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Well, Fools, it looks like the party's over. After seemingly endless months of focusing on nothing but the good news, the market is once again pricing in risk.
And even if the recent volatility should quickly subside -- which would require investors to shrug off last week's unprecedented intraday selloff, the prospect of a euro-zone slowdown, and the dubious forward multiples on junk stocks -- it still makes good sense to consider bulking up on core defensive holdings.
That's where consumer-staples stocks come in.
Anchor your portfolio
There are two components to any portfolio strategy:
- Predicting how a specific group of stocks will perform, based on market psychology and macroeconomic conditions.
- Estimating the health of the underlying companies according to industry and macro fundamentals.
Assuming you prefer to limit your surprises to birthday parties and lottery results, both are important. On that note, let's dig into the consumer-staples sector, starting with stock dynamics.
Attractive to any investor who craves a measure of portfolio stability, consumer staples offer one of the smoothest rides out there. The sector's five-year beta, as calculated by Standard & Poor's, is a welcoming 0.6 (matched only by utilities). In short, the group is 40% less volatile than the broad market. When it comes to historical price fluctuations on an absolute basis, the sector also boasts the lowest five-year standard deviation.
My colleague Selena Maranjian cautions against allowing such metrics to dictate one's long-term investing decisions. In part, I agree. But from a psychological perspective, I'd argue that many investors find it easier to behave rationally -- and opportunistically -- when their portfolios aren't bucking up and down like rodeo bulls. In that vein, an ample allocation to consumer-staples stocks could give investors the confidence to take advantage of suddenly low prices in other sectors, whether for a volatile tech name or a temporarily ailing commodity company. After all, this sort of prudent risk-taking powers long-term returns.
Moreover, stock and sector volatility isn't completely disconnected from business fundamentals. Take cyclicals such as U.S Steel (NYSE: X ) and Terex (NYSE: TEX ) , whose shares have betas above 2.0. These companies saw their revenues more than cut in half from 2008 to 2009. By contrast, consumer-staples names General Mills (NYSE: GIS ) and Colgate-Palmolive (NYSE: CL ) come with betas of 0.28 and 0.5, respectively. The former actually grew sales from 2008 to 2009, while the latter saw the top line slip only marginally.
Built -- and priced -- to outperform
These days, even the normally risk-hungry, momentum-chasing hedge fund world is turning to consumer staples. An industry insider recently featured on CNBC reported that fund managers are slowing things down, turning to names such as Johnson & Johnson (NYSE: JNJ ) and Altria (NYSE: MO ) for their attractive valuations and dividend yields.
I'm not surprised. On the sector level, consumer staples trade at a current-year price-to-earnings ratio of 14.6, based on Standard & Poor's operating earnings estimates. That may not look like a great value compared to the S&P 500's identically measured P/E of 14.5. Consider, however, that consumer staples are the best-performing sector month to date, losing only 0.26%, and second only to IT on a three-year basis (referenced returns do not include reinvested dividends).
The outperformance has staying power. I recently noted the sector's strong relative returns in the mid-to-late part of the economic cycle. And even if we don’t see rising interest rates anytime soon, simple sector rotation by a risk-adverse investing community could push up share prices.
Meanwhile, on the company level, stable historical cash flows and solid balance sheets have allowed certain companies to grow through acquisition. Unilever picked up personal-care brands from Sara Lee, and on a much larger scale, Kraft (NYSE: KFT ) issued shares and debt to bag Cadbury --a deal that appears to be paying off. I expect industry consolidation to continue, which offers the prospect of rising shareholder value.
Why not just hold cash?
I hear the protest -- if you're worried about the market, why not just sell stocks and raise cash? From a purely defensive standpoint, that's clearly the proper course of action. However, while cash secures one against the downside, it offers no upside. There's no potential for multiple expansion in a money market fund. And you'll be hard-pressed to find a CD yielding the 3%-4% that several consumer-staples stocks offer.
In short, for a solid defense that packs a bit of offense, too, consumer staples are an asset class that you just can’t do without.
Need sector investing ideas? These consumer-staples could be takeover targets.