Consumer spending drives the economy and is responsible for most of the growth that Wall Street applauds during boom times. Many of the businesses that benefit from this growth are situated in the consumer discretionary segment, home to companies like car manufacturers, vacation booking websites, and premium apparel manufacturers.

But what exactly is a consumer discretionary company, and how can investors profit from owning stocks in this industry segment? Below, we'll answer those important questions as part of a comprehensive look at what you need to know before adding these businesses to your investing portfolio.

A man carrying white shopping bags.

Image source: Getty Images.

What are consumer discretionary stocks?

These companies sell products marketed toward individual people, or consumers, as opposed to businesses. That puts these stocks in the consumer-focused segment of the economy that tends to drive overall economic growth.

The "discretionary" part of the term refers to a product's place in a consumer's budget. Specifically, "discretionary" (i.e., optional) purchases involve spending on non-essential items -- everything ranging from entertainment to home improvements, from new cars to vacations. That "non-essential" ranking in a household budget captures the key difference between consumer discretionary stocks and "consumer staples," which involve necessary spending in areas like personal hygiene, groceries, and cleaning supplies. If economic times are tough, you'd first cut spending on discretionary purchases like a gym membership or a trip to a theme park before you'd cut out toothpaste or laundry detergent.  

Are consumer discretionary stocks cyclical?

All businesses are influenced by the health of the wider economy. Most companies get a revenue boost during expansion periods when unemployment is low and falling and wages are high and rising. The reverse occurs during recessions, as sales are pressured by reduced spending on the part of consumers and businesses. It's impossible to predict the exact timing of that flow of ups and downs, but the swings are such a fundamental part of capitalism that they have their own term: cyclicality.

Whereas consumer staples stocks are insulated from these swings, and in the parlance of Wall Street are "less cyclical," consumer discretionary stocks are not. By definition, they involve spending that's likely to be cut back significantly – if not eliminated completely – during economic downturns. On the other hand, spending on things like vacations and new home appliances tends to grow quickly when the economy is expanding. That exposure to major ups and downs means that consumer discretionary stocks are among the most cyclical companies in the stock market.

About the industry

The consumer discretionary industry is one of 11 sectors that make up the U.S. economy and the wider stock market. As of mid-2019 it ranked fourth in size, at roughly $5.5 trillion of market capitalization, behind information technology, financials, and healthcare. By comparison, consumer staples ranked sixth at $3.7 trillion of market cap. Those standings in part reflect the fact that, at the time, the economy had been in expansion mode for several years, helping discretionary stocks outperform staples. The reverse usually happens during economic downturns.

There are 11 subsectors in the consumer discretionary industry, according to the official S&P 500 classifications. The biggest of these are internet retailing, hotels, restaurants and leisure, specialty retailers, and automobiles. The industry includes both the producers of things like jewelry and services like vacations, in addition to the companies that distribute these goods and services to consumers.

Investing metrics to know

The wide range of companies in this industry means that there are dozens of metrics that management teams use to track the strength of their businesses. Many of these are specific to a given sector, like hotels or e-commerce retailing.

However, there are a few key investing metrics that apply to essentially all companies in the consumer discretionary space. Let's take a closer look at these figures and how they'll inform your investing decisions.

Revenue growth

It might sound obvious that sales growth is important to follow and that a faster expansion rate is generally better than a slower one. But there are good reasons for Wall Street's sometimes obsessive focus on robust sales gains when it comes to consumer discretionary stocks. Strong demand for your product or service allows you to build formidable competitive advantages over time, such as economies of scale, pricing power, and customer loyalty. It helps illustrate how well your business stacks up against competitors who are targeting the same consumers, too.

This metric is always disclosed up front in quarterly earnings announcements and annual financial reports, and it's usually referred to as "net revenue" or "net sales." To account for seasonal swings, it is expressed as a comparison to the prior-year period, so that investors get an apples-to-apples match against a similar time in the business. When an automobile manufacturer says revenue rose 8% in the fiscal second quarter, that means sales improved by that margin when compared to the prior year's second quarter, not the current year's first quarter.

Drilling down another step, revenue growth is usually composed of two elements, volume and pricing, and both are important for investors to understand:

  • Volume refers to the number of units sold, whether its hotel rooms, entry tickets to a theme park, or automobiles.
  • Pricing is the average price that a consumer pays for the product.

Investors like to see a balance between both elements as they support overall revenue growth because higher volume implies a growing customer base while rising prices suggest healthy pricing power.

Market share 

Almost all companies aim to boost their sales at a faster rate than their competitors. In other words, they target market share growth as a fundamental goal for the business. Some consumer discretionary stocks disclose an actual market share figure, but mostly investors judge a company's growth pace by how it stacks up against key rivals and the wider industry. Persistent market share wins tell shareholders lots of good things about the business, and those wins become amplified the longer they stretch on.

Profit margins

Profitability refers to the percentage of revenue that's left over after the costs of running the business are all extracted. The two main levels of this metric are called gross profit margin and operating profit margin.

Gross profit margin describes profitability at the level of the sale. It captures how much profit a company earns over and above the cost of production and distribution. High and rising gross margin tends to correlate with attractive business characteristics like strong sales growth and pricing power. Falling gross profit margin, on the other hand, usually suggests competitive struggles or challenges with manufacturing costs.  

Operating profit margin is the profit that's left after deducting corporate overhead and general expenses from gross profit margin. This figure doesn't include potentially distorting factors like tax expenses and so it can be a powerful expression of the bottom-line earnings power of a business. All companies aim to keep their expenses as low as possible, but the consumer discretionary stocks that generate strong investor returns tend to be market leaders in this metric.

Dividend payments

Consumer discretionary stocks see wider sales and profit swings than their consumer staples peers, which makes it harder to maintain high dividend payments. Still, many of these companies target returning significant amounts of cash to their shareholders through stock repurchase spending and a steadily rising dividend.

Since the dividend payment will likely account for a hefty portion of your overall return, it's useful to understand a few key terms:

  • Dividend yield: The payout expressed as a percentage of the stock price.
  • Dividend payout ratio: The percentage of earnings that a company allocates toward the dividend.

There's a Goldilocks element to the payout ratio: Investors typically want to see a significant commitment of profits, but not one that's so high that it risks a cut during down years. Usually, the sweet spot for dividend payout ratios is around half of annual earnings.

The risks around investing in consumer discretionary stocks

The main risk of investing in any consumer-focused business is that demand trends can shift rapidly at any time, including through a surprise downturn that sends sales lower for a period of several years. This exposure is more extreme for consumer discretionary businesses due to the non-essential nature of the products they sell.

The fact that recessions are part of a well-worn cycle of recession, recovery, and expansion implies that most stock losses are likely to be short term in nature. However, many investors tend to sell stocks after a period of poor performance (and before the rebound) in a strategy that's in direct opposition to the goal of generating solid long-term returns. A simple approach of just holding the stocks through these inevitable down periods would be better, but that hands-off approach is a challenge for many investors. If you fall into that category, then consumer discretionary stocks are likely to test your resolve as a buy-and-hold investor -- especially during recessions, when it can seem as though the boom times will never return.

Some key players

Investors have a wide range of choices when it comes to discretionary stocks, and below is a list of a few of the biggest in the sector. Let's take a closer look at three of these giants, which have been generating especially strong returns for long-term shareholders.

Company

5-Year Revenue Growth Through 2018

Amazon.com (NASDAQ:AMZN)

26%

Home Depot (NYSE:HD)

7%

Nike (NYSE:NKE)

7%

Starbucks (NASDAQ:SBUX)

11%

TJX Companies (NYSE:TJX)

7%

Home Depot

As you might have expected, Home Depot's business was hit hard during the Great Recession and the housing market collapse that followed, with sales slumping and earnings and profitability each falling by about 40%. Yet its strong retailing model, and its leadership position in the home-improvement industry, helped ensure a quick rebound for investors.

Since hitting lows in 2010, Home Depot's key operating metrics have all jumped to new records, with annual sales surpassing $100 billion in 2018 compared to $68 billion in 2010. It isn't all due to a rebounding industry, either, because the chain's sales growth and profitability figures both routinely trounce that of rival Lowe's (NYSE:LOW).

Home Depot has executed well around key areas like the shift toward online retailing and pushing into the professional contractor segment. That spending has helped push the chain's efficiency up, with returns that are among the highest in the entire market. Investor returns have also been amplified by management's good use of capital, taking advantage of low interest rates to repurchase lots of Home Depot stock while still boosting the dividend at a market-thumping pace. These advantages suggest shareholders will continue to be happy with their Home Depot stock even through the next cyclical downturn.

Nike

Nike is one of the world's most recognizable brands, and its business strength reflects that premium position. The sports apparel and footwear titan counted over $36 billion of sales in fiscal 2018, from which it generated $4.3 billion of pre-tax profit .

Nike's market-leading profitability is the result of several key advantages, including its large sales base, its innovative products, and its ability to spend billions of dollars each year on marketing. The company benefits from a global selling posture, too, with a significant presence in places like Europe and China, in addition to its core U.S. market.

Nike endured slowing growth in fiscal 2017 because of a surprise shift in consumer demand at home. But the company quickly adjusted to the new industry dynamics, in part by leaning more heavily on direct-to-consumer sales and by accelerating its pace of product releases. CEO Mark Parker and his team believe that shift should continue driving robust growth, and improving profit margins, as Nike establishes more direct relationships with consumers.   

TJX Companies

Apparel and home goods are cyclical products whose demand levels tends to rise and fall with moves in the wider economy. But TJX Companies' flexible, off-price selling approach has allowed it to thrive despite those swings. In fact, as of 2019, the retailer had increased its same-store sales for 23 consecutive years.

That impressive streak is a testament to TJX Companies' diverse retailing portfolio, which includes TJ Maxx, Marshalls and HomeGoods stores. It also demonstrates that the chain can attract discount-hunting shoppers in a wide range of selling environments. When economic times are tough, TJX can usually find plenty of quality merchandise at deep discounts as full-price retailers cut inventory. And in boom times, it can stack its aisles with higher-margin products.

In any case, TJX sees plenty of room to add to its store base, mainly by pushing deeper into its existing markets in the U.S., Canada, and parts of Europe and Australia. Meanwhile, its hefty dividend has increased every year from 1995 through 2018, providing investors with an income cushion that helps deliver a nice balance of growth and stability, which is rare among consumer discretionary stocks.

Starbucks

Starbucks is the stock that turned coffee into a premium experience for millions of Americans and for consumers around the world. From its humble beginnings as a public company in 1992, the beverage specialist has built one of the planet's most valuable brands over just a few decades -- and Starbucks has rewarded shareholders along the way.

Starbucks boosts the quality of a product that many people consume each day, and that success, in addition to a consistently positive customer experience, makes its espresso-based drinks a small indulgence that consumers often put in their "must-have" budget category.

The company earns money like many large restaurant stocks, through a mix of company-owned and franchised locations. It also gets a significant portion of its earnings through selling its branded products through retailers and grocery stores. Starbucks has effectively covered many major markets, including the U.S., but still sees places like China as ripe for many more decades of an expanding store footprint.

Amazon

Amazon is the leading e-commerce company, often responsible for over one-third of all digital sales in the U.S. Unlike a "staples" retailer such as Walmart (NYSE:WMT), which sells lots of groceries and daily consumables, the tech giant's biggest sales category is consumer electronics.

Amazon spent its first few decades plowing all of its earnings back into the business in order to build assets such as a world-class shipping and fulfillment network, its own class of consumer devices, a huge web services division, and a popular annual subscription service called Amazon Prime. These additions make it more valuable than a comparable retailer of its size would be.

Amazon was a major beneficiary of e-commerce's expansion from 4% to 10% of the broader retailing pie in the decade ending in 2019. But that growth still leaves plenty of room for more gains in the decades to come.

Consumer discretionary ETFs

If you'd prefer to own a piece of the wider industry over picking individual players, consider purchasing an exchange-traded fund (ETFs) or an index fund. Below are a few of the largest that specialize on the consumer discretionary sector. When picking between ETFs, it is important to keep fees as low as possible while selecting for true industry coverage. Below are a few options that meet those criteria. 

Fund name

Expense fee

Vanguard Consumer Discretionary ETF (NYSEMKT:VCR)

0.10%

Consumer Discretionary Select Sector SPDR ETF (NYSEMKT: XLY )

0.13%

Fidelity MSCI Consumer Discretionary Index ETF (NYSEMKT:FDIS)

0.08%

These funds represent three of the biggest, most popular sector-specific ETFs. Investors prefer them for their low expenses, wide industry coverage, and high liquidity. 

Your first consumer discretionary stock

Ultimately, whether you choose to purchase an individual stock or to own exposure to the entire segment, it makes sense for most investors to own some portion of the consumer discretionary industry. While it performs poorly during downturns, its growth is hard to match during economic expansions. In that way, stocks like these play a critical role in a diversified investor portfolio. Thus, they tend to appeal to all but the most conservative investors, who prize maintaining capital over building up a portfolio's value over time.