Are consumer staples headed for a correction?
It was the export announcement that shook the global economy. On Oct. 9, Germany announced that its exports fell by 5.8 percent, the largest monthly drop in five years. Over the next five days, the S&P 500 plummeted nearly 4 percent, leaving investors wondering, once again, if the world was heading toward another recession.
When the market started to bounce back in mid-October, there was one sector that investors paid more attention to than others: consumer staples. In the final 15 days of that month, the S&P 500 Consumer Staples index jumped by nearly 6 percent, and it’s up another 3 percent since. In the nine and a half months prior, the sector had risen only by 4 percent.
“It wasn’t doing much of anything until October,” said Ryan Lewenza, a senior vice president and portfolio manager with Raymond James, a St. Petersburg-based financial firm. “But then it broke out, and now it’s outperforming the index.”
The sector’s strong numbers shouldn’t come as a surprise. Consumer staples, one of the most defensive industries, typically does well in periods of volatility. These are drugstores, grocery chains, personal-product makers and soda operations—companies that sell goods that people will buy, regardless of where the economy stands.
What is a shock, though, is just how much the staples sector has outperformed. Historically, the industry trades at around 16 times earnings, said Lewenza. It was trading at 18 times at the start of 2014, and it’s now trading at 20 times earnings.
Read More The top-performing sectors of the US stock market
“This is the peak,” he said. “This is where it traded at in 1991 and 2007. Valuations are expensive.”
Investors who own staple stocks, or those who are thinking about following the crowd, need to be careful. While there’s still a lot of uncertainty in the market—not just from slower global growth but also from the end of quantitative easing and other factors—once the recovery continues and people become comfortable with the market and the economy again, those returns could reverse.
“The outperformance will continue for at least the next six months as the Fed gets us through the tightening process, but after that, hold your breath,” said Scott Mushkin, managing director and senior staples analyst at Wolfe Research, a New York-based investment research firm.
Take profits and wait
If you were market weight in the sector a few months ago—staples accounts for about 10 percent of the S&P 500—then check to see if those gains have put your portfolio out of whack.
For those who are overweight the sector, consider taking profits and moving that money into more cyclical sectors, said Lewenza.
“I’d be trimming and looking to laggards, like the industrial sector,” he said.
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What you shouldn’t do, though, is sell out of the sector completely. While you may lose a little money on the way down, these stocks tend to balance out a portfolio.
They don’t fall as hard as the more cyclical sectors, though they don’t shoot out the lights—other than last October—either. Plus, many also pay dividends, which will help when the stocks return to more normal levels.
“These are constant operators that generate consistent levels of cash flow, which they return to shareholder,” said Erin Lash, a senior equity analyst at Morningstar. “So the potential for income on top of return is attractive for investors.”
With that in mind, investors should still be keeping an eye on this sector, but they should wait until the stocks pull back by about 3 percent before buying in, said Lewenza.
Play the pockets
At the moment, the sector’s pickings are slim, but there are some companies that investors could either buy into now and others that could be good opportunities after equities decline.
One stock to watch is Whole Foods (NASDAQ: WFM), which is one of six staple companies out of 40 that are in negative territory this year.
Read More Whole Foods on verge of turnaround, says Jim Cramer
It’s down 19.2 percent—the second worst-performing stock on the S&P 500 Consumer Staples Index—in part because it’s a more discretionary staples stocks, said Mushkin. It tends to do well at the start of a recovery cycle, when money is freer flowing and then falls after that, he explained.
It’s also dealing with problems specific to the company, such as declining same-store sales, lower growth and increasing competition.
While Mushkin thinks that these issues will keep the company’s stock price depressed for a while, Lewenza thinks that it could start to fair better later in the cycle, when incomes rise and more Americans are employed.
Its multiples have fallen with its price—it’s trading at 27 times forward earnings versus 33 times at the start of the year, according to S&P Capital IQ—but Lewenza said to be patient.
“I’d still stay on the sidelines until there’s a pull back,” he said.
One stock that Lash said is a good undervalued buy is Procter & Gamble (NYSE: PG), even though Warren Buffet just sold his $4.7 billion stake in the company.
While some investors view the sale as a bad sign, Lash is optimistic about the business’ future.
Read More Duracell trade is sign Buffett is bearish on P&G
The company has stated that it plans to shed up to 100 brands so it can focus more on the 70 to 80 products that are core to its company. That renewed focus should shed the criticism that P&G isn’t responsive to consumers, said Lash.
“It’s been dogged by that in the past, but this enhanced focus will help, which is particularly important in the competitive environment they play in,” she said.
To Lash, fair value for P&G is a $93, which is close to the $89 it’s trading at today. It’s not a significant discount, she said, but relative to the rest of the sector, it’s a good deal.
Other companies to keep an eye on are Kroger (NYSE: KR) and CVS Health (NYSE: CVS). “They look great,” said Mushkin, and would be good additions to any portfolio. However, they’ve done so well—both are up about 36 percent—that investors should only buy on a dip.
“CVS has had a huge run,” added Lewenza, “but I would not buy the stock at $90 today. I’ll look to add when it hits the low- to mid-80s.”
No matter the stock, investors should be buying staples companies that consistently grow earnings and are gaining market share. “Stick to businesses that are winning,” said Mushkin.
Ultimately, this sector is still a good one to own, just don’t buy in right now. Take profits, wait for a correction and then stock up.
“We’re not bearish, but we’re not incredibly bullish, either,” said Lewenza. “I wouldn’t load up today, but I wouldn’t give up on staples.”