The Dow’s nearly 700-point tumble on Friday was one of the worst days in stock market history. Now granted, the market is at all-time highs, so on a percentage loss basis, it wasn’t absolutely terrible. Well, Monday’s follow through of more than 1000 points to the downside was one of the worst days ever in terms of both points odd the major market indexes and percentage drop. The sell-off that we market has experienced over the last couple of days has wiped out all of the YTD gains.
What’s more, as I write this piece the sell-off in steepening in the after hours and futures point toward another 1000 drop in the DOW on Tuesday morning. No one likes seeing big red numbers like that. If you checked your retirement savings recently I’m sure you noticed that you were thousands (or more) dollars poorer (on paper, anyway). This might have made you feel uneasy, or even sick to your stomach. Fear is a powerful force and I’m sure many investors are just starting to realize just how complacent they had gotten during the last couple of years when volatility was essentially absent.
It’s moments like this that remind portfolio managers why it is so important to stay vigilant in the markets. Prior to Friday, I’m sure that many investors had forgotten when it felt like to feel anxious in the markets. In a way, this is why a significant dip is healthy for the market; it serves as an alarm clock to wake up managers who’ve fallen asleep at the wheel. What’s more, it forces weak hands out of the market, helping to create a floor when long-term, high conviction investors are the only ones left with shares in their accounts.
Obviously no one can predict the future and while many value oriented analysts probably thought we were due for a pullback, I doubt many thought we’d see a sell-off this steep (the DOW dropped 800 points in 6 minutes on Monday; that was absolutely crazy to watch). But, with that being said, it is possible for investors to gauge risk in the markets using fundamentals and macro keys, which have led me to become more cautious as of late. One measure that I’ve taken over the last 6 months or so is to reduce my exposure to “bond equivalent” type equities. In this piece I will discuss my sales in the consumer staples space, highlighting why I don’t believe these historically conservative names are very defensive in today’s market.
Now, let me be clear: there is so such thing as a bond equivalent equity. Stocks carry inherent risks that aren’t found in the fixed income market. This is a flawed notion that I hear in all of the time and cannot stress enough that if you’re purely interested in reliable income without the capital risk, buying dividend aristocrats, no matter their illustrious histories, is not a good idea.
With that being said, I use the term “bond equivalent” because it does paint a fairly clear picture of the types of stocks I’m talking about: low beta, low growth, strong yield (typically 2.5%-3.5%), familiar brand name, and a very long streak of annual dividend increases.
Income oriented investors have been forced to put cash to work in these types of names because of the historically low interest rates that we’ve seen over the recent past. Look, I get it, if you need a certain yield threshold to survive, I can’t blame you for chasing yields in the equity space that simply couldn’t be found in the fixed income markets. We all have bills to pay and if passive income is your main source of income you had to do what you had to do to make ends meet. But, now that the FED has began the normalization process and rates are on the rise, I think it’s time to re-examine your holdings. If the last couple of days have made anything clear, it’s that capital exposed to equities, no matter their quality, is anything but safe.
I’m not saying that investors should panic. As a long-term investor, I’m not concerned about the last couple of days. I actually think the weakness in the market has created attractive opportunities. I re-initiated a position in Realty Income (O) on Friday at $51 after selling my shares 18 months ago for $69. I initiated a position in another REIT, Gramercy Property Trust (GPT), a industrial focused REIT with a yield north of 6%. And, right before the bell on Monday I added to my Apple (AAPL) position at $157.00 (I’m sure that AAPL’s management team is salivating when it looks at this weakness knowing that they have billions of dollars coming ashore that is earmarked for share repurchases).
My point being, if you had a medium to long-term time horizon, recent weakness shouldn’t spell disaster for your finances. I heard a statistic yesterday that said something like 300 of the S&P 500 companies haven’t raised their EPS guidance for 2018 yet, factoring in tax reform. I’m sure that increased cash flows from lowered tax rates is priced into the market to a certain extent, but I don’t think it’s fully there with so many companies still using pre-reform guidance. I expect to see strong bottom line growth and above average shareholder returns in 2018 because of the changes made to the corporate tax system and it’s difficult for me to imagine the next couple of years being totally negative in the markets with such a strong tailwind behind the market.
I’m not opposed to trimming names to make room for better values created by this volatility, but I think it’s important for investors to realize that fear is oftentimes one of the biggest hurdles in between investors and the long-term wealth generation that the stock market has historically provided. If you’re nearing retirement/retired, then things might be different. Like I said before, you’ve got to do what you’ve got to do in terms of meeting income thresholds. I understand that sell-offs like this must be scary for those who don’t have the luxury of time on their sides to recoup any paper losses and I don’t envy your position. I wish you all the very best of luck.
In my recently published January Portfolio Update, I discussed why selling Kimberly-Clark (KMB) at $116.83 early in the month was the only trade that I made. Here’s a quick re-cap:
“Kimberly-Clark is a wonderful company without a doubt. This consumer products company sells things like diapers, toilet paper, and tissues that humans will purchase in any market conditions. KMB has a 46-year dividend increase streak going and a 3.4% yield. KMB has a 57.6% forward payout ratio, which is higher than I’d like to see but still doesn’t appear to represent any danger for the dividend. All in all, this is a very reliable equity for income oriented investors; however, I’ve been concerned with the company’s lack of growth and its valuation for awhile now and with rates on the rise, I’m continuing my gradual exit from the consumer staples space.
KMB posted top line growth of -6.8%, -5.7%, and -2.1% in 2014, 2015, and 2016, respectively. Sales are essentially flat during the trailing twelve months. Sure, KMB’s EPS has risen nicely over the past couple of years and the weakness in the dollar should be a boon to this company as it tries to make inroads in foreign growth markets, but as great as the ~3.4% dividend is, in a rising rate environment I don’t feel comfortable relying on the yield without top-line growth to push the stock forward.”
I used the same logic with this KMB move that I did with Altria (MO), Procter and Gamble (PG), which I sold last year for $66.58 and 90.85, respectively, and more recently J.M. Smucker (SJM), which I sold for $124.22 last week.
All of these companies have (or had, when I sold them) certain things in common. First of all, they all have strong dividend yields and appear to be reliable moving forward. This is a positive. However, they’re also trading at valuations above historical averages with out above average growth prospects to justify those valuations. This is a negative and ultimately led me to believe that the capital risk of holding onto them was higher than the potential rewards provided by the dividend yields.
Another large part of my bearish thesis on the consumer staples space is the trend that I see where consumers, especially those in the younger generations, are eschewing popular brand names in favor of better values in the generic space. When I talk to my grandma about shopping, she has a pretty narrow mind. She has to have a certain brand of coffee and a certain brand of dish soap, and God forbid you buy the wrong type of paper towels.
This simply isn't the case for me when I go to the store. I'm on a constant look our for value and I don't have a lick of brand loyalty. I’ve found that the quality of store branded goods has improved to the point where I’m willing to go that route rather than pay the premium prices for a lot of brand name items. This is especially the case with disposable goods, which played a major role in my recent decision to sell KMB.
Brand names are sometimes demonized by younger generations who are more attracted to local goods. Millennials are oftentimes more interested in things like freedom or their carbon footprint than material goods or traditional lifestyles. Whether its right or wrong, big corporations have gotten a bad name in certain respects. Here is an example of a popular image that I see when looking at the power of the big brands and the “illusion of choice” that consumers have.
As an investor, I see a brand portfolio like these and I think broad moat. However, I think a lot of consumers see images like this and get upset. In an age where we oftentimes hear about wealth inequality this “illusion of choice” issue rubs people the wrong way. There’s a more out dated one from 2012 that floats around the internet showing packaged goods companies as well that really speaks volumes to the concentrated ownership of the brands we know…and love? This has led to a shop local movement that is damaging the traditional consumer goods plays.
Millennials are flocking towards things like the farm to table movement or local craft beer/wine in the food space. Smaller brands that have more eco-friendly branding are thriving in the packaged goods space. Millennials seem to be more interested in corporate responsibility than corporate profits and I don’t think this bodes well for the DGI aristocrats that control many of the well known big brands, in the short-term, at least.
I’ve spent a lot of time thinking and writing about the T.I.N.A. market environment with regard to low rates and income oriented investors being forced to take outsized risks to meet their yield thresholds as of late. It worries me in terms of potential capital losses for these investors who’ve increased their risks to meet ends meet.
I’ve tried to develop a long-term strategy for myself as well. I’d love to own many of the dividend aristocrats that I see championed as wealth generators for DGI investors; however, I simply can’t justify exposure to many of these names because of their valuations.
The recent sell-off that the market has experienced certainly helps in that regard, but at the end of the day, I need to see cheap valuations (below 15x forward earnings) due to lacking sales growth. Many of the classic consumer staples companies are still trading in the 20x range, so they’ve still got some ways to go before I find them truly attractive.
Thus far, staying disciplined with regard to growth/valuation has led to good sales decisions in the consume staples space. Each of the consumer staples that I’ve sold recently has underperformed the market since my sale date. Obviously its never an easy/popular decision to sell a DGI stocks such illustrious histories like MO, PG, KMB, and SJM have; however, I’m happy that hindsight is proving my bearish thesis correct on the low growth, overvalued DGI names in a T.I.N.A. market.
Only time will tell if this thesis continues to hold water, but in the meantime, I will continue to monitor valuations and look for attractive buying opportunities. Certain consumer staples are more attractively priced than others (a company like MO has much better growth prospects than PG, for instance). Moving forward, I’ll continue to do what I always do: let the market and its valuations come to me.
What’s your plan? Are you buying consumer staples of weakness? Do you disagree with me and still view them as defensive holdings in today’s market? Are their yields attractive to you in the face of slowing/negative growth?
As always, I look forward to your feedback and the conversations that ensure. Until next time, best wishes all!
disclosure: I am long AAPL, MO, O, and GPT.