Consumer staples may not be an everyday term, but they certainly represent everyday products. This is the sector of the economy that fills your local supermarkets, drugstores, and convenience stores with their wide-ranging products. For investors, the good news is that most of these big, well-known brands come from publicly traded stocks. There's a good chance you use products from companies such as Campbell Soup (NYSE:CPB)Anheuser Busch InBev (NYSE:BUD), and Procter & Gamble, or their competitors.

What is a consumer-staples stock?

Consumer staples are typified by companies making food and beverages, household products, or tobacco. The sector is defined as consumer-products makers whose sales are largely unaffected by macroeconomic factors because consumers need, or are willing to spend on, these products for their daily routines, regardless of their current financial state. Consumer staples are distinct from consumer cyclicals such as housing, entertainment, travel, restaurants, and automotive, which tend to rise and fall significantly with the overall health of the economy and consumer confidence. Consumer cyclicals also tend to represent big-ticket expenses, especially the housing and auto sectors, which separates the sector from consumer staples, which are primarily low-priced everyday purchases such as shampoo or soda. 

A woman shopping in a supermarket aisle.

Image source: Getty Images.

Consumer-staples stocks tend to be low-innovation, mature companies that rely on big brands and timeless products and pay regular dividends. In recent years, consumer-staples stocks have widely underperformed the broader market for a number of reasons. Investors have become enamored with tech stocks, such as the FAANG group (an acronym for FacebookAmazon.comAppleNetflix, and Google),that have consistently outperformed, and changing consumer preferences have chipped away at consumer staples' traditional leadership in broad categories. Rising interest rates have also made bonds more appealing for conservative, income-seeking investors, leading them to take some money out of dividend-paying consumer staples. Finally, higher input costs have threatened some consumer staples stocks.

How have consumer-staples stocks performed?

There are a number of exchange-traded funds, investment funds that bundle a set of stock and trades as a stock would, that investors looking for exposure across the sector can choose from, including Consumer Staples Select Sector SPDR ETF (NYSEMKT:XLP)Vanguard Consumer Staples ETF (NYSEMKT:VDC), and iShares Dow Jones U.S. Consumer Goods ETF (NYSEMKT:IYK). Mutual fund investors may want to consider the low-fee Vanguard Consumer Staples Index Admiral (Nasdaq: VCSAX). However, all of these ETFs have underperformed the S&P 500 over the past five years.

XLP Chart

XLP data by YCharts

We'll discuss in further detail the struggles of the consumer-goods sector, but first let's go over the basics of the industry, looking at the largest consumer-staples companies to outline strengths and weaknesses of the sector. Then we'll review where these stocks stand today and how to best invest in the sector.

What are the largest consumer-staples companies?

Here are the top 10 holdings of the Consumer Staples Select Sector SPDR ETF:

Company Ticker Industry Market Cap
Procter & Gamble (NYSE:PG) Household products $209 billion
The Coca-Cola Company (NYSE:KO) Food and beverage $196.5 billion
Pepsico Inc. (NASDAQ:PEP) Food and beverage $162.9 billion
Walmart Inc. (NYSE:WMT) Retail $277.9 billion
Philip Morris International (NYSE:PM) Tobacco $124.7 billion
Costco Wholesale (NASDAQ:COST) Retail $101.7 billion
Altria Group (NYSE:MO) Tobacco $117.5 billion
Mondelez International (NASDAQ:MDLZ) Food and beverage $64.1 billion
Walgreen Boots Alliance Inc (NASDAQ:WBA) Retail $69.9 billion
Colgate-Palmolive Company (NYSE:CL) Household products $59.5 billion

Source: Consumer Staples Select Sector SPDR ETF.

Common traits of consumer-staples stocks

The consumer-staples sector is diverse, covering at least four separate industries. Even though companies such as Pepsi and Altria, for example, operate in different businesses, their stocks tend to behave similarly because they are subject to similar economic and consumer trends. 

Consumer staples' strengths are a mirror image of their weaknesses. The companies tend to be reliable, defensive, dividend payers, and many of them are Dividend Aristocrats, stocks that have raised their dividends annually for 25 years or more. However, such defensive stocks, or stocks that pay dividends and are relatively unaffected by broader economic conditions, tend to be slow growers, and as a result, they haven't seen some of the outsize growth other stocks have. As defensive stocks,  they're more likely to outperform in bear markets than in bull markets as investors tend to flock to safety, looking for companies that are reliably profitable and offer dividends. For example, during the market crash from October 2007 to March 2009, consumer staples didn't fall as sharply as the S&P 500.

XLP Chart

XLP data by YCharts

Let's examine current trends in each of the major consumer-staples industries  to give investors a better sense of how to invest in consumer staples.

Packaged-food companies 

The consumer-staples sector is full of food and beverage stocks. In addition to Coca-Cola, Pepsi, Mondelez, and Campbell Soup, there's also Kraft HeinzGeneral MillsKellogg, and many others. Though these companies have global supply chains and well-known brands, many of them are facing the same key challenge. Consumers, especially in the U.S., are increasingly rejecting artificial, pre-packaged foods, instead opting for organic and natural foods, especially foods that are outside the traditional scope of the food and beverage giants, such as fresh fruits and vegetables, Greek yogurt, and plant-based milk alternatives.

U.S. soda consumption, for instance, has declined every year since 2004, with diet soda plummeting in particular, showing that the trend against soda is about more than just calorie intake. Meanwhile, consumers are switching to beverages such as coffee, sparkling water, and coconut water. This trend has led beverage giants such as Coca-Cola and Pepsi to broaden their horizons with recent multibillion-dollar acquisitions such as Costa Coffee for Coca-Cola and SodaStream International for Pepsi.

In packaged foods, the trend is similar. Breakfast cereal is on the decline because many consumers no longer consider it healthy. That trend has forced companies such as General Mills to diversify with acquisitions such as Annie's Organic, the maker of bunny-shaped mac and cheese and other organic snacks, and more recently, Blue Buffalo Pet Products, a maker of all-natural pet food.

Companies such as Coke, Pepsi, and General Mills have the profits and cash flow to support acquisitions, but such moves don't always work out. Campbell Soup, for instance, acquired Bolthouse Farms in 2012 for $1.55 billion to give the company a boost in organic foods, but it struggled to manage a company with a different supply-chain and process from its core canned-foods business. Bolthouse is now up for sale, and Campbell CEO Denise Morrison was recently ousted as a result of the company's struggles.  

Considering the risk in food and beverage stocks, investors may want to select stocks that are benefiting from secular trends in the sector,  such as Hormel (NYSE:HRL), which has long specialized in protein-rich foods, a diet that has grown in popularity in recent years. Hormel has also made smart acquisitions in recent years, buying organic brands such as Justin's, a maker of nut butters, and Applegate, a maker of organic deli meats and cheeses.  

McCormick (NYSE:MKC) looks like another smart choice. The company is far and away the market leader in spices and seasonings, a sector of the supermarket that has seen rising sales as interest in home cooking has increased. As a result, McCormick should respond inversely to the trend weighing on packaged-food makers. Its recent acquisition of Reckitt Benckiser's food brands, including French's mustard and Frank's RedHot, drove sales up by about 10% in the year following the acquisition. Based on its dominant position in a stable, growing industry and its prudent acquisitions, McCormick could be a welcome addition to investors' portfolios. 

Tobacco stocks 

Tobacco stocks once reigned supreme over the investing world. According to Wharton professor Jeremy Siegel, Altria was the best-performing stock on the market from 1966 to 2016. The Marlboro maker and other tobacco stocks have historically benefited from wide profit margins in the industry, which have fueled consistently high dividend payments. The addictive nature of the product and customer loyalty to particular brands also mean that declining smoking rates and higher excise taxes haven't stopped Philip Morris; Altria, the domestic company that broke off from Philip Morris a decade ago;  British American Tobacco (NYSE:BTI); and others from continuing to generate wide profit margins as consumers have proved willing to absorb higher prices.

However, cigarette consumption continues to decline. At Altria,  cigarette volumes have fallen 7.6% through the first half of the year, compared with a 4.5% decline across the domestic industry. Despite a decline in revenue, Altria has been able to increase earnings per share by raising prices and buying back shares to reduce shares outstanding. 

Meanwhile, concerns have mounted recently about tobacco companies' ability to pivot to newer products such as heat-not-burn devices, including vaporizers, and tobacco stocks got shocked in the first half of 2018,  when Philip Morris reported slowing growth in its heat-not-burn IQOS product in Japan, a key market. Investors have been counting on the ability of companies such as Altria and Philip Morris to transition into next-gen products, but the struggles of IQOS in a friendly market show it may not be easy to replace lost cigarette sales. 

In the U.S., Altria has quickly fallen behind Juul in the next-gen race, as the start-up maker of flavored e-cigarettes now has 72% U.S. market share in e-cigarettes.  The market sees Juul as such a threat to Altria and the other tobacco companies that Altria stock actually soared when the FDA said it might crack down on its popular flavored e-cigs because it has become especially popular with minors. That bounce for Altria could be misguided, however, as the FDA is likely to equally scrutinize its similar products. Most recently, the Food and Drug Administration said it would ban sales of flavored e-cigarettes to minors as well as menthol cigarettes, which threatens the broader tobacco industry. British American Tobacco in particular could be at risk because it owns Newport, the most popular menthol brand in the United States. 

Investors in this space can count generous dividend yields in the 5% range, but picking a winner out of the three big tobacco stocks may not be easy. Altria has historically outperformed, but British American Tobacco and Philip Morris have more exposure to international markets, where smoking rates are higher so they may do better with the declining cigarette market.

Household products 

The household-products sector, made up of companies such as Procter & Gamble, Colgate-Palmolive, Unilever (NYSE:UL) (NYSE:UN), and Kimberly-Clark (NYSE:KMB), has undergone a similar transition to the food and beverage sectors.

Consumers, especially millennials, are increasingly favoring smaller, niche brands, with organic or environmentally sustainable products.  E-commerce has also opened up new selling and advertising channels for upstart brands, which have challenged traditional leaders such as P&G's Gillette, causing profits in P&G's grooming division to decline because of challenges from online subscription-based businesses such as Harry's and Dollar Shave Club, now owned by Unilever. Such companies are also threatened by rising private-label sales from retail giants such as Amazon, Costco, Walmart, and Kroger. 

That trend has caused revenue growth at many of the larger consumer packaged-goods companies to slow or even flatten in some cases. As a result, many household-products companies, like the food and beverage category, have been forced to look to acquisitions to fuel growth. Unilever, for example, has acquired brands such as Tazo tea, Sir Kensington's ketchup and condiments, and Seventh Generation cleaning products in recent years, in addition to Dollar Shave Club. Clorox (NYSE:CLX) acquired Nutranext, a health and wellness brand, earlier this year, and P&G acquired Merck's consumer health business for $4.2 billion.

Like the packaged-food giants, household-products companies can use their marketing muscle and distribution networks to ramp up sales of newly acquired brands, and with their brand power and control of retail shelves, these companies tend to have sizable profit margins, allowing for share buybacks as well. However, these stocks have generally underperformed in recent years because of their slow growth and a raging bull market that has avoided defensive stocks.

One exception, and perhaps the best option in the sector, is Church & Dwight (NYSE:CHD). The maker of products including Trojan condoms and Arm & Hammer baking soda is smaller than its rivals, and its shares have nearly doubled over the past five years. Church & Dwight has maintained a strong balance sheet, avoiding blockbuster acquisitions, and posted steady growth as it invests in new products under its Arm & Hammer brand and Trojan continues to deliver steady growth. Church & Dwight has even found itself as a potential acquisition target when Reckitt Benckiser planned to offer $23 billion to buy it in 2016. 

At the time, Church & Dwight played down the potential acquisition, but it's a reminder that the company is small enough to be a takeover target for a larger consumer packaged-goods company. With the best free cash flow as a percentage of net income in the industry, Church & Dwight may be the best bet in the sector. Unilever, which attracted a buyout proposal from the Warren Buffett-backed Kraft Heinz, may also be an appealing choice.

The big retailers 

According to some definitions of consumer staples, retail is a separate category, but we'll include it here because retailers and consumer packaged-goods companies are often subject to the same trends and because the two sectors are dependent on one another. Unlike the consumer packaged-goods industry, the retail sector has been looking strong lately. Retail sales have been surging throughout 2018, increasing 5.3% through the first nine months of 2018. 

That trend has buoyed retail giants such as Walmart and Costco, which have both turned in impressive results, seeing comparable sales rise. With their size and economies of scale, Costco and Walmart have natural advantages over smaller retailers. However, brick-and-mortar retailers have been losing market share to companies such as Amazon, with domestic e-commerce sales growing by about 15% a year. Companies such as Costco, with its Kirkland brand, and Kroger, with its Simple Truth organic brand, have grown at the expense of consumer packaged-goods suppliers as retailers make more profit and can offer lower prices by selling their own private-label brands.

Retailers such as Walmart, Costco, and Kroger derive the majority of their sales from groceries. With tastes shifting to fresh foods and away from packaged goods, that provides an advantage to retailers over consumer-staples suppliers. Retailers also have more of an ability to innovate and embrace trends such as e-commerce, as Walmart, Kroger, and Costco have already done. Suppliers such as P&G, on the other hand, rely on third-party retailers for sales and may have trouble staying top of mind in online channels where they don't benefit from their traditional shelf-space advantage. Changes in media consumption have also chipped away at their longtime advertising dominance in TV and print.

Of these retailers, Costco looks like the strongest. The warehouse-based membership club has a number of competitive advantages, including rock-bottom prices and its membership model, and has done the best of any large retailer at continuing to grow in the face of online competition, with same-store sales often increasing by high single digits.

Pharmacy stocks

Part retailer, part drug dispensary, pharmacy stocks offer investors yet another retail angle to play consumer staples. In the U.S., there are three major chains: CVS Health (NYSE:CVS), Walgreens Boots Alliance, and Rite Aid (NYSE:RAD). Drugstore chains are even more removed from traditional consumer staples because the majority of their business comes from the pharmacy, where they are subject to overall demand trends and issues such as reimbursement rates and prices for generics.

Among drugstore chains, consolidation has been the recent trend, as Walgreens has snatched up chains such as Duane Reade, merged with the U.K.-based Boots Alliance,  and took over 1,932 Rite Aid locations earlier this year after antitrust regulators shot down a full-on acquisition of the nation's No. 3 pharmacy chain. CVS, meanwhile, is in the process of a $69 billion merger with health insurance giant Aetna, which will help CVS defend itself against the looming threat of Amazon and Walgreens' aggressive expansion. CVS and Aetna should also benefit from cost synergies because CVS is already Aetna's pharmacy benefits manager. Finally, the struggling Rite Aid sought to merge with supermarket chain Albertsons, but investors who thought the price was too low blocked that move.  

Considering Rite Aid's ongoing problems, investors would probably be better off with CVS or Walgreens Boots in this sector.

Alcohol stocks 

 Finally, alcohol stocks also make up a significant portion of the consumer-staples sector, and several beer, wine, and liquor manufacturers are among the largest stocks in the space. On that list are Constellation Brands (NYSE:STZ), the domestic distributor of Corona and other Modelo Group beers; Brown-Forman (NYSE:BF-B) (NYSE:BF-A), the maker of Jack Daniel's, and beer maker Molson Coors (NYSE:TAP). Outside the U.S. are a number of international options, including Anheuser Busch InBev, Heineken (NASDAQOTH:HEINY), or Diageo (NYSE:DEO), which owns a number of liquor brands, including Tanqueray gin, Smirnoff vodka, and Johnnie Walker.

The liquor industry has been in the midst of a similar transition to the rest of the food and beverage industry because drinkers have been turning away from beer, in favor of liquor such as bourbon and whiskey and, to a lesser extent, wine.  Within the beer industry, craft-beer sales have boomed for much of the past decade, prompting acquisitions from large brewers such as Anheuser-Busch, Constellation, and Heineken. However, with craft-beer sales now slowing and smaller brands continuing to penetrate the market, there is concern among investors that companies overpaid for those acquisitions.

Constellation has been a standout winner in the alcohol sector over the past five years, with the share price having nearly quadrupled over that period. The company has benefited immensely from its acquisition of the distribution rights to Modelo Group beers in the United States. It has successfully ramped up sales and profits of those brands and ridden the growing popularity of Mexican beers in the United States. More recently, Constellation has made a big bet on the marijuana industry, spending $4 billion to take a 38% stake in Canopy Growth, the Canadian marijuana grower. Still, Constellation's growth has slowed over the past year, indicating that the benefit from the Modelo acquisition may have lapsed.

Elsewhere, Brown-Forman is the only one of this group of stocks to have outperformed the S&P 500 over the past five years. The whiskey maker has seen strong gains from brands such as Jack Daniel's and Woodford Reserve, whose sales jumped 22.5% in its last fiscal year.  

Still, alcohol stocks have been challenged with slow growth in big brands and the rise of small craft brewers and craft distillers. Given that climate, the industry may continue to underperform the broader market.

A future marijuana connection?     

The connection between Constellation and Canopy, Molson Coors' investment in cannabis grower HEXO Corp. (NASDAQOTH:HYYDF), and Heineken and New Age Beverages(NASDAQ:NBEV) moves to launch cannabidiol-based beverage underscores the potential for marijuana to eventually fall within the consumer-staples domain, much as tobacco and alcohol do today. Considering the legal gray area with the drug as well as its medicinal applications, it will probably be years before marijuana reaches the stability required to be considered a consumer staple. However, investors interested in the sector may want to follow the evolving marijuana space as it competes directly with alcohol. One day, the industry could mirror tobacco and alcohol today. 

The dividend equation

Since consumer staples are often defensive stocks, they tend to appeal to conservative income investors looking for dividend payments and wealth preservation. Warren Buffett, notably, is a fan of consumer staples, with major stakes in both Coca-Cola and Kraft Heinz. Consumer staples fit Buffett's style: He likes big, profitable brands that generate income from repeat purchases.

For these types of conservative investors, it's important to consider dividend yields and payout ratios, because stocks with higher yields, sometimes above 4%,  earnings growth, and a reasonable payout ratio, generally considered below 80%,  will be the most likely deliver a reliable dividend stream. After all, there's a reason so many of these stocks are Dividend Aristocrats. Consumer-staples companies crank out consistent profits and stable growth because they own age-old brands that have allowed them to weather recessions and down markets.

Tobacco companies such as Philip Morris and Altria have historically offered the best dividend yields of the bunch, and today, they pay yields of 5.4% and 4.6%, respectively. Other sector stocks offer yields in the 3% range. 

  

The best way to invest in consumer staples 

 

An ideal consumer-staples stock will offer reliable earnings growth and a high dividend yield at a moderate payout ratio, but that is increasingly hard to find given the challenges that many of the consumer-staples subsectors are facing. Smoking rates, for example, are declining. Big food is losing to local and organic, and even entrenched household-goods giants such as Procter & Gamble have been disrupted by scrappy start-ups such as Dollar Shave Club. Therefore, it's worth investigating the macro environment of an individual consumer-staples company, as that will have a significant influence on their returns.

Like investors in any other part of the market, those interested in consumer staples should first assess their needs and investing style. Dividend-seeking investors may be best off with tobacco stocks such as Altria, Philip Morris, or British American Tobacco, as those are the highest-yielding of the bunch.  

Investors with a broader set of needs or ones that are looking for growth may be better off taking the best in breed from each subsector of consumer staples. That would include Costco in retail, because of its competitive advantages and membership model; Hormel and McCormick in food and beverage, since they're getting tailwinds from changing consumer tastes; Altria in tobacco, as its outperformed its international rivals; and Church & Dwight in household products, because it's managed its portfolio effectively and has had more growth opportunities as a small brand. 

Diversification is always a good idea in investing, even when focusing on the consumer-staples sector, so the easiest way to play the space, especially for defensive investors, is to buy an ETF or mutual fund, which will give you exposure to a broad range of consumer-staples stocks.

Though recent years have not been kind to the industry, a change in market sentiment, consumer tastes, or interest rates could lead these stocks to better growth in the future. If a bear market comes, consumer staples are likely to outperform again. Tried-and-true, dividend-paying stocks in a defensive industry are never likely to go out of style.

 

Jeremy Bowman owns shares of Constellation Brands and Rite Aid. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends Anheuser-Busch InBev NV, Constellation Brands, Costco Wholesale, Diageo, and McCormick. The Motley Fool has a disclosure policy.