Warren Buffet famously described companies that “buy commodities and sell brands” as the sort of business model in which he likes to invest. The consumer staple companies certainly fit this description. Their products – basic personal or household items such as shavers, toothpaste or washing-up liquid – are cheap to produce, but sell at a relative premium, packaged in ubiquitous brand names that completely dominate supermarket shelf space.
In the jittery macroeconomic environment of recent years, these companies have become safe haven investments. As investors bid up the price of their seemingly reliable cash flow and dividend streams, consumer staples have significantly outperformed the stock market. Some commentators even refer to them as “the expensive defensives”.
However the outlook for these companies as investments may be far less rosy than the experience of recent years would suggest. I see two headwinds:
First, powerful long-term structural changes in consumer behaviour are slowly undermining the dominant position currently occupied by many consumer staple brands. The vast majority of basic household products are still purchased on the high street, but e-commerce is growing rapidly in this space. Experience from other industries suggests that scale is the critical factor here. The manufacturers of products where usage is regular and predictable, and shipping costs are low, have shown themselves to be particularly vulnerable to disruption. Witness the recent success of Dollar Shave Club in the US as a model of things to come.
These changes won’t destroy the consumer staple business model in the way they have for many high street retail brands. The problem is growth – or lack of it. As e-commerce penetration increases, I think it will be harder for consumer staples to sustain their already fairly pedestrian growth rates.
Again, experience from other industries suggests it is not the incumbents who capture this new online growth, but the more innovative and recent entrants to the market. One solution is to acquire this growth, as Unilever has with its recent purchase of Dollar Shave Club. Yet this comes at the cost of diluting the firm’s overall return on capital, since these acquisitions will only be possible at very high valuations.
Another solution is to buy each other. In the last few weeks, Reckitt Benckiser has agreed to acquire Mead Johnson and Kraft Heinz has attempted – but failed – to buy Unilever. These deals are about cutting costs and leveraging balance sheets in order to create a more attractive earnings growth trajectory. Investors are cheering this today, but these deals are also being done at high valuations. It remains to be seen how much genuine value can be created when five or more years of perfectly executed synergies are required to justify deal financial metrics.
The second major headwind is valuation. Within the UK stock market, the household products sector trades on a price to earnings ratio of over 20 times, with a free cash flow yield of barely 4%1. This is a rich valuation in absolute terms and a significant premium to the wider UK market.
Bulls will point out that the sector has always commanded a premium valuation by virtue of its “quality” business model characteristics. This has certainly been the case in recent years, during which time these companies have mostly performed pretty well operationally. Such high valuations reflect a perception of stability and predictability, against a backdrop of a cyclically and structurally uncertain world. But these valuations are unlikely to be sustained if investors seriously start questioning the long-term growth profile of these companies.
An additional factor to consider when reflecting on these companies’ high valuations is the role of monetary policy. Since the financial crisis began in 2008, interest rates around the world have headed ever lower. As a result, investors have been forced up the risk curve to find income-producing financial assets. With many of the traditional yield paying sectors such as banks and energy disappointing, it is easy to why the consumer staples sector has attracted a scarcity premium. This effect is impossible to quantify, but is certainly something to keep it in mind, particularly as US interest rates look set to head higher over the near term.
One of Benjamin Graham’s great contributions to investing was ‘Mr Market’ – the concept of a psychopathic individual with a tendency to swing from delusional optimism to unreasonable pessimism. Today, Mr Market is singing the praises of consumer staples far and wide. With the ingredients all in place for a very different view down the line, some investors may feel they wish to take advantage of Mr Market’s current mood while it lasts.
1. Source: Morgan Stanley estimates, March 2017