Large-cap consumer stocks offer investors everything they’re looking for right now: high yields, relative safety and insulation from macroeconomic headwinds. But at what price do even the safest defensive plays become too expensive?
That’s the question investors should be asking themselves after the powerful rally in certain consumer stocks thus far this year. It’s unlikely that the sector will suffer a major collapse, but new money coming in at these levels might see more muted future returns than consumer stocks have provided in the past three years.
Consider this: Among the nine SPDR sector ETFs, the Select Sector Consumer Staples SPDR (NYSE:XLP) has the highest price-to-earnings, price-to-cash flow and price-to-book value. So far, investors have gotten what they’ve paid for: XLP is down only 0.44% since April 1, which compares a loss of about 7% for the S&P 500. XLP’s return is second only to the 5% gain for the Select Sector Utilities SPDR (NYSE:XLU) during that time. But at a certain price, stocks become less safe no matter how strong their underlying fundamentals.
This can be illustrated via some examples of “safe” stocks that have been hit hard recently:
- McDonald’s (NYSE:MCD) is the ultimate defensive stock, but it came into this year at its highest valuation in nearly four years. The stock’s advance ended abruptly once the company reported slower-than-expected sales growth, and it is down 12.8% year-to-date versus a 4.6% gain for the S&P.
- Sara Lee (NYSE:SLE) also missed on earnings and revenues when its valuation was near a historical peak in early May, hammering the stock for a loss of 12% since the report.
- Unilever (NYSE:UL), the global consumer products giant, reported great numbers at the end of April, but the stock — which was trading at the upper end of its historical P/E range at the time — has since lost 7% despite its defensive characteristics and 4% yield.
With this as the backdrop, it’s worth looking at a few consumer staples names that have held up extremely well through the recent downturn, but that have reached valuation levels where the yield and stability might be fully priced in:
|Stock||Ticker||Gain Since 8/10/11||Trailing P/E||5-Yr Avg||Premium||Forward P/E|
|Church & Dwight||CHD||36.2%||24.3||20.1||21%||20.0|
|McCormick & Co.||MKC||29.3%||20.3||17.6||15%||16.8|
In comparison, the S&P 500 is at 15.3 times trailing earnings and 12.5 times forward estimates.
There’s little doubt that richly valued consumer names can continue to perform well as long as macroeconomic concerns remain the primary driver of investor preferences. Nevertheless, there are two risks that investors must evaluate when weighting the merits of these and other consumer names.
First, an improvement in investor risk appetites likely would spark a rotation out of consumer staples and into the more inexpensively valued areas of the market. The largest potential headwind on this front is QE3 — if the Fed makes an announcement regarding a new round of stimulus, these stocks are likely to experience immediate underperformance relative to the rest of the market. The second risk is the chance that any of these companies, or their immediate sector peers, will fail to meet expectations in the upcoming earnings season. McDonald’s provides an example of what can happen in this scenario.
The bottom line: Under normal conditions, big-name consumer stocks are typically safe, high-yield vehicles for investing in the stock market. But at these levels, investors might be better off waiting for a pullback than trying to chase what has become one of the market’s hottest sectors.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.