The Consumer Staples Sector: Signs of Upcoming Underperformance?

Consumer staples companies sell essential products, such as food, beverage and household items.  These products are always in demand no matter how well or how poorly the economy is performing.  As such, growth in these companies is generally slow and steady.

This doesn’t however always translate into slow and steady growth out of the stocks that make up this sector.  As a general rule of thumb, these stocks outperform when the economy is weak and they underperform when the economy starts to pick up steam and strengthen.

Signs of a Strengthening Economy

The Unites States in particular has been showing signs of a strengthening economy recently.  We have seen evidence of stronger demand for autos, houses, and machinery from the US.  Furthermore, in July the pace of growth in the US manufacturing sector accelerated to the highest level in 2 years as new orders surged.

As for Canada, the Bank of Canada believes that the economy expanded by 1% in the second quarter of this year, and expects the growth to continue in the third quarter and beyond.

The Bank is forecasting economic growth of 1.8% in 2013 (up from the 1.5% forecast of 3 months ago), and expects that growth will climb to 2.7% in each of 2014 and 2015 as the US economy picks up steam and business confidence rises.

Consumer Staples: Missed Earnings Expectations and Valuations on the High End

As indicated in the opening, good news for the economy tends to correlate with temporary underperformance for consumer staples related stocks.

You see, consumer staples stocks are generally thought of as being defensive in nature.  A safe-haven of sorts.  When the economy is challenged, consumers are still buying groceries, for instance, therefore, results from this space don’t face the decline that a more economically sector, like industrials, may face.

As more favourable economic winds begin to blow, capital may begin to flow out of the defensive areas of the market, like consumer staples, and into more cyclical sectors, like industrials (or resources).

To get a handle on several of the more prominent consumer stocks that may be at risk under this scenario, let’s have a look at where we stand in terms of valuation and projected earnings growth.

As the table indicates, with an average P/E of about 20, valuations in this sector are not inexpensive.  This speaks to their popularity as shelter during the more turbulent economic climate we’ve been in.

And these valuations become even more of an issue when we consider how many of them have come up short in recent quarters in terms of meeting the market’s expectations.  For example, Alimentation Couche-Tard’s earnings have come in below expectations in the last 3 quarters, and Saputo missed expectations in the last 4 quarters.

The sell-side has seemingly set the bar very high for these stocks, as it attempts to justify the relatively high valuations.  And even though the underlying companies may continue to perform well, the bar simply might be too high, which will lead to further disappointments, and eventually have a detrimental impact on the stocks.

The two companies that stand out as having either met or exceeded recent expectations are George Weston and Empire Ltd.

George Weston’s stock seems to be pricing in the good news already, with a P/E of 25.9 times and a PEG ratio of 1.94, which is quite high (PEG = P/E ratio divided by projected earnings growth – a number less than 1 is attractive).

If you remain compelled by this space, Empire appears the most attractively valued at least.  The company has beat or met expectations in the last 5 quarters and is trading at a mere 14 times trailing EPS and carries a PEG ratio of 1.08.  Should earnings continue to exceed expectations at Empire, this discounted valuation won’t be around for long.

Final Thoughts

While opportunities will always exist in every sector of the market at any given time, it’s important to be mindful that certain sectors are better suited to different economic climates.  As more and more signs of an economic recovery continue to roll through, have a look at your portfolio and consider whether or not it might be a good idea to begin “stocking up” on the more economically sensitive sectors and lighten up on the more defensive sectors.

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Fool contributor Karen Thomas does not own shares in any of the companies mentioned.  The Motley Fool does not own shares of any companies mentioned.