It’s conventional wisdom for investors to flock to staples stocks in times of strife, and there’s certainly a lot of that around at the moment. 
Between Russia’s war with Ukraine, rising inflation and the resultant cost-of-living squeeze, it’s difficult to see the good news.
Staples stocks are viewed positively by investors during periods of uncertainty as they tend to sell the products we need rather than just want.
But that doesn’t mean they’re always good value and the multiples on several staples stocks being paid by investors right now could come back to bite them.
The level of earnings growth required to justify these valuations seem upbeat at best and fantastical at worst.
Questionable prices
I believe that the defensiveness of certain staples stocks will be truly tested in the months to come, as the squeeze on consumer finances and rising input costs are likely to damage the earning power of various staples businesses, particularly fast-moving consumer goods (FMCG) companies.
The UK staples sector is currently trading on a price to earnings (P/E) ratio of roughly 15x time, which is slightly below the pandemic-fueled high of around 17x*, but still too elevated for the macroeconomic environment, and priced on earnings expectations we believe to be too high.
Investors are essentially expecting the brand loyalty towards these firms to overpower the spending concerns of households.
At these levels, that simply feels too risky, which is why the only area of the staples sector that does remain attractive in our view is supermarkets.
That’s because these businesses sell a range of brands, and when purse strings are tight, consumers can trade down to own-brand labels owned by the supermarkets.
With the consumer price index measure of inflation rising 9.4 per cent in the 12 months to June, according to the latest data from the Office for National Statistics, it’s likely many households will alter their buying habits, particularly with the energy price cap in the UK set for another significant move higher in October.
Discounted brands in mainstream supermarkets are likely to become more popular, while discount chains are also likely to prosper.
With inflation likely to remain at elevated levels for at least the remainder of the year, it’s likely that the earnings levels of certain consumer-facing stocks will come in lower than expectations, prompting earnings downgrades.
Navigating inflation
Given our view on inflation, it’s difficult to see how energy prices will move materially lower in the short term, because the supply/demand imbalance is exacerbated by years of under-investment in energy infrastructure, something that cannot be rectified quickly.
It’s also extremely difficult to immediately replace Russian energy supplies from other sources of existing production, so while sanctions remain, energy prices are likely to remain stubbornly high.
Importantly though, we’re backing companies in the energy space that are investing heavily in low hydro-carbon fossil fuels as well as renewable energy.
Seeking the ‘tried-and-tested’
Besides identifying investments that can benefit from rising inflation, it’s also important to gain exposure to areas where its impacts are minimal.
Healthcare real estate investment trusts (Reits) are one such opportunity, in our view, as they are not overly impacted by the macroeconomic landscape or the inflation story.
The drivers of the health service, including an ageing population and tackling the backlog of patients built-up during the coronavirus pandemic, are not going away quickly; governments will always win points for building more GP surgeries, medical centres and hospitals, making this area mostly non-cyclical.
In these challenging times, it’s important for investors to identify ‘short duration’ ideas, those businesses where their existing operations are well-established, and the cash being generated by them is solid and sustainable.
In uncertain times, it doesn’t seem logical to exacerbate that uncertainty by backing companies with untested business models or those that need consumers to ignore their challenging financial circumstances in the name of brand loyalty.
Oisin O’Leary is co-portfolio manager on the New Capital Global Equity Income and New Capital Dynamic UK Equity funds. The views expressed above should not be taken as investment advice.
*Source: Factset, MSCI United Kingdom Consumer Staples index, as at 14 Jul 2022.