A Lifetime of Passive Income Is Hiding in Plain Sight

In the stock market, the simplest ideas are often the most effective. The average annual return of the S&P 500 is around 10% -- which is pretty good for a hands-off approach and certainly far better than alternatives. But income-oriented investors may demand more than the S&P 500's mere 1.5% dividend yield.

There are 11 sectors in the S&P 500. One of the safest is consumer staples. The sector's largest exchange-traded fund (ETF) by net assets -- the Consumer Staples Select Sector SPDR Fund (XLP -0.21%) -- is down on the year and is hovering right around a 52-week low. It features a dividend yield of 2.8%, nearly double the yield of the S&P 500. But unlike a risk-free 10-year Treasury note -- which yields 4.6% but features zero growth -- the ETF provides upside potential by investing in a conservative sector of the economy.

Here's why the consumer staples sector is an opportunity that's hiding in plain sight and worth considering now.

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Quality and recognizable holdings

Here is a list of the top 20 largest holdings by weight in Consumer Staples Select Sector SPDR Fund as of Sept. 28. 

Data sources: State Street Global Advisors, Yahoo Finance. 

You'll notice that many of the top holdings in the ETF are Dividend Kings, which are companies that have paid and raised their dividends for at least 50 consecutive years. Dividend Kings have a track record of increasing their dividends regardless of the market cycle, which is an attractive quality if you're looking for a stock to provide a lifetime of passive income.

You'll notice the ETF contains many recognizable names. But the term "consumer staples" may be more lenient than some investors realize. For example, folks don't need Coca-Cola and Pepsi products in the same way that they use detergent, toothpaste, or paper towels. Candy and sugary snacks made by Mondelez (owner of Oreo) and Hershey are delicious, but are certainly not essential parts of a nutritious diet. Rather, "staples" is more or less a loose term for relatively low-cost products that people buy regularly, even if they don't absolutely need those products.

A sector worth investing in

The consumer staples sector is a unique source of passive income because it has a relatively high yield of 2.8%, it tends to outperform the broader market during a bear market or recession, and it also has a bit of growth. Let's tackle these points one by one.

Starting with the high yield, most of the ETF's holdings are low-growth companies that have limited ways they can allocate capital. This profile contrasts starkly with a company like Amazon that is constantly looking for growth avenues and can invest in a variety of different industries. By the same token, most upstart companies desperately need capital to expand.

In comparison, a consumer staples company is more or less focused on operating a strong portfolio, rolling out new variants of top brands, or maybe acquiring an up-and-coming brand that would fit nicely with its product mix.

For this reason, consumer staples companies tend to reward shareholders through buybacks that reduce the outstanding share count. Since buybacks result in fewer shares, they boost earnings per share. Dividends are another way to directly allocate capital to shareholders instead of reinvesting in the business. All told, consumer staples companies offer a nice blend of value and income.

Many consumer staples companies have had success passing along costs to customers. Inflation from higher oil prices and raw material costs has made it more expensive to make ordinary products. But since customers buy these products regularly, they are more inclined to accept price increases from staples and cut spending on discretionary products and services instead. The pricing power and resilience of many consumer staples are why these companies can perform well despite challenging economic conditions.

Consumer staples companies can grow by selling higher-margin products in their product mix, increasing prices, or achieving higher sales volume. Shifts toward more expensive products in the product mix and pricing power are easier to achieve during a strong economy. Meanwhile, higher sales volume can come from something as simple as a rising population.

So although consumer staples companies are low-growth, they certainly aren't no growth. In fact, these companies depend on growth to support dividend increases and buybacks.

A perfect choice for cautious investors

Investing in a consumer staples ETF is not for everyone. Over the long term, the ETF is probably going to underperform the S&P 500. So investors in the asset accumulation phase may prefer to take on more risk and volatility in the pursuit of higher average returns and growth potential.

However, the consumer staples ETF will probably be less volatile than the broader market, and especially less volatile than high-growth sectors like technology, consumer discretionary, or communications.

The sector is worth investing in if you're focused on capital preservation, don't like volatility, and can achieve your financial goals or supplement income in retirement with a lower expected return.