These companies have been very popular with investors over recent years as the common view is that they can continue to perform well no matter how the general economy is performing due to steady demand for their products.These stocks also tend to pay a well-covered dividend, which has made them attractive to “refugee” fixed income investors looking for an alternative to bonds.
However Costar (pictured), who manages the £297m JOHCM UK Growth fund, has no exposure to them within his portfolio as he says there are a number of reasons why they will disappoint investors in the future.
“If you were to ask me what is the most dangerous area of the market for underperformance, I would say consumer staples,” Costar said.
“They have the very unhappy combination of structural margin growth pressures and high valuations.”
The major problem Costar has with consumer staples is that most investors think that they are safe equities that will perform well in all market conditions. This perception has inflated their share prices by a significant amount.
“Consumers are switching from premium products to lower, home-value products. This is always a late-cycle shift,” he said.
“Investors, wrongly in our opinion, think these companies are extraordinarily resilient and can keep growing no matter the economic outlook. Our argument is that they are not, there is simply a huge lag.”
“Consumers act in the opposite way to corporates in many respects. In a downturn, corporates quickly cut down their number of employees, mothball capex and de-lever their balance sheets. Consumers are only doing this sort of thing now.”
“The one argument we use to show this is happening is: why did Aldi and Lidl see 30 per cent sales growth last year, but not in 2009? Consumer staple growth margins will have to come down,” he added.
As FE Trustnet recently highlighted, many of the worst-performing stocks so far this year are defensive UK mega caps such as Unilever, Diageo and SABMiller.
Performance of stocks in 2014
Source: FE Analytics
The major reason for this, experts say, is because they derive a large proportion of their earnings from emerging economies which themselves have had a tough start to the year due to concerns about slowing growth, the Fed’s tapering of QE and currency weakness.
Costar agrees that a number of the consumer staples' emerging markets exposure could be a problem going forward, but he says there is also a combination of headwinds that makes them poor investments at this point in time.
“Emerging markets are not only slowing and have currency weakness, but the consumer staples are facing increased domestic competition from those markets.”
“These companies have highly elevated share prices, overly complacent investors and structural growth margin pressures. History tells us this is a pretty dangerous combination. I have no Diageo, tobacco stocks or Unilever. That’s about 12 or 13 per cent of the index.”
FE Alpha Manager Jan Luthman recently told FE Trustnet that he doesn’t have any exposure to tobacco either, as both political and social attitudes have hardened against smoking.
Costar has managed the JOHCM UK Growth fund since its launch in November 2001.
According to FE Analytics, it is a top-quartile performer in the highly competitive UK All Companies sector over that time with returns of 242.28 per cent, beating its FTSE All Share benchmark by more than 120 percentage points.
Performance of fund vs sector and index since Nov 2001
Source: FE Analytics
It also boasts top quartile returns over one, five and 10 years.
It sits in the second quartile over three years, which is due to the fact it lost 17 per cent in the falling market of 2011.
Costar told FE Trustnet last year that he was also concerned about high valuations in UK mid caps.
He says that the major reason why the FTSE 250 is now over-populated is because small cap investors have moved up into mid caps for liquidity purposes while large cap managers have moved down to find alpha.
Costar says the result of this is that there are now some excellent value opportunities in the smallest and the largest parts of the FTSE All Share.
“One stock we have been buying recently is AstraZeneca, which fits our criteria of mispriced or undiscovered growth,” Costar explained.
The manager says that past prejudices about the pharma’s drug-pipeline have left the company very out of favour.
However, he says it is focusing more and more on R&D and it will once again be one of the world leaders in medical innovation.
At the other end of the UK market, Costar is particularly bullish on Gresham Computing, which has a market cap of less than £80m.
The manager likes the stock because of its potentially disruptive technology called CTC (Clareti Transaction Control) which allows businesses to quickly identify and resolve operational risks, reduce financial transaction losses, optimise business performance and comply with regulatory requirements.
Costar says that it can match 50,000 transactions a minute and is already being used by large investment banks such as UBS and Standard Chartered.
“This is a potentially massive opportunity and could be a two, three or four bagger for us, if it is executed successfully. They do have very sensible management and net cash on the balance sheet,” Costar said.
“CTC already has very wide appeal and that should continue due to regulatory pressures. Gresham Computing is already rapidly expanding its sales pipeline but its sales cycle is getting shorter and shorter,” he added.
Costar’s JOHCM UK Growth fund, which is domiciled in Ireland, requires a minimum investment of £1,000 and has a total expense ratio (TER) of 1.33 per cent.
However, like other JOHCM funds, it has a performance fee of 15 per cent of any outperformance against its benchmark.
