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Sector Performance The Big Picture Sector Rotation By contrast, consumer staples stocks tend to perform best in the middle to end of the economic cycle. Historically, a year to 18 months after a major market bottom (exactly where we are at right now), tech stocks’ outperformance begins to moderate. By that time investors have already priced in large earnings recoveries for these names and valuations have already gotten a bit stretched (sound familiar?). That doesn’t mean tech and cyclical stocks usually head south from there. However, we usually see a more moderate advance or a consolidation period during which these names simply tread water. That’s when the later-cycle movers like consumer staples step up to the plate. Staples represent high-quality, non-cyclical growth. And as the economy improves, the best brands in the business usually have an easier time raising prices. This leads to fatter profit margins and higher earnings for consumer staples firms. What's more, staples stocks usually start to look cheap relative to the hot early cycle stocks as early market advances begin to moderate This exact same cycle has played out true to form in recent trading. Last year was the year of technology. In fact, most of 2003’s best performers were technology stocks back from the brink or cyclicals that saw huge earnings declines during the 2001/2002 bear market. Staples, by contrast, underperformed dramatically. Our chart below shows the relative performance of the S&P 500 consumer staples sector against the S&P 500 itself. When the line is rising, it indicates that consumer staples stocks are outperforming the S&P 500. From late 2000 until early 2003, staples were the place to be. Defensive stocks took over from red-hot tech momentum names as the Nasdaq plummeted. Last year, however, the opposite was true. As you can clearly see in the chart, staples underperformed the broader market throughout 2003.
However, that’s all starting to change. Although corporate earnings have been outstanding in recent quarters, some sectors have gotten a bit ahead of themselves in recent months. In fact, many large-cap tech names, particularly in the semiconductor group, are now trading at valuations unseen since the 1999/2000 tech bubble. As the chart above shows, consumer staples stocks are already starting to show an improvement in relative strength. These names should continue to outperform for the remainder of the year as money rotates out of early cycle plays and seeks stability and income. Branding The best brands also command the best shelf space. No grocery store puts generic cereal at eye level on the shelves. Instead, that valuable space is generally reserved for the best brands. What's more, brand names can lend new products instant recognition. A new Kellogg’s cereal will certainly command a consumer’s attention simply because of the brand stamped on the box. When scouring the investment landscape for quality companies, we look for staples stocks with superior brand recognition. These brands are seeing the best price increases right now and will continue to deliver the best growth. Ideally, we prefer to invest in brands that have captured the #1 or #2 position within their particular sub-sector. Valuations and Financials Investors should not expect eye-popping earnings growth from this group. Instead, they should look for firms with steady, stable growth from core brands and a history of cutting costs and holding profit margins steady. On the profit margins front, we expect consumer staples companies to see a gradual return of pricing power this year. Basic commodity prices--including those for wheat, corn, oil and various chemicals--have been rising for a little over a year now, raising costs for most staples companies. However, the top firms in this sector have been able to hike prices at a faster pace and expand margins even as costs have risen. Rising margins and expanding sales are signs of healthy growth. Valuation levels in the consumer staples sector aren't cheap. However, there are still plenty of attractive opportunities left in this area. In addition, investors are usually willing to pay up for the stability and quality of non-cyclical earnings that the industry offers. Overall Outlook This is the sweet spot of the cycle for consumer staples companies. We’d expect a moderation of economic growth in coming quarters, a change that will prompt investors to look for more stable, defensive growth areas. Staples fit the bill perfectly here, so they should perform extremely well in the months ahead. Consumer Staples Companies: Top Near-Term Sector Pick: Diageo (DEO, $52.60) Alcoholic drinks are among the least economically sensitive consumer staples sub-sectors around. Statistics also show that alcohol brands command great brand loyalty and consumers order the same brands time after time with almost no regard for pricing. That fact alone helped Diageo maintain its margins even during the dark days of the 2001 recession. In fact, the company's margins actually rose nicely in fiscal year 2001 when compared to 2000 levels. Put simply, the alcoholic drinks industry is among the safest and most predictable in the world. Liquor Sales Most analysts count Diageo's Smirnoff as either the #1 or #2 brand in vodka. Meanwhile, its Johnny Walker label is a global leader in whiskey, especially at the premium end of that market. Both brands have been showing nice volume growth and solid pricing power in recent quarters. Even more importantly, brand strength spells distribution power in the drinks market. No liquor store or bar in the U.S. is going to be without Smirnoff and Johnny Walker. This gives Diageo an enviable channel for new products or acquired brand names. For example, the firm managed to put its Smirnoff Ice in front of millions of consumers almost immediately thanks to its instant name recognition and superior distribution capabilities. Diageo then doubled volumes sold about a year after introduction. In a recent earnings update, Diageo reported 5% organic growth in its global priority brands, basically its best-known brand names in all categories. Even more encouraging was a notable uptick in unit value growth, which is a key indicator of pricing power. The company managed to boost pricing by 1% in the first half of its most recent fiscal year while shifting its sales mix to higher-margin premium brand names. We’re looking for a continued boost in pricing in coming quarters. Restructuring and Financials During the past few years, management has transformed the company from an over-diversified food and drinks concern into the world’s largest and most focused player in the alcoholic drinks market. The company sold off its Pillsbury unit in 2000 to General Mills, raising more than $10 billion. And in mid-2003 the firm sold its Burger King fast food franchise to a private investor group, finalizing its exit from the food business. Meanwhile, to shore up its already impressive lineup of global brand names, Diageo completed the purchase of Seagram’s drinks assets from Vivendi Universal in 2001. However, CEO Paul Walsh didn’t just splash out on the Seagram’s deal without regard for shareholder value. The deal was done in concert with France’s Pernod Ricard, a move that alleviated some antitrust concerns and reduced the cost to Diageo’s balance sheet. The company is keeping the best brands and selling the remainder to raise more cash. A few issues continue to hang over the stock as a result of this rapid restructuring. First, the company still holds a stake in General Mills as a result of its deal to sell Pillsbury--a stake that the company is in the process of selling off gradually. There’s still risk that the company could fail to execute this sale at reasonable prices. However, my staff and I feel that risk is overblown. In addition, the company’s recent decision to maintain its sizable stock buyback program suggests management is confident that it can sell the remainder of its stake in General Mills and can continue to post strong cash flows going forward. The other concern is debt. With a debt-to-equity ratio topping 130%, Diageo’s balance sheet is highly levered. This isn’t as big a concern as it would be for a more cyclical company. After all, Diageo’s strong cash flows give the company plenty of breathing room to service its debt and even pay down its obligations. In addition, the firm has reduced its long-term debt from 4 billion British pounds ($7.2 billion) at the end of fiscal year 2001 to less than 3 billion ($5.4 billion) at the end of fiscal year 2003. And the company has over $2 billion in cash sitting on its balance sheet. Trading at 16 times trailing earnings, Diageo is near the bottom of its five-year valuation range despite rapidly improving sales growth and pricing power. Like most British companies, Diageo pays a nice dividend of a little over 3%, which pays investors to be patient here. Although you shouldn't expect rapid price appreciation from the stock, for slow and steady performance Diageo is a great pick. Diageo (DEO, $52.60) Other Major Players in the Consumer Staples Industry
Coca-Cola (KO, $49.38) The last four years haven’t been all roses and clover for Coke. Instead, the company has been embroiled in a series of major restructuring initiatives. The good news for investors, however, is that these changes should have huge long-term positive implications for the stock. Staff reductions have lowered costs and have helped improve margins. Meanwhile, bad news surrounding asset write-downs is likely already factored into the stock. With a 1% dividend and a 33+% return on equity, Coca-Cola should be a steady performer going forward. Coca-Cola (KO, $49.38) Unilever (UL, $36.57) A number of factors have contributed to the firm's recent sales shortfall. Chief among them is the low-carb craze that’s been sweeping the United States over the last year and a half. That hit the company’s Slim-Fast weight loss products, which were slow to respond to the low-carbohydrate diet trend. On top of this, many of the firm's other brands have suffered from aggressive competition and a lack of pricing power in key markets. The good news is that management is now working hard to put the firm back on track. Along those lines, Unilever's turnaround plan is simple. The company is concentrating on its core brands and is selling off the losers. And to better align its products with recent trends, the firm recently introduced Carb-light Slim Fast products and a reduced-carb Breyer’s ice cream. These products are at the core of the firm's new reduced carbohydrate food portfolio. Looking at the overall picture, my staff and I feel that most of the bad news has already been priced into this stock by now. As such, any future positive catalysts should send the shares sharply higher. Unilever (UL, $36.57) Bunge Ltd. (BG, $34.23) Huge demand growth out of Asia has produced record price gains for staple commodities of all stripes. As the Chinese economy continues to develop, consumers there are starting to demand more expensive food products like meat and chicken. And as we all know, livestock consumes a lot of grain before it makes it to the dinner table. This has boosted processing margins for Bunge’s grain business. The stock recently got mauled on some volatility in the commodity markets. We look at that fall as a temporary setback rather than a shift to more bearish fundamentals. As such, the shares are worth looking at now as a possible defensive value play. Bunge (BG, $34.23) Danone (DA, $33.06) What’s most compelling about this stock is that it also holds some of the most powerful brand names in certain specialized local markets. These brands may not be household names in the U.S., but they certainly are in their targeted markets. The list includes Blendina baby foods and LU cookies in France, as well as Wahaha bottled water in China, among others. Danone is truly a global company that thinks locally. Operationally, the firm's recent results have been solid. Operating margins are holding above 12% and growth of the company's core brands has been well within management's guidance. We look at the firm's 1.8% dividend yield as an additional plus for the stock. Danone (DA, $33.06)
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