Wednesday, December 7, 2011

Consumer Staples: Long-term Performance, Part II

Jeremy Grantham has called quality stocks the "one free lunch" over the long run. 

While the definition of quality is necessarily subjective, the Consumer Staples SPDR (XLP) ETF is made up of a whole bunch of high quality businesses. It's a convenient low frictional cost way to gain exposure to them if they're generally priced right.

Top 5 Holding of XLP
Procter & Gamble (PG)
Philip Morris International (PM)
Wal-Mart (WMT)
Coca-Cola (KO)
Kraft (KFT)

Yet, since not all consumer staples businesses are created equal, I'd rather own what I consider the best individual stocks within the sector.*

This recent prior post and CNBC article provide some more background on the long-term track record of many consumer staples stocks.

Jim O'Shaughnessy did a sector analysis of the stock market over a four decade period. 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" over the long run, despite their reputation, and produced above market returns.
(As I've said: Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course.)

Consistent with their reputation, they can provide better downside protection than most other stocks. Yet, the evidence is there that, over the long haul, many consumer staples businesses are, in fact, not just "defensive" in nature even if they're frequently described and thought of that way.

Characterizing them as "defensive" underestimates their long-term "offensive" potential.

Now, consumer staples stocks often do underperform during bull markets so their reputation is understandable. Naturally, some investors and especially traders, attempt to time when they want to own these kind of stocks based upon the perceived risks that exists in the market environment.
(i.e. In a bull market, own fewer consumer staples. In a bear or, at least, uncertain market, own more.)

An approach that, at a minimum, certainly adds frictional costs and the chance to make costly mistakes. To me, it is one of those great sounding ideas until you have to put it into practice. Like choosing the fate of Sisyphus when a perfectly attractive alternative exists: To buy shares of quality businesses at a discount and allow compounding to work for them over time.

Sisyphus had to eternally roll an immense boulder up hill but it wasn't choice, it was punishment. Some seem willing to take the more Sisyphean investing approach by choice.

If, over the long haul, shares of a business or sector (via an ETF) bought at reasonable valuation** can produce higher returns than the market, why add the chance to make costly mistakes trying to time it?

Doing this creates unnecessary execution risks. Understandably, most will heavily weigh the chance of temporary (or worse, permanent) loss more so than the possibility of missing a gain. Loss aversion is a powerful psychological force. Yet, by definition, additional buying and selling brings a chance to make another error into the equation.

Errors of omission comes to mind.

Missing the chance to own something one doesn't understand well, something outside their circle of competence, is not a problem.

That's not a mistake. It's best to only invest in attractively priced things one understands well.

On the other hand, missing the chance to own what one understands that also stacks up favorably against investing alternatives is costly. Sell shares because of concerns about short-term price action, with the intent to buy it back at a lower price, opens up the possibility of making an error of omission. What if it rallies? How do you get back in to the position?

Since consumer staples stocks also generally perform better on the downside during rough markets (their "defensive" characteristics) this jumping in and out of positions based upon perceive market risk makes even less sense.

Of course, this only works if we are talking about a good business that is soundly financed. If business quality was misjudged sell it as soon as possible.

An error of commission.

The fact that many consumer staples businesses have done very well in the past is, of course, no guarantee when it comes to the future. Yet, the evidence more than just suggests businesses with well-known, trusted, small-ticket consumer brands (fast-moving consumer goods: FMCG) that also have broad-based distribution capabilities tend to do very well over the long run.
(Branded shampoo, beverages, beer, spirits, tobacco, chocolate, and gum among other things.)

Great brands and strong distribution, in combination, often produces a sustainable advantage, pricing power, and attractive core business economics.

Are the best days behind these kinds of businesses? Is it too late? Well, maybe, but consider this:

Some think if an investment idea is well-known and seems obvious it can't be really good. In 1938, Fortune Magazine concluded "Several times every year, a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late." Since that time, Coca-Cola has grown significantly both domestically and around the world. It was not too late in 1938, and we believe it is far from that today. - From the 1Q 2010 Yacktman Quarterly Letter

To me, the probability that a business like Coca-Cola will perform just fine, even if not quite as well, over a longer future time horizon is not low. Of course, in the short and medium term, just about anything can happen to share prices. Expect it. Yet, over the longer haul as the "voting machines" gives way to the "weighing machine", share prices will at least roughly track increases to per share intrinsic business value. Well, that value is ultimately driven by business performance. Much as it was not too late in 1938, it seems unlikely that it is too late now. Many, if not all the forces, that created these long-term results remain in place.

These are mostly durable high quality businesses that produce high return on capital, at relatively lower risk, especially if bought at the right price.***

As always, what's sensible to buy at a plain discount doesn't make sense at some materially higher valuation no matter how good the business may be.

They have a good probability of continuing to possess competitive advantages but, as always, keep an eye on how the economic moat may be changing over time along with capital allocation decision-making by management.

One question I like to ask is the following: If a business stopped innovating for five years what would happen to its financial performance? Most consumer staples businesses would miss some opportunities and lose some market share yet still continue making a nice living.

Not so for most tech stocks. Imagine Apple (AAPL), as good as the company is, not innovating for five years.

Now I suspect one of the reasons why more professional investors do not make full use of, what Jeremy Grantham calls "the one free lunch", is this:

"Smart people aren't exempt from professional disasters from overconfidence. Often, they just run aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger in a speech to the Foundation Financial Officers Group

Some seem to think that when a wise but more straightforward approach comes along there must be more to it:

"...our model is too simple. Most people believe you can't be an expert if it's too simple." - Charlie Munger at the 2007 Wesco Meeting

Sidekick has sage advice of his own

In any case, all too many investors have a difficult time keeping up with the S&P 500.

Yet, many consumer staples stocks have a great long-term record of doing just that over the long haul. That may not be true going forward, but their risk-adjusted merits are not insignificant.

Little to no trading required.

Adam

Long common stocks mentioned

Related posts:
Consumer Staples: Long-term Performance - Dec 2011
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

* Three of the six stocks in the Six Stock Portfolio are consumer staples and I also have many in my Stocks to Watch. They are not in these portfolios for "defensive" reasons. They're just quality durable businesses that over the long-haul produce high return on capital, at relatively low risk, especially if bought at the right price. Margin of safety still always matters no matter how good a business might seem to be.
** Though certainly not expensive, the one problem at this time, unlike not too long ago, is that far fewer shares of consumer staples businesses are selling at a discount these days. So some patience in building a long-term position seems warranted.
*** 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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