Betting on Consumer Staples to Beat the Rate Blues

After getting clobbered, stocks in the food and consumer-staples sectors could make a comeback.
Author:
Publish date:

Something truly weird happened in July. For a few days, the lowly

S&P

food and consumer-staples indices -- you know, the ones with all those companies that issued profit warnings last year? -- actually did better than the

S&P 500

index.

It wasn't simply the heat and humidity addling investors' minds, either. With economic growth picking up overseas and higher interest rates possibly on the way in the U.S., some analysts and strategists are saying this is a good time to take a serious look at consumer staples -- food, beverages, cosmetics and tobacco stocks -- with good global exposure.

J.P. Morgan

equity strategists recently recommended investors go overweight on food, beverage and household products. In the past months, J.P. Morgan's food-industry analyst raised earnings estimates on five companies. The investment bank is not alone in its appetite for food stocks.

Salomon Smith Barney's

equity strategy team raised its recommended allocation in the consumer-staples sector from underweight to market weight earlier this summer, while for the past few months

, Merrill Lynch's

chief quantitative strategist has been urging growth investors to move away from the Nifty Fifty and into household products and beverage companies.

Those calls may have been early, but now they could be yielding results.

Here's the basic thesis: In the U.S., the

Federal Reserve

looks set to raise interest rates. Because the U.S. food and consumer-goods industries are mature (a nice way of saying that they're not growing much at all), their shares trade at relatively low multiples. That becomes attractive when interest rates rise and investors are less willing to pay hefty sums for the future earnings of high-multiple, high-growth stocks. And if higher rates slow down the economy, consumer-staples stocks like

Kellogg

(K) - Get Report

,

Coca-Cola

(KO) - Get Report

and

Procter & Gamble

(PG) - Get Report

become attractive because of their predictable, if slow, earnings growth. After all, even if consumers can't afford to buy a new home or washing machine, they still have to eat, drink and (hopefully) use deodorant.

Like many others on Wall Street, Doug Cliggott, equity strategist at J.P. Morgan, believes the Fed will increase interest rates by 25 basis points Tuesday and says the risk is that it'll raise them again in October. "If they do, there seems to be a lot of upside" in buying consumer staples now, he says.

Not only do consumer-staples companies stand to benefit, comparably speaking, from higher rates and lower growth in the U.S., but they also stand to get a boost from a pickup in growth overseas. When things turned bad in emerging markets in 1997 and 1998, "lots of companies suffered because they were supposed to be stable growth, but suffered from cyclicality," says Richard Bernstein, Merrill's chief quantitative strategist.

Gillette's

(G) - Get Report

Mach III blades and Cokes may be staples here, but in emerging markets, they're luxuries. So buying consumer staples is a way to bet on rejuvenated consumer demand in those areas, says Bernstein.

"The first beneficiaries are commodity producers, and we've seen that play out very powerfully over the past four to five months," says Cliggott. (Many strategists went bullish on cyclicals in the spring.) "The next move is into consumer goods."

At J.P. Morgan, food-industry analyst Erika Gritman Long thinks

General Mills

(GIS) - Get Report

,

Nabisco

(NA)

and

Heinz

(HNZ)

are the best bets in the sector. Her firm has done underwriting for Nabisco but not Heinz or General Mills. Salomon Smith Barney's strategy team favors Procter & Gamble as well as

Kimberly-Clark

(KMB) - Get Report

. Salomon Smith Barney has done recent underwriting for both.

Of course, part of the reason food stocks, in particular, look more attractive is simply because they've been beaten down so badly there may be nowhere to go but up. In a recent research note, Morgan's Long said she's more bullish on the earnings outlook for food companies than at any time in the past 18 months. But she also noted that "the market's expectations regarding the earnings power of the industry have gotten significantly more realistic. Estimates have been reduced to such a point that companies are actually exceeding them again." That's hardly a ringing endorsement, though Long adds that in the past month or so, she's upgraded earnings estimates on five of the 12 companies she follows after a string of reduced estimates.

The food and consumer-staples industries will never be for adrenaline junkies. But Ken Safian, president of White Plains, N.Y.-based

Safian Investment Research

, says that the sector is a good defensive play rather than a bet on the resurgence of overseas growth. "If there's a decline in the U.S. economy and consumption was down, and Asia weathered the storm more,

the consumer-staples sector wouldn't lose as much," says Safian. "It might even make a little bit."

For the consumer-staples sector, which underperformed the S&P by 18.2% in the past two years, and the food industry, which trailed the index by 40%, even faint praise may be a relief.