes. This shows that investors are likely still cautious with regards to investing in the subsector but are no longer is pessimistic as they were a few months ago. Vaccination programmes are proceeding well in the U.S. and U.K., and countries across the world are starting to launch their vaccination programmes as well which is in line with expectations with regards to the speed of vaccinations

Cloud gaming
The gaming and consumer electronics subsectors have always been closely related. Traditionally, companies such as Nintendo and Sony would provide the gaming hardware such as consoles and handheld devices, while gaming companies would sell physical games th at you needed to play a game. The trend of buying online copies of games
instead of physical games is nothing new, and has been happening for quite a few years now, and has been a huge part of contributing to the decline of companies such as Gamestop. Howe ver, cloud gaming garnered the most hype in 2020.

Cloud gaming also known as gaming as a service runs video games on remote servers and streams them to the user’s device. This makes games accessible on demand and does not require large storage capabilities of expensive hardware. Therefore, games that would usually not run on smaller devices such as smartphones and tablets can now be played on these devices, improving access to games. From the consumer’s point of view, cloud gaming could be an attractive option if the consumer is unable to afford expensive hardware to run games and could be a large total addressable market for companies. From the company’s point of view, cloud gaming provides stable, recurring revenue streams based on a subscription model and provides higher margins as servers and data centres to run these video games provide economies of scale.

Therefore, it is no surprise that a multitude of companies are starting their own cloud gaming services, with the cloud gaming market estimated to grow at a near 50% CAGR for the next few years by some analysts. Google launched its cloud gaming platform called Stadia in late 2019, while Nvidia and Amazon launched their platforms called GeForce
Now and Luna respectively Sony is still considered the market leader in cloud gaming as it possesses first mover advantage, having launched its platform Playstation Now in 2014.

One interesting thing we can observe now is there is now a n even close link between the Consumer Discretionary and Technology sectors, with technology disrupting more traditional fields such as consumer electronics and the complementary products between the 2 sectors. With demand for both traditional gaming devices and cloud gaming strong, shares in Sony have increased nearly 80% from March 2020 and shares in Nintendo nearly 75%, matching the returns that some tech companies have seen. Companies such as Nvidia and Advanced Micro Devices continue to exceed all expectations in terms of share price growth, in part fuelled by these developments in cloud gaming.

Snowflake, the data warehousing and solutions company also saw an incredible IPO debut late last year as investors now see the multitude of applications that data warehousing can bring, including for the gaming and consumer electronics subsectors.

However, it must be noted that cloud gaming remains a small market, despite its projected high growth. The cloud gaming market is still only worth about half a billion dollars, and despite it being expected to grow to $5 billion by 2023, companies may find it hard to generate revenue in the short term simply because of the increased and intense
competition between players such as Google, Amazon, Nvidia and Sony. There is likely to be consolidation of platforms in the long term as companies such as Google and Amazon simply have overpowering financial strength compared to other players.

Furthermore, if a product is of poor quality, consumers would never buy it. Currently, cloud gaming suffers from major teething issues as gamers have complained constantly about poor resolution and lag both of which are critical to in game success especially for games where quick reaction time is crucial such as in first person shooter games. The
revenue potential of this market and possible margin expansions are undoubtedly attractiv e, but companies in this market need to improve product quality and deal with intense competition to stand out amongst its peers. Cloud gaming is still in its early stages of development but could potentially change the gaming industry.

FUNDAMENTAL QUANTITATIVE ANALYSIS OF MAJOR PLAYERS

In the previous report, we looked at some key ratios that gauge the financial strength of companies in the sector. This time, we take a closer look at P&G and Imperial Brands for Consumer Staples and explain how simply looking at ratios may not be the most effective way of analysing companies, because of the presence of ‘value traps’.

P&G
Procter & Gamble is an American multinational consumer goods compan y headquartered in Cincinnati, Ohio. It sells a wide variety of personal health, personal care and hygiene products and some of its most well known brands include Tide detergent, Oral B dental products and Febreze.

It sells products in 5 main categories, namely:
1. Fabric Home Care (33% of revenue)
2. Baby, Feminine Family Care (26%)
3. Beauty (19%)
4. Healthcare (13%)
5. Grooming (9%)

Procter & Gamble is the classic example of a Consumer Staples company, because it sells products that are essential for daily life, has strong and stable financials and enjoys consistent if unspectacular revenue and earnings growth. Many investors keep stocks like P&G as a hedge against poor macro conditions and also as a recurring income stream, as companies such as P&G usually pay good divid ends every year.

We look at how P&G compares to its competitors on a few fundamental ratios below assessing P&G on price (P/E), profitability (net margins), financial leverage (debt/equity) and valuation (EV/EBITDA).

We see that P&G does not seem out of place in terms of valuation price and profitability being in the middle of the pack for all the ratios. Thus, based on these ratios, it appears that P&G is more likely fairly valued based on comparables. However, we see that Johnson Johnson has very low debt, the higher net margins and yet the 2nd lowest EV/EBITDA. Does this then suggest that Johnson Johnson is undervalued and therefore a good buy? Not necessarily, because looking at ratios alone can often lead to ‘value traps’. Johnson Johnson itself may not be a ‘value trap’, however, and to see a possible example of a value trap we look at the tobacco industry, and Imperial Brands in particular.

Imperial Brands
Imperial Brands is a British tobacco company and is one of the world’s largest producers and marketers of tobacco and tobacco related products. Imperial ’s most well known brand would be Golden Virginia, the world’s top selling hand rolled tobacco. It is also the world’s largest producer of cigars.

We compare Imperial Brands to its competitors in the charts below:

We see that Imperial Brands seems to be undervalued if we were to look at forward P/E and EV/EBITDA. However, we can already see some red flags with a low net margin percentage and relatively high debt/equity ratio, not to mention the lack of product diversification on Imperial Brand’s part. While other competitors are diversifying into alternative tobacco products as cigarettes see stagnating demand, Imperial Brands has not done so.

What about Japan Tobacco then? At first glance, Japan Tobacco seems compelling given its low debt/equity and higher profit margins. However, Japan Tobacco also faces the same problem of industry wide headwinds as mentioned in the first report stagnating revenues and lack of diversification Its large cash position ($379 billion as of FY 2019) shows its financial stability and strength but generate s close to 0 returns given historically low interest rates. Moreover, the company is neither investing it back into operations nor making acquisitions. Thus, Imperial Brands and Japan Tobacco are very likely ‘value traps’: companies that seem compelling at first glance but are likely poor long term investments due to poor long term prospects. Both of the companies have seen share prices decline year after year, and this trend is unlikely to reverse.

To conclude quantitative analysis does play an important role in analysing companies. However, they can only be taken as one aspect of a larger and more holistic approach to evaluating companies. The key is to project future cash flows accurately (via DCF models or otherwise and also to be predict future trends well forecast the growth of a company’s total addressable market TAM) well and discern if a company is able to maintain and build its competitive advantage over time. However, none of these are simple tasks and it is the reason why investing is so difficult, challenging and enjoyable at the same time.

MACRO OUTLOOK

In the previous report, I gave my thoughts on the macro environment for the next few years, which are summarised below:

1. Persistently low interest rates
2. Increasing investment into equities even at traditionally expensive valuations, and
3. The risk of moral hazard regarding debt levels of companies.

In this report, I wish to give further macro updates Biden’s inauguration and fiscal stimulus plans and share my thoughts surrounding monetary policy, fiscal policy, and economic recovery

On January 21st the European Central Bank announced that it would keep its main deposit rate at 0.5% (meaning banks are charged to store money with the ECB, incentivising lending) and continue buying bonds under the pandemic emergency purchase programme (PEPP) at €1.85 trillion. Joe Biden, the new president of the United States, has signed a few executive orders that are focused on improving assistance to workers badly hit by Covid-19. This includes streamlining the delivery of stimulus checks and food stamps and starting the process of introducing a minimum wage of $15 for federal contractors. The Biden administration hopes that this would improve purchasing power on consumers that would help to re ignite the U.S. economy badly hit by Covid-19. Biden also wishes to pass a US$1.9 trillion Covid-19 relief plan in Congress, after a $900 billion plan was passed with bipartisan support in Congress.

While continued fiscal and monetary stimulus are definitely needed at this point in time to try and encourage consumption and investment I feel that using traditional demand side policies to tackle the economic damage Covid-19 has caused are at best a blunt tool. The main focus of governments around the world should be to tackle the public health crisis first, and economic recovery will be the next step in a natural progression.

Taking the example of monetary policy, low interest rates boost consumption and investment for items that typically require loans However, with Covid-19 still a major problem across the globe, there is simply too much uncertainty and risk that consumers and firms face. For example, firms would be extremely reluctant to borrow and expand their business at this point in time even if the cost of borrowing is low, because there is simply no way to tell if/when demand will recover for their goods and if/when supply chain issues caused by Covid-19 will be solved, as long as Covid-19 is still a problem. The effectiveness of monetary policy is not only limited by the zero lower bound, but also by the fact that there is too much uncertainty and risk surrounding the future such that consumers and firms are unlikely to make forward looking consumption and investment decisions.

For fiscal policy, most stimulus packages involve providing cash payments to citizens and providing financial aid (such as furlough schemes) to businesses to help reduce overheads However, these policies are not only incredibly expensive, but are stop gap measures at best. The government cannot provide aid indefinitely, and the only time when governments can stop providing aid is when demand recovers for businesses. This means that people need to be able to go out and spend money, and this will not happen if most employees are still working from home and if most people cannot travel and consume goods and services. We have already seen that half hearted lockdown measures such as the Tier system in the U.K. and stimulus plans such as the Eat Out to Help Out scheme have seen very limited effectiveness in terms of boosting the economy while failing to stop the spread of Covid-19. Swift and decisive action taken by governments to tackle Covid-19 is the only solution and should be the priority for governments before looking to focus their efforts on monetary and fiscal stimulus. Many Asian economies are starting to see economic recovery after strong lockdown measures early on in the pandemic, before slowly and carefully opening up the economy. For the majority of Western economies, a fast vaccination programme is the only way out now given that Covid-19 is already out of control. In this respect, the U.K. has done well with its vaccination scheme and hopefully more countries can now recognise that the way to solve this economic crisis is to solve the public health crisis first.

ETFs PRICE TARGETS

I recommend the DXtrackers MSCI World Consumer Discretionary UCITS ETF for international diversification.

DXtrackers MSCI World Consumer Discretionary UCITS ETF (LON: XDWC)

This ETF offered by DWS Xtrackers has a relatively low expense ratio at 0.25%, while having global exposure and diversification to strong companies.

There is a good mix of companies that are strong and stable (Sony and Toyota), companies that will likely see good growth over the next few years (LVMH, Amazon) and a more speculative investment but could yield very strong returns (Tesla).

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