Just One Word: Staples

Who would have thought at this time last year that stodgy Old Economy companies that produce boring products like cereal and paper towels would outperform the highflying Nasdaq Composite Index and the S&P 500?

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Just One Word: Staples

Click here to see 2001: New Year, New Rules stories from earlier this week.

Not many. But that's just what has happened with many of those stocks this year, as some portfolio managers disillusioned by the fall in tech stocks have sought safe haven in old-line consumer staple companies with dependable earnings streams. The anticipated slowdown in the economy is also helping out, as consumer products are normally considered immune when consumers tighten their belts.

So now that the heady days of triple digit returns seem to be history and relative performance is the watchword of the day, are consumer staple stocks the place to be for the coming year? Some fund managers say yes, but others argue that the group's heyday could already be past.

Evidence of this year's outperformance can be seen in some exchange-traded funds that track the sector. The $14 million (IYK)iShares Dow Jones U.S. Consumer Non-Cyclical ETF, which has around 73% of its holdings in consumer staples stocks like Coca-Cola(KO) and Procter & Gamble(PG), is up around 2% since the fund launched on June 16. While that may not sound impressive, it far exceeds the 32% drop on the Nasdaq and the 9.6% drop on the S&P 500 for the same period.

Some market watchers argue that the group's performance this year has been a product of the whims of the marketplace, with many of these stocks serving as a parking place for growth managers to bide their time while tech stocks sell off. That, coupled with the slowing earnings growth that many of these companies have experienced this year, has made many market watchers skeptical.

"I think the group is ahead of themselves," says John Maxwell, household product analyst at Waddell & Reed. "They're benefiting from the money flowing out of tech, not so much from their performance."

Since April 14, the $196 million (XLP)Consumer Staples Select Sector SPDR, which not only has around 31% of its assets in Old Economy stocks like P&G, Gillette(G) and Coke but also has a hefty 61% in pharmaceutical stocks like Pfizer(PFE) and Merck(MRK), has climbed 23% compared with a 21% fall on the Nasdaq and a 2.5% drop on the S&P for the same period.

"In some respects, it's kind of a fragile shareholder base," says William Steele, consumer products analyst with Banc of America Securities. "If interest rates come down and the outlook for the Nasdaq improves, people will fly out of this group."

Be that as it may, Steele says the group could find some fans if the economy takes a steep downturn.

"Clearly if the economy slows weaker than projected, this is a good group, because in good times and bad, we still use our detergent, shampoos and toothpaste," says Steele, whose firm has done underwriting for Colgate-Palmolive (CL) in the past three years. "But this is a market where you're not buying groups, you're picking stocks."

For investors with longer-term horizons, Steele's favorites include companies with global dominant brands like Colgate and Gillette and Kleenex maker Kimberly-Clark(KMB), which he applauds for its improving cost structure. The analyst has a market performer rating on both Colgate and Gillette, and a strong buy rating on Kimberly-Clark.

The shorter-term picture, however, could be murkier, as many consumer products companies could continue to exhibit the behavior of 2000, a year when their earnings saw more downfalls than Robert Downey Jr. on a Palm Springs vacation.

Rising raw material prices, a slumping euro and reduced inventories at retail have all conspired to make much of 2000 a difficult time for consumer staples producers, with many of those companies forced to repeatedly lower their earnings forecasts. Many household products companies are still struggling with lackluster growth rates -- witness Clorox's(CLX) profit warning just last week. Though many of these companies are working hard to get their houses in order, Steele says it wouldn't be surprising to see more of the same in the coming year.

For that reason, managers like Nick Calamos, director of research and senior portfolio manager at Calamos Asset Management is steering clear of the Gillettes and P&Gs of the world in favor of higher-growth companies like wine producer Robert Mondavi(MOND) and pharmacy benefit manager Express Scripts(ESRX), which he considers solid defensive plays during a slowdown.

"These companies are relatively consistent earnings-growth companies with not a whole lot of cyclicality," says Calamos. "The whole mindset is to stay where the relative earnings are."

Despite these misgivings, other fund managers are optimistic that things are looking up for consumer products stocks.

"On a relative basis, a lot of fundamentals are improving for this group, yet you still see valuations at the bottom end of the range," says Scott Schermerhorn, portfolio manager of the Liberty (CFGAX)Growth & Income and the Liberty (SRVAX)Tax-Managed Value funds.

Schermerhorn, whose funds at the end of September had added positions in stocks like Sara Lee(SLE), P&G and General Mills(GIS), according to Morningstar, says he not only sees some companies in the group as a stable haven in an uncertain environment, he also expects factors like the euro's slide to reverse course in the next year, which would benefit these multinational companies.

"The group isn't as attractive as it once was, but there still clearly are some attractive issues out there," Schermerhorn adds.

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