Due to the nature of the companies that compose the consumer staples sector, business conditions tend to be very stable from quarter to quarter.
During the past six months, the key secular trends that have been in place for the past several years by and large have continued. For example, sales volume growth in the sector continues to be roughly in line with population growth in developed countries, but it’s been faster than the population growth in emerging-market countries, where GDP growth has been stronger and consumers continue to adopt certain staples products as their income levels rise.
Meanwhile, on a global basis, pricing levels on average continue to remain roughly in line with the rate of inflation.
More mature countries in North America and in western and southern Europe have been among the most sluggish areas of the world in terms of growth for multinational consumer staples companies. 2012 organic sales growth for one major multinational personal products manufacturer was roughly flat (0%) in Europe and up 2% in North America, but was 8% to 12% higher in emerging-market countries, for instance. Part of the reason for the slower pace of sales and earnings growth in these more developed regions is because most consumers generally don’t need to buy materially more staples products than they already consume.
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But the moderate growth seen in these areas also reflects less-than-desirable economic trends, such as weak employment and income growth, and lower consumer confidence. As a result, consumers have been somewhat more frugal, leveraging coupons and sales, which can result in pressure on the profit margins for staples manufacturers.
Although most multinational staples companies continue to indicate that the sales environment remains sluggish and subdued in western and southern Europe, recently more companies have expressed signs of improvement in the U.S. relative to the domestic business climate of the past couple of years.
In addition, many companies continue to report that sales growth in the emerging economies of the world continues at a very attractive pace, which is encouraging.1 The sector’s exposure to faster-growing emerging-market economies, such as in China and India, likely had a significant influence on staples companies’ favorable earnings results in the fourth quarter of 2012.
During this period (Q4 2012), consumer staples companies, on average, generated better-than expected earnings growth according to the expectations of Wall Street analysts going into the quarter (see chart right). In fact, it was the first quarter of surprisingly better earnings since 2011.
One reason for this improvement is that foreign currency exchange rates were having a negative impact on the earnings of many U.S. consumer staples companies throughout the first three quarters of 2012, but this headwind largely disappeared in the fourth quarter. The weakening of foreign currencies relative to the U.S. dollar—as took place in early 2012—causes the foreign earnings of U.S. companies to decline in U.S. dollar terms, which is how they are reported by the companies.
Commodity input costs may be less volatile
The cost of commodities that serve as inputs to staples products can influence the profitability of staples manufacturers. During the past few years, the costs of several commodities—such as petrochemicals, plastics, pulp/lumber, and agricultural inputs—have been quite volatile and biased toward the upside. In 2012, the prices of agricultural and food-related commodities soared due to the most severe drought conditions in the U.S. since the 1980s, which curtailed supply.2
High input prices can put significant pressure on the profit margins for companies that aren’t able to fully pass along higher costs in the form of higher prices on products to end-market consumers. It’s also important to note that many companies choose not to raise their end-market pricing to fully reflect massive increases (which results in less profit) or decreases (which results in more profit) in commodity costs over short-term periods; recognizing an unusual period of volatility, some companies often refrain from raising or lowering prices too severely, as they may expect input costs to moderate over time. However, such an environment can lead to more volatile earnings over the short term.
In my discussions with several companies that are locking in commodity contract prices for the coming year, there is the expectation that input costs will increase in the low single-digit percentage range in 2013. If this turns out to be the case, it would be a more benign and less challenging inflation environment than the more volatile backdrop of the past few years. Less volatility in commodity input costs helps to provide more consistent earnings growth and allows investors to get clearer visibility into the profitability of staples businesses. The investors who tend to allocate capital to this sector generally are looking to benefit from its historical pattern of providing more stable earnings growth offered by consumer staples relative to other sectors.
The valuations of consumer staples companies remain reasonable. In aggregate, the sector’s price-to-earnings ratio (forward earnings) stood at about 15.4 as of Feb. 27, 2013, below the 25-year average of 17.0 (see chart below). Comparing this valuation ratio to that of the broader U.S. equity market (14.2 P/E), stocks in the consumer staples sector are currently about 8% more expensive than the market as a whole, which is slightly below the 25-year average of staples stocks being 10% more expensive than the market as a whole.
Staples stocks have tended to trade at modest premiums to the stocks in other sectors, due in part to the historically more attractive balance of earnings growth and earnings consistency that businesses in the sector have produced. During periods when investors have been unusually fearful and risk-averse, they have tended to put a higher-than-normal value on staples stocks, and the relative valuation premium for the sector has tended to be higher than normal.
On the other hand, during periods of investor optimism and complacency, they have tended to assign less value to staples stocks, and the relative valuation premium for the sector typically was lower than normal. The fact that the sector’s current valuation is roughly in line with its historical average versus the broader market is a sign that investors’ current levels of optimism/ pessimism are fairly well balanced.
Outlook for consumer staples stocks
While business conditions generally remain favorable for staples companies, there are always risks to be mindful of. Any significant business disruption in emerging markets—such as an unforeseen geopolitical event or a deceleration in economic growth—would derail an important driver of earnings growth for many companies in the sector.
Meanwhile, investors should always keep a close eye on pricing trends. Periodically in this sector, a specific company that is struggling and perhaps losing market share in a key product category decides to significantly cut pricing to spark demand. When this occurs, very often other competitors follow suit and match the lower price levels. Such a trend can hinder overall profits in a specific industry, as well as stock prices.
From a fundamental business standpoint, however, I expect the remainder of 2013 to be a fairly typical year for consumer staples. Investors are likely to experience single-digit earnings growth and a dividend yield in the range of 3%—which historically have been supportive of stock prices.
There are a variety of reasons to be optimistic. Recent trends in emerging markets continue to provide comfort that the healthy earnings growth rates for multinational staples manufacturers seen during Q4 2012 can continue. Signs of economic improvement in North America also brighten the outlook for profits, and may offset existing economic weakness in Europe. Furthermore, a more benign commodity price backdrop may also lead to modest profit margin growth.