Companies in the consumer staples segment own among the most recognizable brands in the stock market. Their businesses are relatively easy to understand, and most investors are likely to be repeat customers of many of the businesses behind the stocks. These factors make the industry an attractive place to consider making your own individual stock purchases.

Yet investing in the consumer staples space comes with specific risks and trade-offs that you should know before adding them to your portfolio. Below, we'll take a comprehensive look at the segment, from the broader industry right down to a few attractive ways to gain exposure to this important part of the world economy.  

A grocery store aisle from the perspective of someone pushing a shopping cart.

Image source: Getty Images.

What is a consumer staple stock?

Consumer staples are products that tend to sit high on a person's routine shopping list. They span niches like food, beverages, home and personal care, and tobacco. These products are referred to as "staples" to indicate that they're an essential part of most consumers' monthly budgets. As opposed to spending on things like vacations and home remodels, which can be put off during lean economic times, a typical household always allocates cash toward essentials like groceries, personal hygiene, and home cleaning supplies.

Consumer staples differ from the "consumer discretionary" industry mainly because of that non-negotiable spending priority. Discretionary spending, as the name suggests, involves purchases such as entertainment and dining out, which are susceptible to wide swings in consumer demand that follow shifts in the broader economy. Demand for things like toilet paper and shampoo, in contrast, doesn't disappear when a recession hits. 

Are consumer staples a good investment?

There are several characteristics that make consumer staples attractive platforms for generating robust long-term investment returns. As mentioned above, the businesses are protected from short-term economic-driven demand swings, and so they tend to grow steadily, regardless of the status of the economy. That's why stocks in this niche are sometimes referred to as "defensive," or "recession-proof." This reputation for dependability is bolstered by the fact that the stocks often pay generous dividends that have a long history of rising each and every year. Coupled with its protected sales, a growing dividend payout can make a collection of consumer staples a stabilizing force in an investor's portfolio. They work particularly well as a balancing weight against growth stocks.

Consumer preferences are similar across the world, too, and that means successful companies in this space have an opportunity to benefit from huge economies of scale. Their repetitive use, meanwhile, provides a steady stream of demand and the prospect for a deep connection with consumers that can span decades. It's no surprise, then, that some of the most valuable brands on the planet, like Coca-Cola, Colgate-Palmolive, and Procter & Gamble's Pampers, are all consumer staples.

For investment purposes, consumer staples stocks include producers and manufacturers of these goods, in addition to the distributors and retailing chains that support their businesses.

About the industry

Consumer staples span six industries: beverages (including beer and alcohol), food retailers, food products, household products, personal products, and tobacco. Together, they compose one of the 11 main industry groupings that make up the economy. As of mid-2019, consumer staples stocks accounted for $3.6 trillion of market capitalization, putting them in sixth place in relative size, behind information technology ($8.3 trillion), financials ($7.1 trillion), healthcare ($5.6 trillion), consumer discretionary ($5.4 trillion), and communication services ($4.6 trillion). 

The industry has a reputation for outperforming other sectors during the early stages of economic slowdowns and recessions. Conversely, it tends to lag other parts of the economy in periods of robust economic growth. This occurs because these stocks' defensive nature attracts investors to them during weak economic periods, while people move more toward high-growth businesses during boom times.

The main trends that impact the industry are shifts in consumer preferences, and changes here require companies to constantly work to remain relevant. A major recent shift has been the move away from what's perceived as unnatural ingredients in food and drinks. This demand change has upended global brands like Diet Coke and forced many companies in the packaged food industry to reorganize their entire portfolios.

Investing metrics to know

When investing in a consumer staples stock, there are a few important metrics you should know. Some of them apply to producers like Coca-Cola while others apply to retailers like Kroger (NYSE:KR) and Costco.

Tracking revenue

Generally speaking, consumer staples businesses enjoy steady but unspectacular growth rates when compared to other industries like software and consumer electronics. The key metrics to know in this area are organic sales, comparable-store sales, and market share.

Organic sales: Organic sales, sometimes called core sales, represent the change in revenue compared to the prior-year period after accounting for temporary issues such as brand sales or purchases, foreign exchange rate shifts, and non-cash charges. Inorganic sales growth can be heavily influenced over the short term by the purchase of a new franchise, but such gains aren't as valuable as when a company succeeds in raising demand for its own core products.

Two main trends comprise this metric: sales volumes and pricing. In that way, organic sales captures how well a company's products are resonating with consumers. Higher is better, and investors typically look for stocks that can consistently outgrow peers with balanced gains in volume and pricing. That success over a long period is an indication of enduring competitive advantages. Organic sales rates apply to manufacturers of consumer staples such as Procter & Gamble and Kimberly Clark (NYSE:KMB)

Comparable-store sales: This metric is used by retailers to express year-over-year growth after adjusting for the opening or closing of store locations. In that way, it describes the fundamental operating momentum of the business. Strong and accelerating comparable-store sales, or comps, indicate a company like Kroger or Costco is attracting robust customer traffic and standing out in a competitive retailing industry. Weakening comps, on the other hand, imply mounting business challenges.

Market share: This metric refers to the percentage of an industry's overall sales that a company is responsible for delivering in a given period. It's unusual to see consumer staples producers maintain dominant market positions of over 30% or more of the global industry for products like toothpaste, diapers, or soda. That positioning is valuable for many reasons. It translates into higher profits and is easier to defend from competitive threats, for example. A leading brand spot makes it easier to secure lots of shelf space at retailers, too. Consumer staples companies always aim to grow sales at a faster pace than the broader industry, thus boosting market share over time.

Profits and returns

The best consumer staples businesses post market-leading profitability thanks to their valuable brands, their large sales bases, and their efficient operating structure. When judging the earnings power of these companies, the two key metrics to know are gross profit margin and operating profit margin.

Gross profit margin: Gross margin is what's left after a company pays the up-front costs from manufacturing and distributing its product. Investors like to see a margin that's both higher than peers and, ideally, rising or remaining stable. Strength on this metric directly translates into higher earnings and shows that a consumer stock has pricing power.

Operating profit margin: Operating margin is what's left after overhead and selling expenses are deducted from gross profits. It's a more descriptive bottom-line profit metric than net income because it isn't skewed by changes in tax payments, among other things. An efficient business will show higher operating margin than its peers.

Cash returns 

Because they are mature, efficient businesses with modest growth opportunities, consumer staples stocks tend to generate lots of cash, much of which is returned to shareholders through dividends and stock repurchases. That's a key difference when compared to growth stocks, which tend to direct more of their earnings each year into expanding the business and so deliver less cash to investors.

Dividends are recurring cash payments that usually occur each quarter. Investors look for stocks that pay a robust yield that's backed up by a wide cash cushion. It's also important that the dividend has a long history of rising each year. So-called "Dividend Aristocrats" are companies that have boosted their payout for at least 25 consecutive years, and that elite list includes many consumer staples giants.

Stock repurchase spending is another key way that companies return cash to shareholders, although it is less direct than dividend payments. In buying back its own stock, a consumer staples giant lowers its outstanding share count and thus boosts the value of the remaining shares since the smaller pool means that each leftover share accounts for a larger proportion of the business.

The risks around investing in consumer staples stocks

As with all stocks, there are risks involved in investing in consumer staples. These companies are resistant to big demand drops during recessions, but their growth rates are still tied to broader economic trends like global growth in population and wages. A big downturn that hits several geographic markets at once would necessarily hamper earnings and sales gains.

The huge size of these businesses is normally a competitive strength, but it can become a weakness during periods of fundamental shifts in consumer demand. Both Coca-Cola and Procter & Gamble, for example, have spent years restructuring their portfolios and changing their operating structures to better compete in the new selling environments while smaller rivals made quicker adjustments. There's no guarantee that a consumer staple stock will stay ahead of the next market trend.

There's also a good chance that a given consumer staples stock endures a long period of sluggish growth that barely matches wider industry trends, which are already modest. In just the past few years, investors have seen many examples of this gloomy process at work, including with Procter & Gamble, Campbell Soup (NYSE:CPB), Coca-Cola, and many other consumer-facing companies. While each of these giants has protected its dividend payment and sent lots of cash to shareholders over the past decade, returns have been lower than in other, high-growth niches.

The biggest consumer staples stocks 

Investors have no shortage of options when considering investing in consumer staples, but here are some notable names in the manufacturing and retailing segments. Below, we'll take a closer look at three of these companies that have recently been delivering market-thumping performances. 

Company

5-Year Revenue Growth (Decline)

Procter & Gamble (NYSE:PG)

(5%)

Coca-Cola (NYSE:KO)

(7%)

Walmart (NYSE:WMT)

2%

Mondelez (NASDAQ:MDLZ)

(6%)

Costco (NASDAQ:COST)

6%

Colgate-Palmolive (NYSE:CL)

(2%)

Altria Group (NYSE:MO)

2%

Constellation Brands (NYSE:STZ)

11%

Data as of July 8, 2019.

Procter & Gamble

In many ways, Procter & Gamble is the prototypical consumer staples company. Most of its 60-plus brands are considered essential products for people around the world, whether we're talking Gillette razors, Head & Shoulders shampoo, or Tide-branded detergent. Over 40% of U.S. households use Bounty paper towels, to name just one example.

P&G's growth rate was stubbornly slow in the three years following its 2012 launch of a portfolio reboot, but trends are looking better lately. Organic growth was a market-beating 3% in fiscal 2018 compared to 2% for rival Kimberly Clark. P&G gained market share in its fabric and home care segments but lost ground in areas like grooming and baby care.

The company's efficient operations illustrate why many investors consider it among the safest of businesses. Core earnings per share improved 8% in 2018 and operating cash flow jumped 17% to $15 billion, or 22% of its sales. P&G routinely allocates billions toward stock buybacks each year and toward boosting its dividend, which has one of the market's longest-running growth streaks. Its modest growth rate might not turn heads, but this stock could play an important role in a well-diversified portfolio. 

Costco Wholesale

Costco sells most of the same types of products as its main rival Walmart, but that's about where the similarities end when comparing the world's two largest retailers. Costco is a warehouse club, after all, which means its main operating strategy revolves around attracting members and delivering enough value to them to keep subscribers enthusiastically renewing their cards each year.

That approach is working well for Costco -- and for its shareholders. Comps were up 7% in the last fiscal year, or about twice Walmart's pace. The warehouse giant has also seen its operating income soar in the past five years even as its peers have posted reduced profitability due to spending on e-commerce. That's because Costco raised its annual membership fees, which are its main source of earnings. Because fee income is far more stable than traditional retailing profit, management can afford to take a longer-term approach to the business while still rewarding investors. That formula has consistently paid off for shareholders even if Costco's earnings might seem underwhelming over short time periods. 

The best indicator of the health of Costco's business is its membership renewal rate, since that helps show whether the company's pricing and merchandising strategies are resonating with consumers who have many options on where to do their weekly shopping. It's good news, then, that the rate recently crossed 90% despite the higher annual membership price.

Constellation Brands

Constellation Brands is a far different business today than it was before management acquired the rights to sell a portfolio of premium imported Mexican beers in the U.S. Its Corona, Modelo, and Pacifico brands have helped the alcoholic beverage specialist far outpace bigger beer giants in sales growth over the last few years. That robust demand has supported rising prices, too, leading to significant profitability gains.

Constellation Brands' competitive advantages include its focus on premium beer, wine, and spirits, and that focus has become even more pronounced since it agreed to sell off many of its lower-margin wine and spirit brands. Investors are even happier about Constellation's history of wise capital allocation. Lately, that cash has been pouring into initiatives aimed at laying the groundwork for future growth, including capacity expansion for its Mexican breweries. And depending on how the regulatory environment develops in the years ahead, the company might see robust growth in the emerging consumer marijuana space thanks to its aggressive investment in Canopy Growth (NYSE:CGC). In any case, shareholders are relatively confident that this beverage giant will capitalize on the steadily growing demand for alcoholic drinks.

Consumer staples ETFs and index funds

If you're not interested in picking specific potential winners, you might prefer simply owning a selection of the entire industry grouping. Luckily, there are many funds to choose from that accomplish this goal, including exchange-traded funds (ETFs) and index funds. Below are a few of the largest. As usual, when evaluating ETFs, it's important to look for good industry coverage paired with low fees.

Fund Name

Expense Fee

Consumer Staples Select SPDR Fund (NYSEMKT:XLP)

0.13%

Vanguard Consumer Staples ETF (NYSEMKT:VDC)

0.10%

iShares U.S. Consumer Goods ETF (NYSEMKT:IYK)

0.43%

Funds like these deliver most of the benefits of the consumer staples sector, including steady performance during market downturns and above-average dividend yields. Since they focus on the biggest players as well, you're likely to get exposure to global giants including P&G, Coca-Cola, PepsiCo (NASDAQ:PEP), and Altria Group.

Whether it's through individual stocks like Costco or through an ETF like Vanguard's consumer staples fund, elements of this industry grouping deserve a place in just about every investor's portfolio. Buy a few quality companies, or a diversified index fund, and be better prepared to weather the next market downturn. In the meantime, you can collect healthy dividend payments that help make up for the fact that the consumer staples segment tends to lag behind other sectors during cyclical upturns. That attractive mix of growth, income, and stability are likely to ensure that this market niche remains popular with investors for decades to come.