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2012-03-19 12:03:25
March 26 2010 | Filed Under Bonds , Economics , ETFs , Options
The consumer staples sector is characterized by its global industry
classification sector (GICS). The sector is composed of companies whose primary
lines of business are food, beverages, tobacco and other household items.
Examples of these companies, include Procter & Gamble (NYSE:PG), Colgate
Palmolive (NYSE:CL) and Gillette. These types of companies have historically
been characterized as noncyclical in nature as compared to their close
relative, the consumer cyclicals sector.
Unlike other areas of the economy, even during economically slow times (in
theory), the demand for the products made by consumer staples companies does
not slow. Some staples, like discount foods, liquor and tobacco, see increased
demand during slow economic times. In line with the noncyclical nature of the
demand for their products, the demand for these stocks tends to move in similar
patterns. Read on to find out why the staples sector has historically had a low
correlation to the overall market, and why this sector has historically
experienced lower volatility. (For related reading, see Cyclical Versus
Non-Cyclical Stocks.)
Staples and Supply and Demand
Anyone who has taken a basic economics class remembers the function C+I+G =
GDP, where gross domestic product (GDP) is the aggregate of consumption,
investment (often referred to as business spending) and government
expenditures. So, if consumption comprises such a large component of GDP, why
is the sector weighting of consumer staples in the U.S. stock market only
around 10% or less historically? The best explanation of this relationship is
the noncyclical nature of the demand and earnings of those companies.
Staples tend to have a low price elasticity of demand. This means that the
demand for these products does not change much as their prices go up or down.
There are no substitutes for the products themselves; however, there are many
options to shop for lower prices among suppliers. This gives the suppliers of
staples little room to raise prices or increase demand for their products.
Suppliers do, however, have the ability to differentiate their products by the
taste, appearance or results of using their products. This leaves the producers
of staples in the cross hairs of the main costs that go into making their
products: commodities. (Find out how the everyday items you use can affect your
investments in Commodities That Move The Markets.)
If the demand for consumer staples does not grow by much, how do the producers
or sellers of staples grow their businesses and ultimately their stock prices?
They have a few options:
Reduce costs
Reduce prices
Differentiate their products.
Cost Reduction
Companies in the business of consumer staples can grow their profits and
ultimately their stock prices by reducing costs. They can reduce their
commodities costs by buying larger quantities, using hedging techniques,
merging with or buying other companies, and creating economies of scale via
horizontal integration or vertical integration.
Price Reduction
We have already described the demand of staples as being low in elasticity. We
also know that with competition, the same box of pasta at a high-end retailer
will sell for more than at a low-end retailer. This price differentiation will
be much more apparent during slower economic times when the consumer steers
toward the low-end retailer.
Product Differentiation
This strategy to increase demand is used by the staple and cyclical ends of the
consumer business. From cars to razors, each consumer product company tries to
differentiate its product as superior in order to increase demand and give the
company the ability to control the item's price.
Opportunities for Investors
The business of consumer staples is relatively low tech, composed of
commodities that vary in cost, tends to be low in elasticity and shows fewer
swings in demand than the cyclicals. So if this business is so boring, why
would anyone want to invest in consumer staples?
One of the best reasons is slow and steady growth. Since the ebb and flow of
the consumer spending cycles swings wildly with the economy, so do the profits
of the cyclical companies. The staples, on the other hand, tend to move in more
structured patterns - boring, maybe, but for some investors, this relative
stability is just right.
Another reason for committing capital to the staples sector is the
diversification benefits of owning those companies. While the sector itself may
make up less than 10% of the overall market historically, the correlation
between the sector and the overall market is low. (Learn how to diversify your
portfolio by investing in several different sectors of the economy in An
Introduction To Sector Funds and Singling Out Sector ETFs.)
The staples sector has historically exhibited a beta of .68 and a correlation
of .64. Herein lies the best-kept secret of owning consumer staples: a low
correlation to the Standard & Poor's 500 Index (S&P 500). It is pounded into
the heads of investors to diversify their stock portfolios with holdings whose
asset classes have low correlations, so they add bonds, international stocks,
oil, real estate and gold. While this has worked historically, there have been
times when all of those asset classes had higher correlations as they all fell
and the staples sector maintained its value. This is just one of those backup
singers of the market that does not get much attention until it's too late.
Conclusion
It's safe to say that the business of consumer staples and investing in them is
boring to some people. The demand for these products does not swing up and down
and they don't exhibit the flashy characteristics of their close relative, the
consumer cyclical.
They do, however, offer investors an opportunity to diversify into a sector
that is easy to understand, has a relatively low beta and a low correlation to
the overall market. So the next time you go to buy a razor when the stock
market is in a tailspin, take a look at the company that makes that razor: it
might be a good time to buy its stock.
by Michael Schmidt