Why Consumer Staples ETFs Struggle

August 01, 2018

What has traditionally been one of the safest sectors of the stock market has been anything but safe this year. The consumer staples sector, as measured by the $9 billion Consumer Staples Select Sector SPDR Fund (XLP), is down 5% so far in 2018, sharply underperforming the 6% gain for the S&P 500.

Top holdings in XLP include Procter & Gamble, Coca-Cola, PepsiCo, Philip Morris, Walmart, Costco, Walgreens and Colgate-Palmolive, to name a few.

Analysts say that the consumer staples sector—which comprises stocks of noncyclical companies that manufacture or sell essential consumer goods, such as beverages, tobacco products, household products and food products—has been battered and bruised by several key head winds.

 

YTD Returns For XLP And S&P 500

 

More Competition, Less Innovation

“Competition, inflation (or lack thereof) and investments in long-term relevance all seem to be weighing on consumer sector margins with no obvious signs of abatement,” analysts at Credit Suisse recently wrote.

The analysts pointed to consumers’ growing preferences for upstart and private brand products as sapping demand for the well-known, established products that consumer staples companies are known for.

To compete, the staples companies are being forced to innovate and invest more in research and development, which can be costly in the short term.

Cost-Cutting Catches Up

According to John Baumgartner, equity research analyst covering food and agribusiness for Well Fargo Securities, this problem facing consumer staples companies is self-inflicted.

“Coming out of the credit crisis—the first four or five years, you saw general consumer malaise,” Baumgartner told CNBC. “To counter lack of top-line growth, you saw very aggressive cost cutting—advertising coming down 30% and R&D coming down 10-15%.”

At first, it was good for profits. Costs came down and margins improved, he says. But now years later, the innovation pipelines have run dry and the companies are lacking good, differentiated products.

Along with a dearth of new products that appeal to consumers’ changing tastes, staples companies have been hurt by the trend toward e-commerce shopping. E-commerce is one of the factors making consumers hypersensitive about value, reducing staples companies’ pricing power at the same time costs for labor and transportation are rising, analysts at Credit Suisse explain.

Discounted Valuations

Despite the bearish factors encumbering the sector, consumer staples have perked up a bit in recent weeks. Since the sector low point on May 3, it is up nearly 10%. Some of that has to do with the market rebounding (the S&P 500 rose 7% in the same time period), but some of it also has to do with investors bargain hunting in a beaten-down space.

Wells Fargo’s Baumgartner says valuations for the group are now trading at a discount to the broader market, compared with a premium of 35% only a few years ago. Baumgartner expects sales growth for staples companies may accelerate from current low-single-digit levels in 2019 or 2020 as new product ideas come to fruition.

Safe-Haven Support

On top of bargain hunters buying because of attractive valuations, other investors may be wading into the sector for its safe-haven properties.

“When market volatility picks up … the consumer staples sector is often viewed as a port in the storm, said Brad Sorensen, managing director of market and sector analysis for Charles Schwab. “Temporary increases in domestic political and geopolitical tensions could continue to help support the group for short periods going forward.”

It’s the reason analysts at Ned Davis Research Group upgraded consumer staples to overweight earlier this month, recommending that investors buy the safe-haven sector with trade tensions heating up and the U.S. midterm elections in November approaching.

“We have chronicled consumer staples as the most hated sector while rates have been rising and the threat of e-commerce negatively impacting staples retailing has grown. The sentiment may have swung too far negative though,” the analysts said, while noting that the weighting of consumer staples in the S&P 500 is starting to approach the lowest level since the year 2000.

Cyclicals Still Favored

Even as they suggest consumer staples may see support in the near term thanks to safe-haven flows, Schwab’s Sorensen and the analysts at Ned Davis Research aren’t convinced the outperformance will last.

Unless trade tensions materially reduce growth in the U.S. or some other factor derails the economy, they expect cyclical sectors to outperform the defensive consumer staples sector.

“We will be watching global growth indicators closely in the coming months, but unless the U.S. outlook deteriorates, it would be difficult for us to lift the rating of the staples sector to outperform in the near term,” Sorensen concluded.

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2

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