Four months of rising stocks and suddenly enthusiasm for a strong economic recovery seems to be on the rise. But there's one rather large obstacle in the way of any meaningful recovery: over-capacity. Note this line from Alan Greenspan's testimony on Tuesday:
In the past, such reductions in private yields and in the cost of capital faced by firms have been associated with rising capital spending. But as yet there is little evidence that the more accommodative financial environment has materially improved the willingness of top executives to increase capital investment.
This has to be anathema to Greenspan. Thirteen rate cuts since 2001 have done practically nothing to promote business expansion. What does that say about the extent of over-capacity created during the bubble years? Worse yet, the Fed's "medicine" of ultra-low interest rates has only served to keep alive companies that might have otherwise gone out of business and thereby alleviated some of the over-capacity. The inescapable conclusion is that it will be a good while before business spending picks up again.
Of course, so far the slack in business spending has been offset by the consumer's strength. Homeowners benefited mightily from those 13 rate cuts and the resulting record-low mortgage rates. But with interest rates now on the rise, the mortgage refinancing spigot will inevitably slow, perhaps as soon as year-end. Tax cuts will give a boost to consumers in the meantime, but we could easily enter 2004 with a slowing consumer and still-slow business spending.
All told, I don't think anyone should be getting lathered up over a return to sustained 3%-plus GDP growth anytime soon. I, for one, am looking for stocks that will fare well in a slow-growth economy. That brings me to the real subject of this article: my attraction to the consumer non-cyclicals.
The consumer non-cyclical sector includes most of your everyday household consumables: food, beverages, cleaning agents, and office supplies. Yes, these are boring companies and boring stocks -- but sometimes boring is good, especially when the economy is soft. These companies maintain decent sales and earnings in all economic seasons -- hence the "non-cyclical" label. Big names in this sector include Coca-Cola
In addition to their ability to fare well in practically any economic environment, the consumer non-cyclicals are all the more appealing right now because investors are flocking away from this sector. Why? In an effort to get more exposure to the "rising economy." That's why technology, retail, and financial services have been the biggest stock market winners so far this year. Meanwhile, the consumer non-cyclicals have languished -- unfortunate for investors who've owned them so far this year, but great for investors considering these stocks right now.
Some of these conclusions became all the more clear to me recently when I looked at Yahoo!'s sector summary. The table on that page includes a sector-by-sector comparison of various fundamental metrics such as price-to-earnings (P/E), return on equity (ROE), and dividend yield. An additional metric that's easy to compute based on this table is the P/E-to-ROE ratio. I like this ratio because it's a gauge of price relative to business quality. In other words, the lower the P/E-to-ROE ratio, the greater the value.
Check out how the market's various sectors stack up, as ranked by P/E-to-ROE:
Sector
PE/ROE
P/E
ROE%
Yield%
Cons. Non-Cyc. 0.62 21.4 34.3 2.42Conglomerates 0.81 18.2 22.4 2.53Consumer Cyc. 1.07 16.6 15.5 2.83Health care 1.11 27.5 24.7 1.85Financial 1.24 19.0 15.3 2.31Transportation 1.51 24.8 16.4 1.15Capital Goods 1.54 20.1 13.1 1.72Utilities 1.66 14.8 8.9 4.46Energy 1.87 20.2 10.8 2.80Services 1.88 25.1 13.4 2.39Basic Materials 3.40 30.8 9.1 2.66Technology 4.42 36.6 8.3 0.67
Lo and behold, the consumer non-cyclicals offer the greatest relative value and the technology sector offers the least. Pardon my tongue-in-cheek attitude, but this conclusion comes as no surprise to me given the Nasdaq's 30.9% moon shot year-to-date. Sure, this sector comparison is backward-looking, but the value disparity between the consumer non-cyclicals and technology is so large that I doubt any improvement in technology earnings over the coming year will close the gap.
All in all, I think the likelihood of subpar economic growth along with the relative value of the consumer non-cyclicals makes this group prime hunting ground for good investment candidates. Obviously, the average consumer non-cyclical stock at 21 times earnings is no great bargain. But I've done some sleuthing through this sector and have found a number of promising candidates trading for less than 15 times earnings. We'll take a look at some of these Hidden Gem-type companies over the next few weeks, starting this coming Monday. See you then.
Matt Richey ([email protected]) is a senior analyst for The Motley Fool. At time of publication, he had no position in any of the companies mentioned in this article. The Motley Fool is investors writing for investors.
