Investing in consumer-related companies during a recession could be a path to long-term gains -- if you pick the right companies at the right prices.

You just know that some stellar consumer brands have suffered unduly from Wall Street's unfair treatment.  To give yourself the best chance of finding these stocks, you'll need to answer two questions:

  • Which sector currently represents the better buy -- consumer discretionary goods, or staples?
  • How has the recession affected consumer habits, and will this behavior persist through a recovery?

Disposable income: Yeah, some still have it
As of last week, S&P consumer discretionary stocks as a group were up 22% in the current quarter, and 11% for the year. Meanwhile, consumer staples gained 11% in the quarter, but lost 1% on the year. In light of continued job losses and mortgage troubles, which are now spreading to prime borrowers, it looks like shares of apparel, hotel, and leisure companies are ready for a dose of gravity.  But not all discretionary stocks are created equal.

I took a look at May same-store sales results for chain retailers to see which companies were faring well year over year. Then I winnowed down my shopping list to include only companies with strong balance sheets:

Company

Market Cap

P/E

May Comps

Total Debt

Quick Ratio

American Eagle Outfitters (NYSE:AEO)

$3 billion

19.5

(7%)

$75M

1.6

The Buckle (NYSE:BKE)

$1.5 billion

13.7

13.4%

$0

2.2

Aeropostale (NYSE:ARO)

$2.5 billion

15.0

19%

$0

1.6

Data from Yahoo! Finance and Motley Fool CAPS on June 8.

While this is far from a buy list, all three of the above stocks appear to deserve additional consideration.

Personally, I'm interested in Aeropostale. Although the stock is up around 60% in the past three months, it's nonetheless trading at an attractive PEG ratio of around 1.0. The PEG ratio is imperfect for many reasons -- for one thing, it relies on analysts' five-year earnings forecasts -- but there are still legitimate reasons to be upbeat about Aeropostale's future.

First off, the company sells its hip clothing and accessories to the trend-conscious 14-17-year-old crowd. Much of this demographic probably couldn’t tell you what a recession is, and teenagers have a way of wringing cash out of mom and dad, even when times are tight. In addition, the company's expansion into the Middle East looks promising, especially given the region's oil-driven long-term economic prospects.

Of course, there are risks. Teenagers who've historically relied on summer jobs to fund their back-to-school clothing purchases might pay Aeropostale fewer visits in the next few months. But with no debt and a strong brand, it looks to me like the company has staying power, even if business drops off for a season or more.

The enduring appeal of soap and cereal
Discretionary goods may be all the rage, but nothing beats the safety of consumer-staples companies. You'd be hard pressed to find dividends this healthy in other consumer-related industries. Below, I've listed some of my top picks, based on company fundamentals and valuation:

Company

Market Cap

2010

P/E

Dividend Yield

Volume Growth Most Recent Quarter

Volume Growth Est. FY09*

General Mills (NYSE:GIS)

$17.2B

12.5

3.3%

(1%)

positive

Colgate-Palmolive (NYSE:CL)

$35.4B

15.2

2.5%

(0.5%)

positive

Unilever (NYSE:UL)

$67.2B

12.4

3.7%

(0.5%)

improved from first quarter 2009

Data from Yahoo! Finance as of June 8.
*Fiscal year 2009 volume growth estimates based on company statements and management's remarks.

Colgate-Palmolive is clearly trading at the richest valuation. Interestingly, the company's brands do not include food products (not for humans, anyway). That could be an advantage; I've long felt that food's one of the sectors most susceptible to consumer trade-downs in tough times. CP's management reported that, excluding Europe, private-label or store-brand market share is below 5% in all its categories, save for mouthwash and liquid soap. That said, depending on the length of the recession, I am leery of a sales drop in certain product areas, particularly the company's premium-priced Hill's Science and Prescription Diet pet foods, which accounted for 14% of sales in 2008.

Elsewhere in the staple sector, Unilever -- the name behind Hellman's mayonnaise, Lipton teas, and Dove soaps -- wins the dividend yield contest by a healthy margin. In addition, the company is taking specific actions to drive volumes, including a focus on brand innovation and rollout.

Meanwhile, General Mills makes such brands as Cheerios and Yoplait, and it raised its earnings forecast for fiscal year 2009, which ended in May. In 2008, the company's international sales grew by 21%, and it entered 10 new regions in China alone.

Over the long term, I think that investors will do well with all three of these companies, although I wouldn’t be surprised to see share prices briefly pull back if the market sells off. That's especially true for Colgate-Palmolive and its relatively higher valuation.

Word of caution
Even though I think that the aforementioned staples stocks will protect you from a massive loss and provide long-term gains, investors should note that consumer habits are changing. Cheaper private-label brands appear to be one threat to these brand-name staples.  According to GfK Custom Research North America, over the last year, 55% of consumers have been "frequently" buying private-label products, up from 41% in 2006. Nielsen reports that private-label sales grew 9.1% through the 52 weeks ending March 21, 2009 -- roughly four times faster than branded goods.

I suspect that many consumers will remain value-oriented during an economic recovery. Investors who want exposure to this trend can consider grocery-store chain Safeway (NYSE:SWY), whose CEO appears committed to stepping up the company's private-label offerings if national brands don't drop prices. Alternatively, there is Ralcorp, a maker of store-brand products including breakfast foods and salad dressings.

All in the mix
Whether right now or in the future, there's probably no single best way to invest in consumers. Instead, much as companies carefully consider their product mix, investors should diversify their own exposure to the sector. Cautious investors might consider some of the staple names mentioned in this article. For those with a more aggressive bent, select retailers still look reasonable at today's prices. As always, take your time compiling your shopping list, lest you end up with a serious case of buyer's remorse.

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Unilever is a Motley Fool Income Investor pick. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Mike Pienciak does not hold shares in any company mentioned. The Fool's disclosure policy is a staple that should be freely consumed -- at your discretion, of course.