Consumer Staples, Part II

 “We see change as the enemy of investments…so we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.” Warren Buffett

In Consumer Staples, Part I, I explored the unique nature of consumer staples stocks and their impressive historical returns. In this part, I’ll explore how to find the best individual consumer staples stocks.

Some aspects of security analysis require a heavy touch. For example, evaluating the value of a brand, or the sustainability of a “business moat” requires hands on work and deep knowledge of each company. My approach is, instead, quantitative.  In this sector series, I’ll highlight “factors” that can be quickly calculated and compared across a wide universe of stocks. I’ll cluster these stock selection factors into several key categories: valuation, profitability, momentum, and quality.  I’ll also include some factors that do not add value historically, despite their appeal.

As we will see, the secret to success in the consumer staples sector is similar to the secret to success in the broad market: focus on high quality, cheap stocks. Value has been the most successful factor for choosing consumer staples stocks, but the value strategy can be enhanced by insisting on strong profitability and a shareholder orientation.

What Matters for Stock Selection

There aren’t that many consumer staples stocks. Today, there are just 108 U.S. stocks in the sector with a market cap greater than $200MM. If you include international stocks listed on a U.S. exchange (usually as an American depository receipt (ADR)), there are 161 stocks.

Because there are so few, my analysis of factors separates the universe into quintiles (buckets that represent 20% of the market sorted by a factor, or roughly 32 stocks each today) rather than deciles (which I normally use in a bigger universe). I’ve tried to include as many factors as possible that are available at free screening services like www.finviz.com, but I’ve also included some factors that are not available from the free screening services.

Value

Given that consumer staples stocks have had such high returns on their equity for so long, it is curious that they are have been, on average, the second cheapest sector after utilities over the past 50 years[i]. And their valuations have been steady. Look at the thick black line in the chart below. Measured against all stocks, consumer staples are almost always cheaper (i.e. their average valuation percentile is less than 50).  In this chart, 1 means cheapest and 100 means most expensive.

The sector is often cheap, but investing only in the cheapest stocks within the sector has yielded even more impressive results. The panel below breaks the universe of consumer staples stocks into quintiles based on different valuation factors. The analysis is run since 1963, and the quintiles are rebalanced on a rolling annual basis (so if you were to run a similar strategy, you’d want to hold positions for 12 months—this holds true for all other factors referenced below).

Clearly, buying cheaper stocks works. All four value factors can point you to sector-beating stocks, but EBITDA/EV and Earnings/Price work best.  Where do these factors point you within the staples sector? Here is the historical valuation percentile (similar to the one above) for the three industry groups within the staples sector.

Food & Beverage companies have tended to be cheaper while Household & Personal Product companies have tended to be more expensive. Take Altria Group (formerly known as Philip Morris) for example. It is the single best performing stock since 1963, but has spent a lot of time as one of the cheapest stocks in the entire market! Pretty amazing. Bottom line: buying the cheaper staples stocks leads to superior results.

Quality

The term ‘quality,’ like the term ‘smart beta,’ can mean a lot of different things. I’ve included a number of different factors here that I think are applicable to the staples sector.

Several lessons stand out.

·         High ROE is the defining feature of the Staples sector: the sector as a whole has earned market-beating returns on equity for 50 years. But buying the stocks with the highest individual ROEs has not been a winning strategy. Return on invested capital has been a better measure of profitability and a better way to select stocks.

·         I remember thinking the cash conversion cycle was very compelling during my CFA days, but it is not a helpful selection factor in this study.

·          A focus on strong free cash flow can help you find the best staples stocks. By avoiding stocks with low free cash flow/ sales and avoiding stocks with low free cash flow / short term debt, you can sidestep stocks that have tended to underperform the broad sector.

·         A focus on earnings quality (change in net operating assets[ii], and total accruals to total assets) can also give you an edge.

Yield

Two measurements of yield are very effective in the consumer staples sector: dividend yield and shareholder yield[iii]. I’ve only included the top 25 stock portfolio for dividend yield[iv].

Buying stocks with higher yields has been a very effective strategy. Companies paying regular dividend (whose yield is high because the stock is out of favor) have been reliable investments, and companies buying back shares have done well.

Momentum

Buying stocks with strong momentum has worked well in the broad market, but hasn’t added much value in the staples sector. This could be a coincidence of history, and I cannot think of a reason why it hasn’t worked that well in this sector, but it is interesting nonetheless. 

Combining Factors for Superior Results

So what happens when you rank stocks on a combination of the best factors? Below are the results of a strategy that combines EBITDA/EV, shareholder yield, change in operating assets (earnings quality), and free cash flow/short term debt (financial strength).  Each stock is given a rank 1 to x and the 25 stocks with the highest average ranking are selected by the model.  The annualized return is similar to some of the factor portfolios above, but the Sharpe ratios are significantly improved. The annualized return is 17.5%–slightly better than the 17.3% for the cheapest stocks by EBITDA/EV listed above. But the volatility is just 14.6% for the four-factor strategy, versus 16% for EBITDA/EV.  That means the four-factor strategy has a Sharpe ratio of 0.85, a big improvement over the 0.76 Sharpe ratio for EBITDA/EV.

BONUS FACTOR

In my research, I found one final factor very interesting: Research & Development expenses divided by market value. I didn’t include it above because not all companies have R&D, so you cannot compare all companies to each other. But among those that do spend on R&D, it is a very effective factor. It is part value factor, part earnings quality factor. It measures value because the denominator is price, but also measures earnings quality because of an accounting quirk.

R&D is an investment meant to provide a long term benefit, but it must be “expensed,” meaning subtracted from earnings during the period that the spending takes place. This stands in contrast to other investments like property, plant and equipment which can be “capitalized.” Capitalizing just means that you only count a fraction of the cost—of say a machine—against current earnings. If a machine is going to last 10 years, you only subtract 1/10 of the cost of the machine in the first year. Capitalizing makes sense and smoothens earnings. You can argue that like a machine, R&D spending will have an impact over the course of many years, so the fact that companies have to expense R&D costs can make earnings look weaker than they are and lead to nice future earnings surprises and therefore nice future returns. Here is the factor, split out by quintile.

As always, let me know your thoughts by commenting below or emailing me at patrick.w.oshaughnessy@gmail.com

IMPORTANT DISCLOSURE! These backtests do not include any costs whatsoever and so should be taken with a grain of salt.  While a once-per-year trading strategy is fairly easy to trade these days, the costs can still be significant when trading in small cap names. These test also have a fairly small sample size. With just about 150 stocks at any given time, the staples sector is small. The good news is that the factors that work in the staples sector work in the other nine sectors too, as we will see over the course of this series, and also work in international and emerging markets (which are nice out of sample tests).

Calculation Notes: everything, as always, is rebalanced on a rolling annual basis to avoid seasonality in the results. Only stocks with an inflation adjusted market cap above $200MM are included in the sample. Going smaller can improve results, but leads to trading and liquidity concerns.  Due to several comments about excluding international stocks in part I, I’ve included non-U.S. stocks that have a U.S. listing in this study. Results are similar if the universe is U.S. stocks only, but are improved for the most part with a larger (global) universe. The inclusion of ADRs is the reason the consumer staples overall sector return is slightly different from my first post.

[i] Cheapness measured using a composite of value factors: p/sales, p/earnings, ebitda/ev, etc.

[ii] Net Operating Assets = non cash assets minus non debt liabilities. A large positive percentage change is bad: it means things like accounts receivable, inventories, and property plant and equipment are growing at a rapid pace, which has historically boded poorly for future returns.

[iii] Shareholder yield = dividends yield plus buyback yield (% change in shares outstanding in prior year, negative better)

[iv] Dividend yield doesn’t “quintile” cleanly because of a group of stocks with zero yield.