Investors Once Flocked to Name-Brand Consumer Stocks. Is the Ride Over?

Consumer defensive stocks are stocks that are resilient during times of economic downturns and market turmoil.

They fare better in downturns because they produce products that consumers need, regardless of the state of the economy. These items include, food staples, paper products and cleaning materials.

Consumer staples are prized for their stability because the prices of their shares decline less than the market as a whole during periods of economic stress, changes in the business cycle or market tumult.

As the chart below indicates, over the past 20 years the consumer defensive sector has provided investors with consistent and generous total returns relative to the S&P 500.

For many years staples companies have been alluring to investors because of the generous dividends they pay out, payments which enhances total return.

Some companies in the sector have increased the dividend payout ratio consistently for the past 30 years. Their high dividend yields have made staples stocks a favorite in periods of low interest rates.

Profound changes

Nevertheless, over the past five years a number of factors have upended the traditional — and profitable — staid business models of staples companies.

The impact of these changes is now having a profound impact on the earnings stability of companies in this sector.

For decades, the strong and ubiquitous product branding staples companies enjoyed commanded unwavering consumer loyalty. Bounty, Mr. Clean, Kleenex, Band-Aid, all of these products were well-known names that through years of clever advertising, enjoyed unrivaled customer loyalty.

These products were present in virtually every household in the country. Consumers were willing to pay a premium charged for these products because they were assured of quality and felt comfortable with purchasing a brand name.

Such market dynamics lent stability to the staples sector.

Today however, a newer generation is failing to inherit the loyalty of their parents when shopping for household or food items. Many consumers today prefer alternative products that are cheaper and available online.

Younger shoppers’ exposure to social media limits the effectiveness of traditional advertising — long an essential marketing component for staples companies.

Changing consumer preferences, in conjunction with a greater variety of alternative products from which to choose, has now diminished the pricing power of companies within the consumer defensive industry.

Gillette offers good example of the current competitive predicament for many companies within the staples sector.

For decades Gillette enjoyed a dominant position in the men’s razor and shaving products industry. Its razors and cartridges were priced at a premium and stayed at that level for decades. Gillette razors were never discounted.

Gillette’s dominance in the shaving market has been challenged recently by a scrappy start-up company called Harry’s, whose mail-order razors have successfully eroded Gillette’s once insurmountable market share.

Many men, tired of the price-gouging for a simple cartridge razor, were only too happy to ditch the Gillette brand when a comparable product appeared at a substantially lower price.

Impact on market share

Today, Harry’s robust sales and growth are in part responsible for Gillette reducing its prices for the first time. For nearly a century, Gillette was synonymous with shaving products and priced its products accordingly.

In the new business environment, that will no longer be the case.

In a year-end interview with Barron’s, Rupal J. Bhansali, Equities Portfolio Manager for Ariel Investments, had similar sentiments concerning the lesson to be learned from Gillette’s loss of pricing power due to defections to alternative razor companies, such as Harry’s.

“The industry’s yesteryear playbook of relying on distribution strength, brand and pricing power, and customer segmentation is going to get upended. The market isn’t paying sufficient attention to this long-term risk,” Bhansali noted.

The availability and convenience of online shopping has had a particularly pronounced effect on the staples sector. For almost a century, when consumers needed food or household items, they had to drive to the local store.

The presence, rapid growth and marketing muscle of the online goliath Amazon has disrupted traditional business models across diverse sectors, most prominently the staples sector.

Not only do consumers want to order online, they expect competitive product pricing and delivery options.

Over the past two years, Kroger, the nation’s larger grocery chain, has been scrambling to develop a viable online component to complement its brick-and-mortar stores.

Implementing these new initiatives is costly and have forced staple companies to devotes substantial resources towards meeting the online shopping challenge presented by Amazon.

Eroding margins

A loss of once-dominant pricing power, diminished value of product branding, increased transportation costs and expenses for creating online and in-store pick-up services have severely eroded staples companies operating profit margins.

The chart below starkly reveals the decline.

The tumult the staples sector is experiencing mirrors the travails ravaging the retail industry. Some brick-and-mortar retail chains have fallen prey to the new Amazon world, such as long-time retail icon Sears.

The new Darwinian market reality for both the staples and retail sector means only the strong will survive in a ruthlessly competitive environment where long-held operating processes need to be revamped and revised quickly to respond to changing consumer preferences. Some companies are adopting to the new world; others are not.

An example of how the once-mighty have fallen in the new, rapidly evolving consumer staples market, is the recent and sudden demise of Kraft-Heinz.

The company’s results from its last quarter were dismal yet notable for how changes are wreaking havoc on those consumer defensive companies that have failed to adopt to changing industry conditions.

Kraft cut its dividend and was forced to take a massive and unprecedented write-down of its once inviolable Oscar Mayer and Kraft trademark brands to the tune of $15.4 billion.

The steep downward trajectory of the lines in the Kraft stock chart below paints a bleak picture. But, misery loves company: Kraft Heinz isn’t the only company in distress; the entire packaged food product sector has been experiencing turmoil.

Though historically, the staples sector has performed well, the last two years have been erratic, with individual stocks in the group experiencing wild price swings, as demonstrated by the precipitous drop in Kraft-Heinz shares.

This new reality has been recently reflected in disappointing revenue growth figures for many companies, firms where revenue growth has never dropped substantially.

Although many of the staples companies recently announced price increases for 2019 to maintain margins, these increases may prove fleeting as they are still vulnerable to losing customers in an economic downturn who may balk at paying higher prices.

To add insult to injury, rising interest rates over the past two years have made stocks in the sector less alluring than they have been for the last decade.

Frequently, the price of high yielding equities drops in response to increased interest rates.

The total return for the staples sector has outperformed the S&P 500 for the past 20 years. However, due to the recent pressures on the sector as noted above, the gap recently has narrowed considerably.

Those who own or are considering adding consumer staples stocks to their portfolio may want to reassess the historical earnings stability this sector once provided in light of the many recent challenges companies now face.