It has become an almost religious consensus among fund managers that the large, consumer packaged goods companies are such an attractive investment that they now form a key part of many portfolios. 
But what have been the reasons behind their long term outperformance, and can this persist?
In the early part of my career sectors such as tobacco, household products and beverages were regarded as unattractive and as a consequence were at much lower valuations than the broader market.
However, for many years now these areas have been very much in vogue, initially because growth was expected to accelerate as consumers in emerging markets added to demand. More recently the attraction has been relatively high dividend yields and strong dividend growth.
Performance of indices over 10yrs
Source: FE Analytics
The market clearly believes that these stocks are set to have attractive dividend growth for the foreseeable future, but it’s important to consider what has been driving this dividend growth.
We looked at 16 of the most popular companies in this area, such as Coca Cola, Unilever and Philip Morris, which add up to a combined $2trn of market value. Over the past five years they have delivered close to 10 per cent annual dividend growth, a not unimpressive feat.
The growth hasn’t been fuelled by the supposed driver of growing end markets in the emerging world, as sales growth for the above group has been near zero for most, and in many cases negative. Nor has the growth been driven by improving profitability, gross profits (before interest, tax and depreciation) have been growing at less than 2 per cent.
What has been happening is debt has been growing to fund acquisitions and share buybacks, while interest costs have been falling as rates go ever lower.
In fact, debt for the group has grown at over 8 per cent per annum while shares outstanding have fallen and hence, earnings per share have been growing rapidly. So, the dividend growth we have seen has largely been driven by financial engineering not a fundamentally attractive business model.
The argument for these companies’ shares will come down to whether these trends can persist and their relative attraction compared to other investment possibilities.
Clearly, the group overall still has debt levels which remain comfortable, particularly given the search for yield in the fixed income market. Gearing up further to sustain dividend growth remains likely, although further large falls in the interest costs are now unlikely as yields worldwide are already so low.
So, dividend growth will likely slow from past levels as the companies cannot squeeze the lemon forever. The opportunity to engineer dividend growth remains but not at the levels of the past.
The group now yields about 3 per cent and market estimates suggest continued dividend growth of 8 per cent over the next three years, which seems implausible over a longer period given that at least one of the drivers of past growth, falling interest costs, is no longer available.
Growth in the future must come from top line growth or increasing debt burden. Simply borrowing money to pay dividends should not be seen as a value adding strategy.
Arguably, the golden era for these companies is coming to an end so we are now much more selective in what we hold in this area.
In absolute terms perhaps a 3 per cent yield growth at only 2 per cent looks attractive given that these are unarguably low risk businesses. But are they the best opportunity for investors right now?
Recently more cyclical parts of the market have started to do well as have higher growth areas such as technology and emerging markets.
This reflects the markets’ view that economic growth is looking less challenged and, therefore, investors have been more prepared to take risk. So, perhaps the defensive stocks are not overvalued, simply other areas now look attractive in comparison.
Performance of indices in 2016
Source: FE Analytics
We doubt we will ever sell out of these areas completely as the absolute attractiveness of a slow growing 3 per cent yield makes sense in the long run, but as total return investors we have to accept that dramatic outperformance of this area versus other equities cannot persist forever.
David Jane is head of multi asset at Miton. All the views expressed above are his own and should not be taken as investment advice.
