The underperformance of consumer staples stocks since the end of 2016 isn’t just a blip but the start of a longer-term decline as tightening monetary policy removes the tailwind that has driven the sector to such elevated levels since the financial crisis.
This is according to Bettina Edmondson, global investment analyst at Saracen Fund Managers.
Data from FE Analytics shows that the MSCI World/Consumer Staples index made 193.44 per cent between the start of 2008 and the end of 2016 compared with 104.72 per cent from the MSCI World index. This coincided with the era of ultra-low interest rates and quantitative easing, which suppressed yields on bonds and pushed income-seeking investors into defensive dividend-paying stocks, pushing up valuations.
Performance of indices 2008 to 2017
Source: FE Analytics
However, the Federal Reserve’s decision to speed up rate hikes – it raised them four times between December 2016 and December 2017, compared with just once in the preceding 12 months – has begun to act as a drag on the sector.
Data from FE Analytic shows the MSCI World/Consumer Staples index is down 6.03 per cent since the start of last year, compared with gains of 5.75 per cent from the MSCI World, and Edmondson said this divergence will only widen in the coming years.
Performance of indices since 2017
Source: FE Analytics
“For many fund managers, valuation is at the heart of everything they do,” she explained. “Many believe buying a good business at an inflated valuation is a poor investment and we have long talked about the stretched valuations for many businesses in the staples sector, where the appreciation in their share prices appeared more related to their comparison to bond yields, rather than any improvement in their earnings outlook.”
“The tide has now turned. Global economic growth has persisted and there is less requirement for central banks to buy bonds to depress interest rates. The Fed has turned from a net buyer of bonds to a net seller and the European Central Bank [ECB] has reduced the amount of bond buying. The combination of these factors has led to a fall in bond prices and rise in yields. This process towards normalisation still has some way to go. We would expect this scenario to maintain downward pressure on bond prices.”
Edmondson (pictured) added that the underperformance of the consumer staples sector since the start of 2017 can also be attributed to disappointing results from the underlying businesses. This derating, as measured by a declining price-earnings ratio, has accelerated since the start of this year and the analyst said that with competition remaining fierce, she expects earnings growth to remain subdued.
This combination of headwinds has led to further problems for consumer staples. Edmondson claimed that dividend yields in the sector are not sustainable and highlighted Coca-Cola as an example of a company that is using leverage to fund payouts to shareholders.
“Over the last five years, Coca-Cola has reported declining earnings per share (from $2.12 in 2013 to $1.93 in 2017), yet its dividend increased every year (from $1.12 in 2013 to 1.48 in 2017),” she said.
“Looking at the cash flow statement, the total dividend payment from the company represented 62 per cent of free cash flow in 2013. This rose to 119 per cent in 2017.
“It is quite clear that the only way Coca-Cola was able to continue its progressive dividend was by increasing its leverage. In fact, over the last six years its net debt to EBITDA [earnings before interest, taxes, depreciation and amortisation] ratio rose from 1.2x to 3.1x.”
Not everyone is so pessimistic about the prospects for Coca-Cola. Data from FE Analytics shows seven funds in the IA universe hold the stock in their top-10, as do two trusts in the AIC universe. One of these is Henderson International Income, whose manager Ben Lofthouse said his enthusiasm for the stock can be attributed to the fact he “likes turnaround situations”.
“Coca-Cola is a business that is in transition,” he explained. “This will surprise some given that it has been around for so long. It has been restructuring to change the business and drive returns on investment higher, and part of that process has required investment.
“If successful returns will improve, capex will fall from current elevated levels and cash flow will improve significantly.”
However, Coca-Cola is not alone in adding leverage. Edmondson noted that net debt in consumer staples has tripled since 2009 from 1x to 3x, while the rest of the market has de-levered from 5.3x to 3.3x. While part of this increased leverage was used to return money to shareholders via dividends and share buy-backs, the analyst said some companies also increased borrowings to acquire businesses at stretched valuations to bolster underwhelming top-line growth.
“For example, AB Inbev’s net debt/EBITDA rose to 6.6x after the SABMiller acquisitions,” she continued. “Reckitt Benckiser bought Mead Johnson with debt (and equity) and geared up to 3.7x, while Danone’s leverage ratio reached 4.2x after it acquired WhiteWave. The list goes on. Extended leverage ratios can be accommodated in high cash-generative businesses. However, cash generation within the staples sector has slowed in recent years.
“When interest rates rise and companies have to refinance their relatively stretched balance sheets at higher interest rates, there will be an impact on earnings and cash flow. It is possible that dividends will be under pressure.”
All this is happening at a time when the fundamental backdrop for fast moving consumer goods companies has deteriorated. Edmondson said she has long argued that top-line growth expectations are optimistic and that while the average sales growth over the last 10 years is 5 per cent, this has been inflated by the emerging market boom in the early 2000s – over the last five years this growth rate has more than halved to 2.3 per cent.
“We do not believe we are going back to the 5 per cent growth rates that many investors are expecting,” she continued.
“Many companies are experiencing increased competition from niche players who are more nimble and better attuned to consumer needs and wants.
“In particular, e-commerce is offering greater choice to consumers and negating economies of scale. When volumes are persistently low, especially in developed markets and when pricing power is eroding, revenue growth is under pressure.”
Edmondson said she accepts that some consumer staples stocks are among the world’s best-run companies and Saracen expects to own them again in the future, but this would be at a price that more suitably reflects their earnings growth.
“However, the combination of increased leverage, still elevated valuations and a subdued growth outlook, means that we still think it’s too early to reinvest,” she finished.