Thursday, December 1, 2011

Consumer Staples: Long-term Performance

Jim O'Shaughnessy of O'Shaughnessy Asset Management and author of "What Works on Wall Street" performed a sector analysis of the stock market over a four decade period. He appeared on CNBC recently and revealed the results of his analysis.

According to O'Shaughnessy, the highest return long-term sector has been consumer staples.

So the sector that has tended to outperform long-term is still frequently described as "defensive".

Many consumer staples stocks are not just "defensive" in nature, though they're frequently described and thought of that way. They can, consistent with their reputation, provide better downside protection than other stocks but, otherwise, calling them "defensive" is actually quite a mischaracterization when viewed over the long haul.

It underestimates their long-term "offensive" potential.

Defensive implies lower risk and lower returns. Well, when it comes to businesses like Coca-Cola (KO) that's half correct. Lower risk certainly, but historically Coke's shares have produced above market long-term returns and the company's future prospects aren't exactly dismal.

So consumer staples can be both offensive and defensive -- especially the highest quality ones -- but, like any stock, they still need to be bought at a nice discount to estimated per share intrinsic value.

The best are generally just quality durable businesses that produce high returns on capital at relatively low risk (again, especially if bought at the right price).

This CNBC article sums ups some of O'Shaughnessy's analysis.

Here's a couple of his findings:

- Not only did consumer staples do the best among 10 sectors, the highest performing stocks in the consumer staples sector had the highest buybacks plus dividend yield (shareholder yield).
- Those with the highest shareholder yield had an average annual return of 17.8%.

So they have worked very well as an "offense" long-term, despite their reputation, and produced above market returns.

Consistent with their reputation, they have also worked as a pretty good defense.

Higher returns...lower risk.

Over the shorter run -- less than five years or so -- anything can happen as far as price action and relative performance goes, of course (and some these days consider five years longer term no doubt). Even the best stocks in the consumer staples sector are just not likely to do particularly well in bull markets. In fact, anyone buying these stocks expecting them to outperform during a bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being "defensive". Yet, this defensive reputation isn't quite correct when you look at their historic returns over long enough time horizons. So it's generally when they're looked at over longer time frames -- more than a full business cycle or two -- that the picture becomes more clear.

Though there's no way to know how they'll do going forward, it has generally been over the longer run when their merits become more obvious.

Here's a recent example.

At yesterday's close the S&P 500 was at 1246, down from its pre-financial crisis peak of 1565 hit back in 2007. A 20% drop (excluding dividends).

Now, imagine some unlucky person who happened to put all their money into the SPDR S&P 500 (SPY) on that day (it's generally not wise to commit dollars all at once like that).

So, assuming that person didn't sell, that person's portfolio would unfortunately now be down a little over 20%.

Naturally, that person would be similarly disappointed with portfolio results if, instead he or she happened buy each of the nine Select Sector SPDR ETFs* (Consumer Discretionary XLY, Consumer Staples XLP, Energy XLE, Financial XLF, Healthcare XLV, Industrials XLI, Materials XLB , Technology XLK, Utilities XLU) at their peak prices.

Eight of the nine sectors are, in fact, still below their pre-financial crisis peak. Some much more than others, of course.

The one exception is the consumer staples sector.

So somewhat amazingly, the unlucky individual who bought the Consumer Staples SPDR ETF (XLP) at its very highest pre-crisis price and held it throughout is not underwater and would have collected a very nice dividend**.

The returns from owning the XLP would be positive even if bought at the highest possible price when, nearly 4 years later, the S&P is still 20% below its peak levels. Even if not spectacular absolute performance it's exceptional relative performance.

Now, consider what the results could be with just some disciplined buying of the ETF as stocks were falling and falling during the crisis. Anyone who did that would have a relatively low cost basis and very nice returns these past few years.

Better yet, consider the results if someone was buying the best individual consumer staples stocks as they were getting cheaper and cheaper during that time.

Each sector, of course, went down dramatically during the worst days of the crisis. Most of the sectors were down more than 50% at some point. The best performer, once again, was consumer staples but it still was down for a brief period by a bit more than 30%.

Clearly pretty much nothing went unscathed as far as the price action goes. In the short to medium run, any sector will be vulnerable when stock prices are falling across the board.

Yet, in the long run, the best of the businesses that reside within the consumer staples sector are mostly consistent intrinsic value creators so, while prices can fall in the near term, over time it becomes like trying to hold a beach ball or basketball underwater as the tide rises.

The good news is, unlike the ocean, many of them have a tide that will be rising for a very long time.

Consumer staples have at times in the past few years been anywhere from extremely cheap to attractive.

While not necessarily expensive now, most consumer staples stocks are certainly no longer cheap.***

So there are some great stocks in this sector to own for the long haul but the price paid still matters. The bargains have all but disappeared. Even for very good businesses, what's sensible to buy at a discount to intrinsic value makes little sense at some materially higher valuation.

Finally, if the shares of higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered.

So does the reduced likelihood of permanent capital loss and more narrow range of outcomes.

In fact, if these quality franchises produced merely market returns they'd still win in my book.

The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss.

In other words, temporary paper losses can happen with just about any stock.

Also, what these have done historically guarantees nothing going forward. Yet, considering risk and reward, these still seem like not a bad place to start.

Figuring out the likely future prospects -- and what to pay for those prospects -- still requires plenty of work.

The best of these high quality businesses tend to experience little change. They sell similar products year after year. They do it while maintaining, give or take, often rather attractive business economics.

That's their strength.

Innovation is a wonderful thing for the world but, as far as the investment process goes, picking winners while avoiding the losers is a good idea mostly on paper, less so in practice.

The idea that stocks in the consumer staples sector can be bought and sold at just the right time -- in other words, owning them when a defensive posture is warranted, selling them to buy something with more upside when not -- is another thing that looks good on paper but is just not easy to do in practice.


Long position in KO

Related posts:
Consumer Staples: Long-term Performance, Part II - Dec 2011 (follow-up)
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

Select Sector SPDRs are ETFs that divide the S&P 500 into nine sectors. 
** At roughly 2.7%, Consumer staples as a sector has higher dividends than the S&P 500 so, if you compare returns including dividends, the gap in performance only gets bigger.
*** With any investment, no matter how seemingly attractive, margin of safety is all-important. It protects against the unforeseen real, even if fixable, business problems. Still, it's worth considering this: "If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." Charlie Munger at USC Business School in 1994
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