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Equity Perspectives

While consumer confidence has improved, consumer stocks underperformed last year.  Astute research and stock picking will be key in 2017.  

 

In Brief:

  • Consumer confidence may be up, but consumer staples and consumer discretionary sharply lagged the broader market (as represented by the Russell 1000) in 2016.
  • The post-election “Trump trade” crushed consumer staples, with household/personal care and beverage stocks particularly hard hit. But in 2017, value and growth opportunities may be driven by mergers and acquisitions and standout fundamentals.
  • Well-managed companies, particularly ones generating significant earnings growth, also should be rewarded.
  • Lord Abbett partner and equity research analyst John McMillin still favors beverage companies (which helped propel the consumer staples sector last year).
  • Consumer discretionary stocks, which have lagged amidst shifting consumer spending on leisure, technology, media, and health care, may not benefit as much as other sectors from expected stimulus measures, but home and auto stocks should resume outperformance (at the expense of apparel retail) in 2017.   

 

After 32 years of covering myriad consumer companies across the capitalization spectrum, John McMillin, Lord Abbett partner and research analyst, has developed a keen insight into the investment opportunities and the pitfalls in industries that have been transformed by technology, consolidation, and demographics. And he doesn’t mince words about ill-timed bullishness. 

In a recent presentation, he recalled a June 2016 newspaper ad for a competing mutual fund company that delineated why consumer staples (food and staples retailing; food, beverage and tobacco; household and personal products) should be on investors’ shopping lists. While the more conservative and defensive sector is known for its relatively high risk-adjusted return, plus dividends over time, McMillin noted the rotation out of staples began right after that ad ran, as lofty valuations led investors to trim their holdings.

As a result, the Russell 1000 consumer staples index was up only 6.8%, versus 14.5% for the Russell 1000 in 2016. While tobacco and food products companies were the strongest sectors, home and personal care showed more modest gains, beverages were flat, and food retail was down sharply amid significant deflation. 

“Consumer staples are no longer expensive, but they’re not cheap,” said McMillin, whose remit includes more than $1 billion in stocks spread across mid- to large-cap and dividend growth portfolios. “Picking merger and acquisition [M&A] candidates will be critical to outperformance. Higher interest rates aren’t a positive, but deals are going to happen.”

McMillin’s M&A outlook for 2016 was particularly prescient, thanks to extensive industry knowledge that helped him anticipate some major deals. Of course, past performance is no indication of future results, and the jury is still out on whether some of those transactions made sense. But McMillin had no qualms about predicting more M&A activity in the consumer staples sector in 2017, and he identified prospective takeover plays based on continued globalization and consolidation among key players.

“Making consumer staples ‘great again’ depends on reuniting some companies that may have been together before, or finding companies with standout fundamentals that deliver high-quality growth,” McMillin said.

A Toast to Beverages
Of all the sectors in McMillin’s universe, beverages is his favorite for 2017. One beverage company is poised for higher earnings per share and a possible spin-off, he said. A second beverage company he covers remains well positioned in the United States. A third appears to be a target for a global beer company, and a fourth appears undervalued, he added.

“Beverage price elasticity isn’t as good as tobacco’s, but it’s still pretty good,” McMillin said, referring to the relationship between a change in the quantity demanded of a particular good and a change in its price.

Of course, beer and carbonated drinks are in the mix, but the real fizz is in the nonalcoholic, ready-to-drink market (like coconut water), which is growing 5–6% a year, faster than most consumer staples categories.

Cigarette sales have plummeted since a landmark 1998 settlement, in which the four largest U.S. tobacco companies agreed to pay 46 states billions of dollars to offset tobacco-related health costs; but higher prices have helped offset volume declines, and have enabled companies to maintain healthy dividends. Beverage companies, on the other hand, have not enjoyed as much pricing power, but with increased concern about the role of sugary drinks in the global obesity epidemic—not to mention how much federal food stamps pay for such products—carbonated soft drink producers are taking a page out of Big Tobacco’s playbook by charging more for smaller servings.

Which Stocks Will Benefit from Trump Tax Policies?
McMillin has identified more than a dozen companies that stand to gain from lower corporate taxes, and a handful that stand to benefit from repatriation of overseas profits at a lower tax rate. On the other hand, a number of companies, including some major retailers and a multinational consumer goods giant, could be hurt by proposed “border-adjustment” taxes based on the amount of goods produced abroad, he said.  

"Tobacco companies could benefit the most from lower taxes,” McMillin added. “They also are poised to gain from ‘heat not burn’ innovation, as opposed to e-cigarettes, which rely on liquid nicotine," McMillin added. 

The confluence of Big Tobacco’s move into “vape” technology and increased state legalization of marijuana for medicinal and/or recreational use has stirred speculation that the tobacco companies might someday enter that market as well. Manufacturing, marketing, and distribution might come easy, but tobacco companies continue to disavow any interest in such diversification in defiance of federal law, and such a scenario seems even more improbable, with Republicans controlling the White House and both houses of Congress. 

“Even so, four more states recently legalized marijuana [for recreational use], with sales already at $3.4 billion,” McMillin noted. “Long term, with states increasingly addicted to tobacco tax revenues, tobacco companies may have an opportunity to enter this market and would probably use ‘heat not burn’ technology.”   

Consumer Discretionary: Favoring “Experiences” over “Goods”
After the elections, investors rotated into consumer discretionary stocks, convinced that lower taxes, less regulation, and higher disposable income would spur increased purchases of goods and services.   (Consumer discretionary goods include durable goods, like auto and home, apparel, entertainment, travel and leisure.)  

Despite the late surge, the sector still lagged the broader Russell 1000 in 2016, but Anthony Attardo, a Lord Abbett research analyst, is anticipating increased consumer optimism in 2017. With consumer discretionary margins at a cyclical peak of 11.5%, Attardo advised his portfolio manager colleagues to focus on businesses with pricing power and to avoid lower-margin businesses that are unable to pass through looming cost inflation.

“There is tremendous demand leakage from ‘classically defined’ consumer discretionary segments to sectors like technology, media, health care (premiums, deductibles), and real estate investment trusts (rent),” Attardo said.  “Healthier sectors include auto, home improvement, restaurants, personal care, off-price, lodging, and the cruise line industry. Weaker sectors include electronics, sporting goods, apparel retail, apparel brands, and mass merchants.”

Are We Early or Late in the Consumer Cycle?
Considering the current macroeconomic environment and sector fundamentals, Attardo suggested the consumer cycle is in the “seventh or eighth inning,” before fiscal stimulus from Washington takes hold.

“Consumer confidence has captured 90% of its post-recession drop1 as home values have recovered 95% of the drop2 and equity values stand 38% above their prior peak,”3 he said. “Employment is generally regarded as full, despite declining corporate profits until recently. Employment was likely to skew to the negative absent a stimulus-driven rise in business sentiment.”

Potential Impact from Trump Stimulus?
For all the uncertainty about federal tax policy, Attardo said a stronger U.S. dollar and inflation likely will reward consumer discretionary companies with pricing power. Businesses without pricing power, however, could get hammered.

“The proposed personal income tax reduction is a clear positive, as it should aid a 1–5% increase in earnings per share and a 10–12.5% move in stock prices,” Attardo said. “But if a proposed border-adjustment tax passes [a measure Trump recently deemed too complex], it will have a profound impact, as most retailers and apparel companies import goods from Asia and sell in the United States.”

The bottom line is that tax-policy changes point to more risk than reward for retail and apparel, which suggests consumer discretionary sector as whole may “detach” from other stimulus beneficiaries such as energy and financials.

Will higher interest rates hurt? “History suggests the consumer will absorb the first 100 basis points of a rate increase before curbing demand, as it typically coincides with an improving economy,” Attardo said. “Monetary tightening likely will affect consumer discretionary purchases in 2018 more than this year.”  

 

1 Source: The Conference Board Consumer Confidence Index. 
2 Source: Bloomberg, National Median Home Price Survey.
3 Source: Dow Jones Industrial Average.

 

The Russell 1000 Index® measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index. 

The Russell 1000 Consumer Staples Index® comprises companies whose businesses are less sensitive to economic cycles. It includes manufacturers and distributors of food, beverages and tobacco and producers of non-durable household goods and personal products. It also includes food & drug retailing companies as well as hypermarkets and consumer super centers.

The Russell 1000 Consumer Discretionary Index® encompasses those businesses that tend to be the most sensitive to economic cycles. Its manufacturing segment includes automotive, household durable goods, leisure equipment and textiles & apparel. The services segment includes hotels, restaurants and other leisure facilities, media production and services, and consumer retailing and services. 

The information provided here is for general informational purposes only. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual re turns or results will not be materially different from those described here.

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Small and Mid cap company stocks tend to be more volatile and may be less liquid than large cap company stocks. Mid cap companies typically experience a higher risk of failure than large cap companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. Investing involves risk, including possible loss of principal.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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