Has the Safety Been Squeezed Out of These Stocks?

On the heels of May's flash crash, I described consumer-staples stocks as a must-have in any balanced portfolio. Since then, the group, as measured by the Consumer Staples Select Sector SPDR ETF, has returned roughly 2.5%, versus a slightly negative showing by the S&P 500 (not including dividends).

So far, so good. But there's a hitch. Rapidly escalating raw material costs could pressure companies' margins in coming quarters, sending stock prices skidding and disappointing investors who have turned to the group for its historical stability.

Look out above
By "raw materials," I don't mean oil -- crude has appreciated a modest 12% during the past year. Rather, it's agricultural inputs that are off to the races. According to The Wall Street Journal, in the past year dairy prices have risen 27%, grain and coffee each gained more than 30%, and fruits moved up better than 60%.

And corn, a key input for beverage makers such as Coca-Cola (NYSE: KO  ) and PepsiCo (NYSE: PEP  ) , is up nearly 50% since the end of July.

Now, it's true that the corn and soybean markets have recently been goosed by the USDA's downwardly revised crop yield estimates. Yet there's reason to believe that recent price movements are representative of a multiyear uptrend.

Consider, for instance, that Nomura's chief Asia economist sees food prices climbing above their 2008 peak, driven in part by demographics and wage increases in the developing world. That view is seconded by fertilizer producer PotashCorp (NYSE: POT  ) , whose CEO, incidentally, recently told reporters that the company's stock would "blow the doors off" its all-time high of $240.

All this sounds plausible, even likely. But we don't have to rely on professional soothsayers. Input cost inflation is already showing up in companies' results.

In its second-quarter conference call, Kraft (NYSE: KFT  ) reported that higher input costs "dampened" margin gains. Detailing its fiscal 2011 first quarter, ConAgra (NYSE: CAG  ) told investors that inflation outpaced cost savings. General Mills (NYSE: GIS  ) , my packaged-foods favorite, also named "rising input costs" as a factor in its most recent quarterly performance.

And all this comes as the promotional environment remains aggressive, making price increases a difficult, if not outright dangerous, undertaking.

Is it really so bad?
In a word, no. In a phrase, no, not yet.

Taking General Mills as an example, the increased value of commodity hedging positions boosted Q1FY11 gross margin. Moreover, management held fast to its previous forecast of 4%-5% input cost inflation. Why the confidence? For one, the company is 65% hedged. Two, certain commodities -- packaging resin, for example -- have risen less than expected. 

The story is similar elsewhere in the industry. In its Q2 conference call, Kraft reported that it was "well hedged for the year" (management declined to offer specific figures). And ConAgra indicated that a beefed-up hedging program in the second part of its fiscal year would yield better margins.

In other words, it's probably premature for investors to panic. That said, companies don't appear to be hedged more than a few quarters out. So if food prices are still soaring this time next year, look out. Either the higher cost of entering into hedges will eat into margins, or the cost of not hedging at all will outright pummel profitability.

All of which suggests that consumer-staples investors might consider doing what the professionals do -- hedge!

Protect your downside
I know, investing in consumer-staples companies is supposed to be a simple strategy that even your grandmother can get comfortable with. Well, if all you're looking for is dividend income, then I think you'll be just fine.

But if you also want to protect your invested capital in the short-to-mid-term, then you're going to have to get a bit more sophisticated. Below, I offer several suggestions on how to hedge your consumer-staples positions for a sustained, margin-crushing rise in input costs.

  1. Write calls options on stocks you own. Collecting the income on written calls is akin to creating an additional dividend stream. If the stock falls, your downside is minimized by the percentage yield on your written call. Furthermore, you can always buy back the call at a lower price if you think the shares are soon headed back up.
  2. Sell short shares of the Consumer Staples Select Sector SPDR ETF. This would act as a general hedge against a decline in the entire consumer-staples group.
  3. Buy what's appreciating. That could mean fertilizer names such as Potash or Mosaic whose shares tend to move up with crop prices. Or you could look into the commodities themselves. Here, I'd recommend the ELEMENTS Rogers Intl Agri Commodity Exchange-traded Note, which tracks the futures contracts of 21 agricultural commodities. Note that contango -- the phenomenon that has infamously laid low the United States Natural Gas Fund (NYSE: UNG  ) -- is a potential risk here.

And if you're not comfortable hedging, hey, that's fine. Just know that things could get lean in the quarters ahead.

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Fool contributor Mike Pienciak holds no financial interest in any company mentioned in this article. Coca-Cola is a Motley Fool Inside Value recommendation. Coca-Cola and PepsiCo are Motley Fool Income Investor picks. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Coca-Cola. Try any of our Foolish newsletter services free for 30 days

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.


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