In times of economic or political stress it is always good to have defensive, iconic consumer stocks in the portfolio – at least this “common wisdom” applied in the past. However, during the current market decline which in technical terms was not even a correction (the peak to trough drop was less than 10%), the overall sentiment already showed first signs of a panic. Not only that, the highly praised “defensive” stocks actually lost disproportionately. How come? And was it foreseeable?
Summary and key takeaways from today’s Weekly
– Consumer stocks are loved by “defensive” retail and even professional investors.
– However, these stocks had excessive valuations and still are not cheap to justify a buy.
– Valuations and debt always matter. Selling overvaluation and buying undervaluation is the way to go, even though many don’t understand it.
Who hasn’t heard of it?
When markets are richly valued or in times of insecurity due to political and / or financial stress, it was almost always a good move to preferably pick defensive consumer stocks of iconic companies, instead of cyclicals like tech, industrials, energy or materials (btw, it is a common misconception that commodity stocks always decline during broad market corrections as I have written here).
The arguments for consumer stocks were as simple as straightforward.
One has to drink, eat, wash oneself and clean the house no matter the state of the economy. In some cases also smoking and drinking came on top. The strategy was not only to lose less than the overall market, but also to collect dividends in the meantime to raise cash in order to buy stocks after the correction was over.
Bear markets usually last several quarters, hence it might not be over, yet.
But we can already make an interesting observation. These businesses are pretty robust – however, the stocks this time, to the surprise of many pundits, have lost even disproportionately during the current market decline. Even more surprising is that e.g. the S&P 500 technically has not even entered correction territory, yet, which is defined as a drop of at least 10%.
From the early-August peak until the recent low, the drop was not even 10%.
Anyway, I don’t care what the broader market does. My members receive my exclusive stock ideas which are experiencing tailwinds and some even have way above average dividend yields. And yes, valuations are attractive, too.
So what’s up with many of these consumer stocks with often iconic names?
Although I was a bit early, did not pick necessarily the right headline and despite not all names from my list having dropped more than the S&P 500, in my Weekly from 10 November 2022 (“the last dominos to fall”, see here), I warned about having too much faith in the pretend ever-lasting robustness of consumer stocks.
The reason: every stock, no matter the business, can be too expensive.
Likewise, historically there have always been sector rotations. If you haven’t already, please read this Weekly where I explained them (“What you should know about ETFs and dividends”, see here).
Too high valuations sooner or later (often later) cause frustration because the stocks underperform. It can be a disappointing earnings outlook or just nothing special because everything good and better was already priced into the stock.
During the era of zero to near-zero interest rates, one could buy nearly everything.
But with interest rates back up, these times are over. Obviously, previous excesses must be corrected. Today, we are going to have a look at some consumer stocks and I am also going to check which of my candidates from a year ago were affected – or not.
Keep in mind: valuations always matter.
Many of my stock ideas have not even recognized any market decline.
No matter the short-term noise, my ideas are chosen to outperform on average over a mid to long-term window.
Currently, they are even increasing their outperformance.
as per 18 October 2023 market close
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Interest rates and valuations
Originally, I wanted to write this article already a few months ago.
I had several bullet points in my notes, but I did not write the Weekly, because I managed to find more interesting topics. What finally triggered me to catch up with it was a piece from last Monday’s edition of the Wall Street Journal newsletter.
Here is a screenshot:
source: WSJ newsletter 16 October 2023
My long time readers will know instantaneously that it was not the headline that made something inside of me work, but the following text passage with the explanation.
It falls short of the key issues.
While I agree that interest rates are higher again and that many of these stocks are primarily bought for their reliable dividends, I am missing some key elements in the three paragraphs.
No word about:
- development of free cash flows
For a complete picture, however, these should be taken into account.
But first a few words on “consumers are starting to exercise more caution with their purchases” which is nonsense, because it did not happen just right now.
Despite higher sales which were mainly a result of price increases, volume growth was at best erratic or even showed negative figures already in the years prior, so this cannot be now the reason. Also, due to margin pressure, higher sales did not translate into higher earnings or cash flows.
Just a look at the free cash flows of some consumer companies. It clearly shows they have been moving at best sideways, many have been in decline already for longer.
You can see that inflation already trended higher more than two years ago.
I used the US inflation numbers, but it was not that much different in other countries.
Another missing piece is that the S&P 500’s performance this year (and for a good chunk of the last decade) was due to the massive outperformance of tech stocks, especially Big Tech, as they depending on how one calculated have achieved a total weighting of 25–35% of the whole index!
But now back to the bullet points from above.
Interest rates are key to the fair value of any asset.
The housing market has already experienced it as activity in many areas has almost frozen because mortgages have become too expensive.
With higher interest rates, the alternatives to more volatile (some say risky) stocks are here back again. So, why buy a dividend stock with barely any earnings / cash flow growth and a dividend yield of just 3% when you can have 4% or even more by just holding cash in your brokerage account?
Of course this is somewhat simplified, as it likely is not the best idea to hoard big amounts of cash, but it illustrates the key issue.
If the easy alternatives are back in the game, risk-off usually is the go-to strategy.
Serious investors, especially from the value corner, do not define risk as a measure of volatility (more volatile = more risky), but instead by the valuation of an asset.
In other words, with higher interest rates and more lucrative “easy” alternatives, valuations of stocks in this case must be cheaper to justify a buy and to offer a decent enough margin of safety.
The reciprocal value of an interest rate is its expected valuation multiple. Replace the interest rate with a return expectation. With 5% expected returns and no growth, the valuation multiple is 20x. And yes, sales growth does not count, earnings or better free cash flows have to grow. Prior with say 3% interest rates, the multiple was a lofty 33x.
This is a huge difference of nearly 40%.
Interest rates are used to allocate capital towards its most efficient use and to manage risk.
Though I am not saying that this group of stocks will fall by 40%, the absurdly high and excessive valuations had to be corrected. And this is what is happening, no matter what pseudo-explanation is used.
Let’s have a look back at the companies I had on my list nearly a year ago to see how they developed (EV / FCF = enterprise value / free cash flow):
|name||performance since |
08 November 2022
(until latest available per 16 October)
|EV / FCF then||EV / FCF now|
|Procter & Gamble*|
|Johnson & Johnson*|
|on average||+3.7%||35x||37x |
|*consumer stocks on average||–13%||35.6x||26x |
I did the mistake to not use just pure consumer stocks in the sense of everyday physical products, but I also included other richly valued companies.
Just looking at the consumer stocks, I was right.
Since my Weekly in November 2022, this selected group has declined on average by 13% (yes, including dividends), though Dollar General was a clear accelerator to the downside. But even without it, the best performer was Procter & Gamble with a total return of just 8%. The rest is way below that.
Anyway, the average multiple has come down substantially. Time to jump in?
Nonetheless, 26x means an expected return of 4% while interest rates are higher than 5%. From a deal-maker perspective, this is still not sufficient, despite many calling to buy aggressively every dip. Personally, I think these stocks are not interesting for as long as they don’t fall below 20x multiples. Otherwise, the expected return is too low with the current interest rates.
Dividend yields of below 5% don’t excite me in this environment. I am by no means under pressure to get active on this front.
The same applies to other companies from the sector which I did not have on my list like
- Kraft-Heinz (ISIN: US5007541064, Ticker: KHC)
- Hormel Foods (ISIN: US4404521001, Ticker: HRL)
- Smucker (ISIN: US8326964058, Ticker: SJM)
- or Hershey (ISIN: US4278661081, Ticker: HSY).
All had excessive multiples without meaningful growth.
source: all Seeking Alpha
All dropped like stones in the bigger picture, despite having been seen by many as nothing-can-go-wrong stocks. Sorry!
I had to laugh that over the last weeks the argument of the new wonder-drug Ozempic from Novo-Nordisk (ISIN: DK0062498333, Ticker: NOVOB) came to the surface. Because of it helping obese people to lose weight, these people shall suddenly stop or dramatically reduce consuming unhealthy food.
Maybe slightly provocative, but would this not be an incentive to consume even more cola, chocolate, fried and potato chips, because you lose the pounds later again anyhow?
Anyway, be on guard for the next bubble. I am talking about Novo and Eli Lilly, which also was in the news for the same reason. Not only am I skeptical about the long-term effects, but leaving this aside, the respective valuations already have priced in a huge success.
Where’s the upside?
The last point I want to comment on is debt, but just briefly, as I have already written about it several times in other Weeklies. Although I am not expecting bankruptcies among these companies, at least no immediate ones, the majority of them has taken on lots of leverage in the past, mainly to repurchase their own shares.
But now exactly these repurchases – at not seldom lower stock prices now – are dialed back or stopped altogether, as cash flows are under pressure.
This should drag on stock returns. Dividend increases if at all shall be more symbolic.
As they also have in many cases high payout ratios and would want to continue to pay, hold or even increase their dividends, it is likely that with now higher refinancing costs growth will be even more limited, effectively justifying even lower valuation multiples.
Let’s have a look at net debt / EBTIDA (I don’t like it, but it is commonly used):
|name||net debt / EBITDA|
|Procter & Gamble||1.2x|
|Johnson & Johnson||0.5x|
You can look around, all indebted companies are at least held back.
Depending on how their debt is structured, whether bigger parts have variable interest rates or bigger near-term maturities are waiting, these are clearly not the best ideas I am keen on jumping in.
Far from it.
The reason I don’t like EBITDA is it’s before interest rates. As those have risen dramatically, but do not affect EBITDA, this figure is masquerading the true picture. What has already started to happen will continue to be the case for as long as interest rates stay higher, is that net results and cash flows will be negatively impacted.
(Free) cash flows repay debt, not EBITDA.
It will be interesting to watch, but I am clearly staying away here, no matter how loud the voices to buy the dip of these “wonderful” companies. I would even go as far as many if not most of these companies already have their best days behind them and won’t be good investments anymore, at least not at such valuations and levered balance sheets.
By the way, many of the stock ideas I presented to my members are sitting either at or near their all-time highs – they are not interested what the broader market does or what “safe quality stocks” do. Some of them even pay dividends with double-digit yields and do not have any debt worries.
Consumer stocks are loved by “defensive” retail and even professional investors.
However, these stocks had excessive valuations and still are not cheap to justify a buy.
Valuations and debt always matter. Selling overvaluation and buying undervaluation is the way to go, even though many don’t understand it.
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