Sector report by Jun Wei Seah, 27 November 2020
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 can first take a look at the changes of the S&P 500 Consumer Staples and Consumer Discretionary indices against the S&P 500 Index, which consists of the 500 largest publicly listed companies in the U.S.
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%.
For the year-to-date changes, the Consumer Staples sector has slightly underperformed the S&P 500 while the Consumer Discretionary sector has outperformed the S&P 500. Interestingly, the Consumer Staples sector actually outperformed the S&P 500 at the start of the 5-year period, between late 2015 to late 2016. However, it has since underperformed the S&P 500 possibly due to the larger weightage to technology stocks for the S&P 500 in recent years, with these tech stocks experiencing great price appreciation.
Both the Consumer Staples and Consumer Discretionary sectors are huge sectors with a multitude of industries. For Consumer Staples, the subsectors include:
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.
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.
These companies sell luxury items such as handbags and designer jewellery. Companies include LVMH and Estee Lauder.
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:
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.
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:
- Macroeconomic conditions and population growth
- Adapting to consumer trends and preferences
- Cost efficiency and margins due to steep competition faced by companies in the sector.
Although it is difficult to predict near-term macroeconomic conditions due to huge uncertainty surrounding Covid-19, there are a few subsectors that I wish to highlight that could either see strong secular growth or strong headwinds in the near future.
Restaurants could see strong secular growth, especially in Asia
The restaurants subsector, particularly fast food, will likely see strong secular growth over the next 5 years, due to rising affluence and aggressive expansion plans by companies into emerging markets.
First, the industry has proven to be relatively resilient even in uncertain economic conditions. As economies slide into recession, fast food restaurants tend to be shielded from macroeconomic variables due to affordable prices. For example, Yum China, the operating company of KFC and Pizza Hut in China, has seen Q3 sales recover to 94% of sales of Q3 2019, despite the harsh lockdowns placed across China in Q1 and Q2.
Second, many fast food restaurant chains are embarking on aggressive expansion plans even after the effects of Covid-19. For instance, Yum China was planning to open 800 to 850 new stores in China in 2020 but has instead increased it to 900. Restaurant Brands International, the holding company of Burger King, Popeyes and Tim Hortons, plans to push ahead to reach its 40,000-store target by 2030.
It is no use if companies open restaurants but do not see an increase in customer base. However, fast food restaurant chains are set to take advantage of high population growth in Southeast Asia, Countries such as Vietnam and Indonesia are rapidly growing in population, with a rapidly growing middle-class population with an appetite for fast food.
Big Tobacco will continue to face headwinds, with increased regulation, ESG considerations and cannibalisation of revenue
The tobacco industry was a historically powerful industry. With huge profit margins, a product that is highly price inelastic and considerable lobbying power, tobacco companies were thought to be the ultimate defensive stock – companies that will pay out high, steady dividends even if the economy was doing poorly. However, that has all changed in recent years. Cigarettes have declined in popularity with smoker growth stagnating, and heated tobacco and e-cigarettes have exploded in popularity, particularly amongst young people. As such, tobacco companies faced the difficult dilemma of whether to move away from their key and most profitable product (cigarettes) and cannibalise their own revenue or risk seeing their market share get eroded by e-cigarette and other heated tobacco companies.
Predicting that cigarettes will be replaced in the future, many tobacco companies have now made a strategic shift in direction, pivoting towards heated tobacco products. Phillip Morris International has invested billions of dollars into its new heated tobacco product IQOS. Altria paid $12.8 billion for a 35% stake in JUUL, the e-cigarette company.
However, the industry now faces even more regulatory challenges that paint a bleak outlook for the industry. In January 2020, the Food and Drug Administration (FDA) in the U.S. instituted an effective ban on flavoured e-cigarettes in the U.S. This was a huge blow to tobacco companies in the U.S. which were hoping to capture that rapidly expanding market. E-cigarettes continue to be banned in many countries across Asia. The alarming spike in cases of lung damage amongst e-cigarette users in the U.S. late last year did not help the case for e-cigarettes either. As a result of poor performance, Altria has repeatedly written down the value of its investment in JUUL and is now worth less than $3 billion on the balance sheet.
In addition, the trend of ESG investing will put further pressure on the tobacco industry. Investing with ESG (environmental, social and governance) considerations in mind has been incredibly popular amongst asset managers recently. Virtually every asset manager claims to incorporate ESG considerations into its investment process now, and some asset managers have chosen to focus on green investments while divesting their assets in ‘sin’ stocks like casinos and tobacco, due to their perceived negative social impact. The tobacco industry has had a history of hiding the harmful effects of cigarettes on smokers for years. However, the damage that cigarettes cause to smokers and society are now well-documented and irrefutable. Therefore, with asset managers moving away from these stocks, this puts pressure on the share prices of tobacco companies which are already beaten down by the effects of COVID-19.
In conclusion, with governments and big corporates around the world looking to “do good” (or at least appear to), the tobacco industry faces significant headwinds as it seeks to improve its public image and convince the world that it genuinely aims to reduce the harm that its products bring to its customers. However, it is difficult to see how the tobacco industry can fight the threat of government regulation.
There should be optimism for travel-related stocks
Travel-related stocks have not done well this year, for obvious reasons. With leisure travel grinding to a near-halt, hotel chains, cruise companies, casinos and airline companies have suffered. Many of these companies have had to issue bonds and ask for additional funding from its investors as it burns through cash maintaining their businesses while seeing little revenue. For example, Carnival Cruises sold $4 billion in junk bonds in April and is now seeking to sell a further $1.6 billion in junk bonds. Royal Caribbean Cruises sold $3.3 billion in bonds in May. Even companies that have had historically strong financials such as Singapore Airlines have seen trouble, with the company raising more than $11 billion through a secondary offering and convertible bond raise in April.
We can see from the above chart that the Hotels, Restaurants & Leisure subsector has lagged behind the S&P 500 for the past year. However, the subsector has seen strong recovery in terms of share prices after it was down more than 40% in April and is now only 4.61% down from a year ago. Even though Covid-19 still threatens operations of companies in this subsector, there are 2 reasons for optimism.
First, there is a good chance that effective vaccines will be rolled out to key healthcare workers and the most vulnerable by the end of the year. Both the Pfizer and Moderna vaccines have aced clinical trials and are currently in the process of getting emergency approval from regulators. Both these vaccines could be rolled out by the end of the year, which will reduce infection rates. Furthermore, there are signs that infection rates are plateauing in many European countries, after Europe was badly hit by the 2nd wave of COVID-19. This, along with the rollout of vaccinations across the world, means that the worst of COVID-19 could be over in about half a year’s time. Many countries will once again reopen borders and travel will be restarted.
The second reason pertains to the belief that travel-related companies will be permanently damaged after COVID-19, and the ‘new normal’ will mean that business and leisure travel will be drastically reduced. I believe that despite all this talk, there are clear signs of pent-up demand and a hope by consumers all around to world to start going out and travelling again. A few examples are stated below.
Firstly, countries that have kept the coronavirus under control have seen strong growth in consumer spending post lockdown. For example, retail sales grew 3.3% in September year-on-year in China, the fastest rate of growth since December 2019. GDP also grew 2.7% in Q3 quarter-on-quarter. Luxury goods companies have also reported better-than-expected sales figures in Asia after lockdowns. For example, LVMH reported a 13% year-on-year increase in revenues in Asia and Asia was the only region that LVMH saw an increase in revenues and profits this year. This all points to the fact that consumers are still willing to go out and spend money as long as there are no movement restrictions. Of course, travel is not fully equivalent to retail spending, but it is an indication that consumers are willing to travel and spend once borders open.
Secondly, demand for limited leisure travel arrangements has already far exceeded supply in some places. For instance, Singapore and Hong Kong recently announced plans to restart a ‘travel bubble’, with travellers not needing to serve the 14-day quarantine when travelling from Singapore to Hong Kong and vice versa. Limited air tickets were sold, and air tickets tripled in price while selling out in less than a week. The start date of the travel bubble has since been postponed, but this points to the fact that there is likely pent-up demand for travel, and therefore hotels, restaurants, casinos, etc.
Therefore, we can be optimistic about hotel and leisure as the subsector will benefit from pent-up demand and the improving COVID-19 situation over the coming months.
FUNDAMENTAL QUANTITATIVE ANALYSIS
We move on to look at some key ratios which are a gauge of financial strength and valuation of the companies in the sector. (Data from CSIMarket)
|Q4 2019||Q1 2020||Q2 2020||Q3 2020|
|Leverage Ratio (Debt/EBITDA)||1.84||2.05||2.16||2.32|
|Q4 2019||Q1 2020||Q2 2020||Q3 2020|
|Leverage Ratio (Debt/EBITDA)||2.51||2.63||3.02||2.99|
In general, we can see that P/E ratios and price/FCF ratios in the Consumer Staples & Discretionary sectors are at levels a lot closer to the S&P 500. However, it must be noted that these are extraordinary times and even the S&P 500, on average has a high P/E ratio by historical standards and is currently at 41.34 TTM. While in normal conditions this would suggest that the S&P 500 is incredibly overvalued, the P/E ratio was likely skewed by low earnings numbers as many companies saw a huge drop in earnings due to COVID-19.
We can also see the effect of COVID-19 on other ratios, such as the Debt / EBITDA ratio and Debt/Equity ratios. They have been generally increasing for the 2 companies, as companies borrowed to improve liquidity as revenues and costs were negatively impacted by COVID-19. There are some subsectors that consist of companies still burning through cash at high rates. For example, cinemas have been virtually closed since the onset of COVID-19, and many cinema operators had to maintain their theatres and staff while collecting zero revenue. Other companies such as cruise companies also face the same situation.
It is difficult to judge an entire sector based on these ratios that only give a very broad overview of the financial health of companies within the sector. To truly gauge the risk of default, one must go down to the level of individual companies to analyse financial statements, which is not the focus on this report. However, the companies that have had high-profile financial distress were companies that were already heavily leveraged before COVID-19 happened, such as Neiman Marcus and Hertz. Therefore, most companies in the sector would be relatively safe given the low leverage ratios we observe before the pandemic at Q4 2019. Also, the next section on macro outlook paints a slightly favourable outlook for companies in terms of paying down their debt obligations.
We can now take a broad view on some macroeconomic variables and the impact of Federal Reserve action on companies in the sector.
In general, we are likely to see a low interest rate environment for the next few years favourable for debt repayments. The low interest rate environment we observe now is likely to persist. Why? The Federal Reserve has effectively committed to low interest rates after announcing recently that they would be pursuing a target of 2% inflation averaged out over a few years (the Fed’s timeframe is unknown for now). In recent years, inflation has been low and stable and due to COVID-19, the USA is expected to hit an inflation rate below 2% this year. Central banks keep interest rates low to increase inflation and increase interest rates when inflation is expected to go up. Central banks also keep interest rates low when economies are in recession, as many countries are right now, as low interest rates encourage spending. Thus, it is unlikely that we will see a change of interest rates from near zero levels across the world, as many central banks take the lead of the Federal Reserve. Some central banks also do not set their own interest rates, and rates determined by the market depend a lot on Federal Reserve action.
Interest rate policy is important because it affects financial markets to a large extent as well. For example, low interest rates allow companies to borrow cheaply and improve liquidity cheaply. Thus, companies that have managed to borrow or raise debt during this current pandemic will benefit from lower interest payments, reducing financial burden.
Also, with low interest rates, we can see a shift towards investing in equity markets as opposed to credit markets, especially investment-grade bonds. Low interest rates push up prices of bonds, which lowers effective yield – this means that investing in bonds appear less attractive and equities offer higher returns. Some people believe that many investors now do not mind seeking out more risk in exchange for higher returns, which may explain the stock market rally that we have seen not only from the lows in March, but in general for the past few years. It does seem the future seems bright for companies in the Consumers sector. Low interest rates will reduce repayments, improving cash flow, and with investors seeking out equity investments in all sector share prices may well continue to increase.
However, there are macro risks that we should be aware of. Firstly, recent unprecedented action by the Federal Reserve will only encourage companies to borrow more as perceived risk of default is lower. In March, the Federal Reserve intervened in the credit markets to prevent a ‘credit crunch’, buying not only investment-grade bonds (bonds rated BBB or higher) but also buying ‘junk’ bonds or bonds that have a lower credit rating. This sparked a rally in the equity markets as it was seen that the Federal Reserve would ‘step in’ to prevent large-scale defaults, and improved investor sentiment.
This could increase leverage levels for companies not only in Consumers, but across all sectors, and the consequences are unclear. There is concern that there could be a problem of moral hazard. In this context, moral hazard means that companies may take excessive risk as they do not have to bear full consequences of this risk. For example, companies could overleverage to drive growth and then expect the Federal Reserve to step in and prevent default if things go awry. It is unknown if the Federal Reserve is willing or able to step in continually to intervene if defaults due moral hazard becomes a widespread problem. It is also unknown if, or when the markets will react to this.
It is incredibly difficult to predict macro trends accurately, and even macroeconomists get it wrong a lot of the time. However, these macro-related risks above need to be highlighted so that we may have an optimistic, but at the same time cautious outlook on the sector and the macroeconomy.
ETFs & PRICE TARGETS
Finally, we conclude by looking at some ETFs to take note of.
Vanguard Consumer Discretionary ETF (NYSE: VCR)
|Key facts||Top 10 holdings (53.90% of total net assets)|
|Stock exchange – NYSE |
Index tracked – S&P 500 Consumer Disc. Index
Fund total assets – $4.1 billion
NAV (as of 27/11/2020) – $262.84 (discount of $1.56)
Market Price (as of 27/11/2020) – $264.40
Expense ratio – 0.10%
This ETF offered by Vanguard has its key advantage in its low expense ratio at 0.10%, while being exposed to some companies that are poised for strong long-term growth.
If we look at the 10 largest holdings, we can see quality companies that will do well in the long term. Amazon has shown to be incredibly dominant in internet retail and delivery services. Companies such as McDonald’s, Starbucks and Target have beat earnings expectations this year and have shown that their earnings are resilient even in difficult macroeconomic conditions. This ETF also includes, with substantial holdings Lululemon Athletica and Best Buy, 2 companies that have succeeded with a strong online retail presence and unique business models.
Given that the ETF has already appreciated in price above levels seen in February, we should be conservative, however with our price target. A price target of $300 within the next year is not unrealistic, given that constituent companies will continue to see strong growth.
Invesco Dynamic Leisure and Entertainment ETF (NYSE: PEJ)
|Key facts||Top 10 holdings (47.5% of total net assets)|
|Stock exchange – NYSE |
Index tracked – Dynamic Leisure & Entertainment Index
Fund total assets – $471.4 million
NAV (as of 27/11/2020) – $37.34 (discount of $0.16)
Market Price (as of 27/11/2020) – $37.50 Expense ratio – 0.69%
|Domino’s Pizza |
Warner Music Group
Chipotle Mexican Grill
Penn National Gaming
This ETF offered by Invesco has a higher expense ratio at 0.69% but is worth considering given that most of its constituent stocks are cyclical and will likely rebound strongly once leisure travel resumes. For example, Disney, Hilton Worldwide and Penn National Gaming are stocks that will see an increase in demand once again when vaccines are rolled out and travel resumes. Furthermore, stocks such as Domino’s Pizza and Yum China continue to see strong secular growth, particularly in Asia where Domino’s and Yum China are rapidly expanding. Thus, it is not unreasonable to see the price of this ETF appreciate even more over the long term, given that it is still trading at a 25% compared to February of this year. We set a price target of $45 with a 1-year horizon, which is the price the ETF was trading at pre-pandemic.