Consumer staples – past performance does not guarantee future results

In our many client meetings in the last few months it became apparent that Consumer Staples companies are still widely owned by our clients and our peer group. As many will know, we haven’t seen much value in the sector for some time now. In fact, the Saracen Global Income & Growth Fund has only one holding in this sector at present. Hence, the question “why does the fund have such a low weighting” came up frequently. Here we explain our concerns on the sector.

Consumer Staples companies are considered squarely in the defensive segment of the equity market. That’s no surprise considering we have no choice but to buy food, beverages and household products.

For years this meant steady top line growth with stable volume and pricing. With benign cost inflation and some efficiency gains, margins also expanded. Add in a 2.5-3% dividend yield in a zero-interest rate environment and you had the perfect backdrop for consumer staples.

However, as investors our job is to look forward. We see multiple headwinds for this sector:

   2. Pricing

Food inflation rose sharply and suddenly in 2021. While price rises have slowed, the cumulative increase in the U.S. now adds up to almost 30% versus pre-pandemic levels.

Any further price increases from here could be challenging as the consumer is already stretched. However, many consumer staples companies need to do just that to offset ongoing wage inflation and renewed raw material cost inflation (e.g. cocoa and coffee). Additionally, for many companies hedging positions are rolling off just as pricing power falls and volumes decline.  

Any fading pricing power combined with input cost headwinds will have a negative impact on gross margins. These have steadily declined since the start of the century. The market expects some improvement in the next two years. However, due to the above-mentioned headwinds we believe the risk is to the downside.

Between 2000-2019 both volumes and pricing contributed about 2.5% each to top line growth in the sector. While volumes stayed at a similar level in 2019-23, pricing shot up to 10%+. With minimal to negative volumes going forward and a push back on price, the sales CAGR for the next two years is expected to be below the 5% average:

   3. Valuation

There’s a reason why Staples are called bond proxies. In times of low bond yields, valuation expands as they are held as a substitute to fixed income instruments. This worked particularly well after the financial crisis. Between 2010-19 PE expansion added 4%, 8% and 10% respectively to the total shareholder return of food, beverage and household product companies. (Source: Morgan Stanley) However, as interest rates rose the valuation premium, which we always thought was too high, has started to unravel, starting with food and beverage companies. Valuations are only returning to long-term averages, not yet undershooting.

   4. Structural Headwinds

Looking out into the longer term, we also see structural headwinds for staples companies. Many have spoken about the use of GLP-1 weight loss drugs, but we believe the bigger risk is a backlash on ultra processed foods (UPF). Medical evidence on the impact of ultra processed foods is increasing. We are still early in fully understanding the science, but consumers are becoming more cautious.

And it seems some have already started to alter their diet:

The highest consumption for UPFs is in the USA and UK at >55% of total calories consumed (Source: BMJ, Link, Barclays), with the average in developed markets around 30-35%. According to a poll for the Grocer Magazine “Almost a million customers a month are turning away from ultra-processed food products.” Younger consumers are especially conscious about the nutritional value and health impacts of food.

Staying with the younger generation but moving on to beverages we see another headwind. Alcohol consumption. In recent years this has declined markedly.

There are many reasons, but again the impact on health is the biggest. Younger generations are much more aware of the health risks of excessive alcohol consumption than previous generations, especially in relation to mental health. An increase in prevention programmes also contributed to lower alcohol intake. Then there is the opportunity of social drinking. With more virtual meetings and fewer face to face interactions there are fewer occasions in which alcohol would be consumed. And sometimes it’s just the costs. Consequently, compared with previous generations, alcoholic beverages play a smaller role in young people’s lives. The legalisation of marijuana for recreational use in many US states and countries seems to also have influenced this trend. Many 18-34-year-olds seem to prefer cannabis consumption. Funds managed by RGI, including Saracen Global Income & Growth Fund, do not invest in cannabis.

We are not overly optimistic on the outlook for Consumer Staples companies. Looking at the needs of the world over the next decade and the potential for a long capex cycle, we find many more supportive tailwinds for industrial, financial and materials companies. You can read more about our analysis and how it has shaped our portfolio here.

KEY RISKS

The value of investments and any income generated may go down as well as up in response to general market conditions and the performance of the assets held, and is not guaranteed. An investor may not get back the amount originally invested.

Past performance is not a reliable guide to future results.

Changes in exchange rates may have an adverse effect on the value, price or income of investments.

There is no guarantee that the Fund will meet its stated objectives.

The movements of exchange rates may lead to further changes in the value of investments and the income from them.

There is a risk that any company providing services such as safe keeping of assets or acting as counterparty to derivatives may become insolvent, which may cause losses to the Fund.

IMPORTANT NOTICE

This document has been prepared by River Global Investors LLP (“RGI”). RGI is authorised and regulated in the United Kingdom by the Financial Conduct Authority (Firm Reference No. 453087) and is registered in England (Company No. OC317647), with its registered office at 30 Coleman Street, London EC2R 5AL. This article does not constitute an investment recommendation and should not be used as the basis for any investment decision. Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. Please note that individual securities named in this article may be held by the Portfolio Manager or persons closely associated with them and/or other members of the Investment Team personally for their own accounts. The interests of clients are protected by operation of a conflicts of interest policy and associated systems and controls which prevent personal dealing in situations which would lead to any detriment to a client.