Call it a defensive play. Call it portfolio diversification. When the market is down, investors should understand that some sectors still do better than others. And the Consumer Staples Select Sector ETF (NYSEMKT:XLP) has been on the rise since volatility jumped in October.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma discuss the value of holding established consumer staples companies when the broad market and economy turn for the worse. From consumer stalwarts like Procter & Gamble (NYSE:PG) to retail leaders like Walmart (NYSE:WMT) and TJX Companies (NYSE:TJX) -- these companies still have long-term potential even if their growth fails to impress.

A full transcript follows the video.

This video was recorded on Nov. 13, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, November 13th. Joining me on the show today via Skype is senior Motley Fool contributor, Asit Sharma. Hey, Asit, how's it going?

Asit Sharma: Good, man. How are you? 

Shen: I am doing pretty well. Enjoyed spending some time with you over the weekend. It was definitely nice to get down to North Carolina, catch up with some friends, catch up with you. That was really nice.

Sharma: We had an awesome time. I really enjoyed being able to hang out with you and your lovely wife Gina, also with my wife Dil and a couple of your friends. We had some very delicious Mexican food. 

Shen: Yeah, those tacos were good.

Sharma: I nibbled a little bit on Dil's. I don't know why I walked into one of the few really authentic joints in Raleigh and ordered the burrito. A long story we don't have time for today. To cut it short, I had a great time seeing you. It was really fun. Listeners, if you have a chance to catch dinner with Vincent Shen, you should never refuse. A great evening. 

Shen: [laughs] Alright, before we get into our main topic, we have to spend at least a few minutes talking about Amazon (NASDAQ:AMZN). Last year, in September, you and I first discussed the news that Amazon would be opening a second headquarters, expanding outside of the current campus in Seattle, and showing just how much pull and influence that the company has in this country. The past year has been pretty much a rat race among many major metropolitan areas pitching Amazon on why they would make a great site for what they're calling HQ2. The official decision was actually announced this morning. There have been rumors floating for the past several weeks about this decision being finalized. We're looking at a split for the new headquarters between Crystal City in Virginia and Long Island City in Queens, New York. 

Crystal City or National Landing, which is what they're trying to rebrand it to, is not too far from Fool HQ. I actually pass through that area every day during my commute on the Metro. The news just came out this morning. We talked about it a few times. Are you surprised at all, Asit, by these choices?

Sharma: I'm not surprised in the least. These are two great cities, great locations if you're a company with such a gargantuan reach. Both offer much in terms of an educated workforce, proximity to really prime -- not to make a pun there -- shipping points for the East Coast. Also, I think the choice of Crystal City obviously has political implications for Amazon. As it grows larger, it'll be closer to the politicians who are making rules which might regulate it. Being close to New York City, which is the nation's financial center, doesn't hurt, either. These are great choices for Amazon. They will add much to the local economies. 

I am a little curious. Both of those points are congested already, in terms of commuter traffic. Both have surrounding areas that they can build out, in terms of logistics. I'm curious to see what will happen in the future. I live not too far from Northern Virginia, so I anticipate it'll be much more crowded getting in.

Shen: Yeah. I'll say that the whole HQ2 process, I feel like it comes up at least a few times a month in conversation for people who live in this area, especially now that there have been rumors that they were coming close to making this decision. You think about 25,000 new jobs, lots of money, potentially billions of dollars in investments. It's a big deal. But the reaction this morning, it seems like, around HQ and talking to some of my friends and family, it seems to be a mix depending on if you're a homeowner or not, and how it might affect home prices in the area. A lot of people also seem to be grumbling about the idea of more traffic, higher housing prices. 

Another big question that also remains, that I know a lot of people are curious about, is basically the full extent of the incentives that Amazon will receive from the local and state governments in Virginia and New York. In the press release, the company mentions over $550 million of incentives for the potential 25,000 jobs it's bringing to the Crystal City region, the Virginia region. Additional details will become public in the coming days and weeks. They're certainly going to be an important part of the equation for the communities that will soon be homes of the new HQ2 campuses. 

Now, let's get into the rest of our discussion. That's what role consumer and retail can play for investors in a weak market. We bring this up now, because yesterday, the S&P, DOW, and NASDAQ each declined 2-3%. All three indices are down significantly from their highs earlier this year. Volatility has been the name of the game for a few weeks now. Asit and I talked about what's driving some of this volatility two weeks ago. But that doesn't necessarily make it any easier to sift through all these headlines, these predictions that you see that the next bear market is coming, it's on its way. As this bear sentiment grows, we're seeing certain names in consumer and retail outperform. Specifically, we're talking about consumer staples and the value that they can have in your portfolio as a source of stability and diversification, especially when you're hoping to play defense without panicking and selling out of all your positions. 

I remember back in Econ 101, my professor discussed certain sectors of the economy, concepts like inelasticity of demand. Asit, can you break down consumer staples for us, and the appeal that they can have in down markets?

Sharma: Absolutely. Consumer staples are pretty much what they sound like. They're the staples that you buy every day that exist in your household. We're going to talk a little bit in this show about Procter & Gamble. They give you maybe the easiest way to think of consumer staples. They have everything from Tide to packaged food products that they own and that consumers buy. Consumer staples, the things that you buy before the layer of your income that we call discretionary income.

I'm going to briefly mention discretionary consumer stocks as a group, as well. We'll touch on that during the show. Discretionary income is also just what it sounds like. It's the money that you can afford to use for the things that are treating yourself in life, maybe going out to eat or buying stuff from amazon.com. Amazon is thought of as a discretionary stock. 

These are the two poles of consumer stocks. I should say, these are the traditional ways to think of consumer stocks. On this show, of course, we talked a few months ago in our future episode about how the line between tech and consumer stocks is becoming vague. Some stocks which we now classify as consumer stocks might as well be tech companies. But we're going back to bedrock definitions today. I'll flip it back to you, Vince, so we can dive into the rest of the tickers that we have for folks today. 

Shen: A big thing that I want to cover to start things off and to offer some perspective as to why this sector, these consumer staples, these names, this part of the economy, can be very powerful during times when things are uncertain, people are more bearish in the market. It's the performance of certain proxies. Asit, one that you turned me on to before the show the show is the Consumer Staples ETF, ticker XLP. You look at it as a proxy for this sub-sector. You only have to look at the past month to see how its trading has diverged from the broad market. Since the big sell-off in mid-October, XLP is up almost 9% while the S&P 500 is flat over the same period. That outperformance also shows through year to date in more recent months. You shared the chart with me, Asit. How did those numbers pan out?

Sharma: Let's start with the year to date numbers. This is from Fidelity. You can also find this if you go to the S&P website and look at their sector funds. Fidelity's numbers show that year to date, the healthcare sector has the largest gain. It's gained 11%. Next is consumer discretionary, which is up 8%. I'm rounding here. Information technology is next, then utilities. Information technology is up about 7%, utilities up 4%. 

Everyone who's followed market understands that conditions have really deteriorated over the last three to six months. I'm going to now read you a three-month view of market sector leaders. The first is consumer staples. That's up 6% in a three-month period. Utilities are up 3.5%. Healthcare is up only 2%. Real estate is up less than 1%. Every other sector, from communication services to financials to information technology to energy, they're all negative over the last three-month period. 

Shen: I'll also give you a more historical look. Take 2008 and the lead-up to the financial crisis. That was a year when the S&P 500 shed just under 40%. A huge scare for investors across the market. The XLP during that time took a hit of just 17% that year. It's not hard to see how having part of your portfolio invested in consumer staples during that time could have softened the blow from the rest of the market as things were selling off. 

I took a look at the fact sheet for XLP. The top industries represented in it -- these are the things that arguably, you can't go without. That's the main theme for these industries. Think about food and beverages, household products. Tobacco is also traditionally included in this category, as well. Among the top ten holdings for XLP, you have companies like Procter & Gamble, which we mentioned, Coca-Cola, Walmart, Costco, Altria, among others. These are supposed to be the companies that remain stable even in these weaker market or economic conditions. People need what they sell regardless of those conditions. 

Next up, we'll look a little more closely at what these consumer staple companies can offer, and then some of the stocks that fit into the category, and how they they're individually bucking the bearish market trends in 2018.

Alright, Asit. I know there were at least a few tickers in other aspects of this consumer staples category that you wanted to highlight, and how they've outperformed this year. Where do you want to start?

Sharma: I want to dive in with the largest holding of the XLP. Listeners, I'm going to pause for two seconds while you try to guess the largest holding. I think I already gave it away earlier in the show. It's Procter & Gamble, which is 13% of this fund. I know there are some board members at Procter & Gamble who, these past few weeks, are thinking, "How do you like me now?" This was an unloved stock. I'm going to give you the annual average return of Procter & Gamble going back to this period that Vince talked about, the beginning of the financial crisis. I did a search for an anchor date of January 1, 2008. The company has only returned about 7% a year in this great bull market, versus the S&P's nearly 13% annual return. That's because it's had very slow organic growth. It's had to compete with the smaller brands that have taken advantage of e-commerce, and how cheap it is to build out a new brand and take it to market. It's had some other difficulties in its approach to brands, which we've talked about on this show. Listeners are familiar with the plethora of products that it's had in the past. It has reduced that product line. It's reduced its brand line. Still is looking for a turnaround. Of course, we've also recently talked about board member Nelson Peltz, who's an activist shareholder, looking to effect change at the company. 

The reason that Procter & Gamble, which was down almost 26% just a few months ago, is now even for the year and is one of the best-performing stocks in the S&P 500 over that period, is that it's a stalwart flight-to-quality company. When you hear the talking heads on TV mention defensive stocks, and terms like "flight-to-quality," they're really talking about these companies which grow revenues very slowly. The more stable the cash flow, the less volatility there is in the earnings. What becomes a black mark on a company when the market is rising, and technology companies are grabbing everyone's attention, those become virtues when folks are starting to run scared and thinking about, "What's going to happen to my capital? I had it invested in some high-flying stocks, and I see they're down about 20-25% in just the last couple of weeks. How will I preserve that capital?" This is why a stock like Procter & Gamble becomes so attractive. 

I should mention that, in addition to the really stable cash flows it's known for, it still throws off that widows and orphans dividend yield, which we've talked about on this show. I looked this morning, it's currently at 3%. That's not a bad yield if you have to park some of your money. 

The reason that this stock in particular is starting to stand out on many lists is because of the relative underperformance over the last few years. The thinking is, there's some upside here, especially if Peltz can initiate some of the change he wants. Maybe this could be more than a 7% return, and it provides that defense in an uncertain market. What are your thoughts, Vince, about P&G?

Shen: I think that's a great overview. It's funny. We last talked about P&G in late September, and really, I don't think anything has changed fundamentally since then in terms of the story. We know that around the middle of the year, the stock got a boost thanks to the push from activist investor Nelson Peltz. But we're not at a point yet where the company has come out and officially announced that they're adopting any of these major changes that Peltz has offered up as a way for the company to return to the stronger growth and better portfolio of brands that it had. But the stock is up over 17% in the past month. I think you summed it up. Even though the story hasn't changed, as somebody looking in from the outside, you have a company that is looking to pay $7 billion in dividends and do $5 billion of share buybacks for fiscal 2019, that has to be looking pretty good right now, even though they've been struggling relatively for the company, in terms of growing and maintaining their market share. This is still a company that has a portfolio of many well-known, household-leading brands. I think that really does sum up this idea of the flight-to-quality. 

Another company that I'd like to move on to, and I can't help but chuckle a little bit about this one, is McDonald's (NYSE:MCD). The company has really roared back in recent years under the leadership of CEO Steve Easterbrook. Personally, I swear, all my friends will groan when McDonald's comes up. It's something they don't eat anymore, they complain it's unhealthy. But privately, one-on-one, I'll talk to my friends, and they'll admit to the occasional guilty pleasure drive-through for a Big Mac and French fries. And I feel the same way. 

Given the success that we've seen with things like all-day breakfast, a better value menu, they've been investing in new technology like kiosk ordering, the re-franchising efforts, I think the company has a lot of long-term irons in the fire to help it stand out even more in a weak market. You look at the most recent quarterly results, U.S. comps were up 2.4% while international markets grew 4.6%. Revenue is down from that re-franchising effort that I mentioned, but the bottom line grew 17%. These franchising fees are far more stable, exactly what investors want in this kind of consumer staple business. The chain is renovating 1,000 locations every quarter. Delivery is now available 15,000 restaurants. Add to that the 2.5% dividend yield and a market-beating 7% gain for the stock year to date, and this really jumps out as an interesting option now for somebody who isn't looking to completely clear out their portfolio. They're looking for something to play defense, like we've talked about. What do you think?

Sharma: I think McDonald's is a surprising source of growth in the fast food industry. Surprising because it's so large. One would think that the smaller rivals would take the available market share. But you're right, Vince. Since CEO Steve Easterbrook took over, the company's made a lot of rapid change. It's aligned itself with a more progressive eating out culture, which appeals to millennials. It's removed some harmful ingredients from its list. To point to the innovations that you mentioned, I'm especially interested in delivery. That's not just a U.S. story, but it's a global story. McDonald's has really ramped up its global sales. You mentioned 4.6% comparable sales internationally versus that slower U.S. growth. It used to be that McDonald's depended more on North America for expansion of revenue and margins. That equation has slowly flipped. Under Easterbrook, who really honed his chops in the U.K., I see that continuing. 

I've always been interested in this stock. I think there are more guilty-pleasure-seekers, as you mentioned, than folks realize. I do think that the company has an in to the newer generation. Their app has been pretty successful. I know anecdotally -- take this with a grain of salt, maybe as much salt as you might find in a Big Mac, listeners -- anecdotally, my teen sons use that app, and we have always succumbed to guilty pleasures. I love McDonald's coffee. I can't say that we eat there all the time. But, I do think they've gotten into the millennial mindset, especially with the delivery.

Here's something that will interest readers. First of all, this company isn't found in the staples fund, but it's found in its sister fund, which is the Consumer Discretionary Select SPDR Fund, ticker XLY. It's supposedly a discretionary stock, but I want to make an argument here with this stock and one other stock that's coming up that we're going to talk about. In times of declining income, a stock like McDonald's is a staple stock. When you drop down from eating from a fancy restaurant to a fast-casual or quick-service restaurant, of course McDonald's will benefit. So, I always think of it as a staple more than a discretionary stock. 

The wealth effect is very interesting to think about in relation to McDonald's, too. Vince brought up his college economics class. Here's one from mine. When the stock market declines, consumers feel less rich, and they tend to pull back their spending, which can then have a reinforcing effect on the economy, especially a consumption-based economy like we have here in the U.S. I think McDonald's can actually benefit if the stock market goes down or if the economy really does start to, indeed, slow. Either way, it will see some tailwinds. 

Last thing I want to say about this company. If you went back to January 1st, 2008, and looked at the company's total return since then -- listeners, I'll pause again. What do you think it would average in the last several years? Almost 11 years now. McDonald's has returned 31% per year on an annualized total return basis since the Great Recession. I kid you not.

Shen: That's an unbelievable number. When you mentioned that to me before the show, I was blown away. That's the kind of number that you'd expect not from McDonalds, but maybe some of these high-flying tech companies.

The next one that we'll look at is TJX Companies. This is another business model that I think, like you mentioned with the wealth effect, and in general, can thrive in weaker economic environments and markets thanks to the focus it has on quality at a discount. The company reported 6% comps growth in its fiscal second quarter. Year to date top line growth is in the double digits at 11%. All of this is for a company with over 4,000 stores, and management sees an end goal of about 6,100 locations. This is not a small chain. It's a big, multi-billion-dollar business still managing to put up those kinds of numbers. And, as a brick-and-mortar-focused retailer, their e-commerce business is still very young and only starting to get its legs. Still a very small part of the company. What else stood out to you, Asit?

Sharma: TJX Companies, to me, is a twofer. It's a two-for-one buy. You get a defensive place to rest your money, but you also get, in acquiring this stock, a growth narrative. We've talked about TJX off and on on the show. I can't remember us devoting an episode to it. One of the things that I really love about this company is that it has an inordinately acute grasp of inventory. It has buying teams dispersed all around the world, and they just specialize in buying discontinued inventory, discounted inventory, inventory from other retailers. They put it on the shelves. Fashionistas love to come in and see what's new every week. It's a very lucrative model that has served TJX Companies well.

What's caught my eye recently, I wrote an article a couple months back about how TJX utilized its square footage. I noticed that the new square footage growth is actually going not into its core fashion stores like Marshalls and TJ Maxx, but more towards this new line of business personified by the Home Goods store. The company has made a move into the home furnishings industry. It's taking its inventory chops and applying that with some pretty nice merchandise. Those stores are doing quite well.

Again, this is in the discretionary version of the ETF that we've talked about; but to me, it's a staple stock when the economy goes bad. Those who are buying clothes that are top-of-the-line start going more to TJX to see what's on their shelves, maybe at a discount. The same with home furnishings. We saw in the recession that stores like Home Depot, which offered folks a way to spend on their homes without buying a new house -- that is, renovating or putting in new furnishings -- this is the type of line of business that would benefit TJX if the economy indeed goes south. 

I like it for all those levels. The stock is up 42% this year. That's because you have this twofer. Investors acknowledge and recognize that it's a safe place to put money, but it's also a growth story. What are your thoughts on TJX? 

Shen: You're right. I'm not sure if we've had a single episode dedicated to TJX before, but it's come up a few times -- and in one episode, at least, as a best-in-class retailer, maybe a special shout out for the brick-and-mortar-focused category that we really like here. I know a lot of Fools are fans of how TJX is flexible with the layout of its stores, what those store formats look like, and ultimately having very strong management of its inventory, keeping people coming into the store, showing really strong comps growth, and specifically maintaining strong traffic levels. So, keeping customers coming back to the store again and again. Definitely another one to keep an eye on.

We have a few more minutes, and I want to make sure we have time to cover Walmart. I feel like this is a gold standard for a consumer staples retailer. Going back to 2008, that year and I mentioned and the lead-up to the financial crisis, the lows reached during that time, the S&P down 40% for the year. Walmart was actually up 18% that year. Just a single data point for you to consider.

More recently, this is a story that I think shares a lot of similarities with McDonald's. Management's focused on growing its e-commerce arm. They're focused on investing and acquiring all these new businesses and taking generally more market share. It's a long-term focus that I like to see, even if it means that there's going to be a near-term hit to profitability in the next fiscal year or two. It's a focus that seems like management at both of these companies -- McDonald's and Walmart -- are taking on. I think it'll be good for shareholders looking out five, ten years and further. What are your thoughts here?

Sharma: Longtime listeners will remember that we devoted an episode to Flipkart, which was Walmart's great e-commerce acquisition. That's the up-and-coming e-commerce online operation in India. One thing that's really caught my eye since that show is Walmart's attention to, again, millennials and Gen Z. It's invested in a number of brands. I'll read a few. Bonobos, ModCloth, Moosejaw and ShoeBuy. These are non-traditional categories for Walmart. It's investing where millennials are shopping and in the brands that millennials like. It's also really ramped up its own private label offerings. Fashion turns out to be a large opportunity in the economy in good years and bad years. Walmart, in doing this, is extending beyond that brick-and-mortar, away from what jet.com, another acquisition, brings it, which is a quasi-competitor to Amazon, and more of an individualized, standalone concept with each of these brands that it acquires. It's diversifying that base out. Of course, when your revenues are in the several hundreds of billions of dollars a year, it takes a long time for an effort like this to provide diversification. But we've seen it acquire delivery companies, logistics companies, waging this multi-front battle with Amazon. I would urge listeners to look beyond Amazon to a future where retail stores still exists, consumers are still going into Walmart stores and buying products which you today might not associate with this company.

I also wanted to note, in the most recent quarter, Walmart's U.S. comps rose 4.5%, which was the best performance in ten years. I believe they're reporting results on the 15th of October in just a few days. We'll get to see if that trend continues. It's a long-term classic defensive play, but again, there's a growth story in here that's starting to emerge. 

Shen: Thanks, Asit. We have like two more minutes, so I want to give you an opportunity. With this broad conversation that we've had on the idea of consumer staples as defense during market downturns, what's a big takeaway you want to leave our listeners with?

Sharma: The biggest takeaway, we really haven't mentioned this, but it's probably a question that many listeners have as we pull to the end of this show. If I buy these stocks tomorrow, am I just going to suffer another big downturn, as I have with other names in my portfolio? My answer is, we might. You never know how low the market can go when there is a bear market. However, each of these companies is grouped around 21X forward earnings. That's fairly cheap, given today's market. The only outlier is McDonald's, which is trading at 24X one-year forward earnings. Take TJX, even with its 42% rise, it's still comparatively cheap when you look at the broader market. You have some true defensive muscle in here. I would urge listeners to explore these and other big quality staple stocks in more detail, and maybe start nibbling, adding some defensive positions to their portfolios. 

Shen: Reiterating some of the warnings that we had, the takeaways that we had when we talked about what's driving the recent volatility -- this was two weeks ago on the show. Panicking: not the right move. Selling out of everything: not the right move. You're in a position right now to think about your portfolio. If you're worried about something like this, like a downturn, consider: am I diversified? If you're not, these are the kinds of sectors and companies that you can look at to help bolster things. That's just one of many routes that you can take.

Asit, as always, thanks for joining us.

Sharma: Absolutely. As always, this was a load of fun. See you guys soon.

Shen: Fools, thanks for tuning in. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Asit Sharma has no position in any of the stocks mentioned. Vincent Shen owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has the following options: short February 2019 $185 calls on Home Depot and long January 2020 $110 calls on Home Depot. The Motley Fool recommends Costco Wholesale, Home Depot, and The TJX Companies. The Motley Fool has a disclosure policy.