Wednesday, April 29, 2015

What makes Consumer Staples the Perfect Dividend Growth Companies?

Most consumer staples are also called defensive companies, because their earnings and dividends do not decline by much during recessions. During economic recoveries however, their earnings and dividends tend to increase also. Because they are mostly mature and large companies, growth expectations are low, which usually leads to low valuations.

The thing that truly appeals to me in consumer staples includes the recurring nature of their revenues, which are generated from a wide number of products that customers love and buy regularly. Most consumer staples offer products with strong recognizable brands, for which customers are willing to pay a slight premium for. A customer, who is used to Gillette razorblades and shaving crème or foam for years, is not going to downgrade their experience merely in order to save a few dollars, but end up with cuts all over their faces. If you have used Colgate toothpaste for years, chances are very high that you would keep purchasing a tube every month or so. The nature of the products that consumer staple companies offer, satisfy basic human needs, which are satisfied only when the branded product is exhausted. Once it is all used up, the consumer needs to go ahead and purchase the product again, thus ensuring a repeatable stream of sales for the company for decades to come from each consumer it wins over.

Consumer staple companies also benefit from strong distribution networks and economies of scale in production. They have wide moats. The distribution networks help the products to be easily accessible to the everyday consumer, and increase the likelihood of a repeated sale. The economies of scale allow companies to allocate their costs over a larger pool of product, thus resulting in negligible per unit in additional cost. For example, a company like Procter & Gamble (PG) has a better staying power than an upstart consumer-staples company, because P&G can reach out tens of millions of consumers in the US through advertising, as it already generates billions in revenues and already has millions of customers buying its products. The global scale of manufacturing also makes it cheaper to make its products, relative to a smaller competitor.

Furthermore there are always plenty of opportunities for growth, driven either through acquisitions or international expansion. In addition, the general level of increase in populations over time also leads to an organic growth kicker for consumer staples.

The fact that consumer staple products are relatively inelastic, meaning that people use those in good times and bad, translates into a stable stream of recurring revenues for these companies. This translates into stable cash flow generation, that provides the fuel behind dividend payments, share buybacks and acquisitions.

If you think about it, as long as people use hygiene products such as toothpaste and shampoos, eat food like ice-cream, cookies, jelly and canned soup, chances are that consumer staple companies should do well over time. Even if you get a consumer staple company whose customer base grows by 1%/year, you can generate very decent returns over time. This is because the company would be able to pass on rising costs to consumers, deploy some excess cash flows to repurchase some stock on a regular basis, make strategic acquisitions, and make operations more efficient. If you add in a small starter yield of 2 – 3% today, chances are that these factors described previously could easily translate into a minimum very conservative annual earnings per share growth of 6% - 7% for decades.

Some of the huge macro trends that Consumer Staples are riding include the increasing prosperity in the emerging market world, where over a billion people would be lifted out of poverty and join the middle class within a couple decades. In addition, some demographics trends that no one is paying attention to includes the baby boom in the US, as well as the potential for a baby boom in China, as the one child per couple policy seems to be phased out by the government. Even the population ageing in developed countries such as Japan or those Western European ones could be a boom for consumer staples. As people age, they would want to do so in dignity, which could only translate into more sales for the likes of Johnson & Johnson (JNJ), Procter & Gamble (PG) etc.

The time to purchase these companies is when valuations are low, and avoid overpaying, as this would mean that the next decade of growth is already baked in the stock price. The perfect time to purchase could be when there is a temporary snafu at the company, such as the Tylenol scare for Johnson & Johnson in 1983 or the 2010 recalls again at Johnson & Johnson (JNJ). The financial crisis of 2007 – 2009, also created an environment where quality companies such as Procter & Gamble (PG), Clorox (CLX), Colgate-Palmolive (CL) and PepsiCo (PEP), to name a few, were on sale at some of the lowest valuations in years.

After you purchase those companies, your job is to sit patiently and collect those growing dividends. Only if prices become terribly overvalued, north of 30 times forward earnings should you consider thinking about trimming. So far, even if you held on through the 1972 Nifty Fifty bubble, or the 1999 – 2000 bubble, the rising earnings tide on those companies eventually bailed out the long-term investor. Just be mindful that if you sold a company that raises earnings and dividends like clockwork at 30 – 40 times earnings, chances are that any replacements you find might look cheaper, but wont offer the same level of quality.

Unfortunately, many consumer staples companies I like are overvalued. A few which are fairly valued today include:

Johnson & Johnson (JNJ), together with its subsidiaries, researches and develops, manufactures, and sells various products in the health care field worldwide. This dividend king has raised distributions for 53 years in a row. In the past decade, Johnson & Johnson has managed to boost dividends by 9.70%/year. The stock currently sells for 16.50 times forward earnings and yields 3%. Check my analysis of Johnson & Johnson for more information about the company.

Altria Group, Inc. (MO), through its subsidiaries, manufactures and sells cigarettes, smokeless products, and wine in the United States and internationally. This dividend champion has raised distributions for 45 years in a row. In the past decade, Altria has managed to boost dividends by 11.60%/year. The stock currently sells for 18.60 times forward earnings and yields 4.10%. Check my analysis of Altria information about the company.

Diageo plc (DEO) manufactures and distributes premium drinks such as Johnnie Walker, Crown Royal, Buchanan’s, J&B, Baileys, Smirnoff, Captain Morgan, Guinness, Shui Jing Fang, and Yenì Raki.. The company has raised dividends for 15 years in a row. In the past decade, the company has managed to boost dividends by 5.80%/year. Currently, the stock is selling for 20.20 times forward earnings and yields 3%. Check my analysis of Diageo for more details.

Full Disclosure: Long JNJ, CLX, PG, CL, PEP, MO, DEO,

Relevant Articles:

Are dividend investors concentrating too much on consumer staples?
Strong Brands Grow Dividends
39 Dividend Champions for Further Research
What dividend stocks would I buy if I were just starting out as a dividend investor

10 comments:

  1. I entirely agree. I am looking to bulk up my consumer defensive exposure at the moment.

    I currently hold--being a UK investor--Unilever, Diageo, PZ Cussons, Imperial Tobacco and Britvic (in fact, I only bought into Britvic yesterday. See http://bit.ly/1Ej99aB if you're interested in why). I therefore have quite a bit of exposure. But I would like it to be more.

    Diageo is looking good! I am seriously thinking about topping up if the price continues to sit low. It certainly seems that spirits, in particular, will continue to see growth consistently into the future.

    Have you looked at GlaxoSmithKline as well? Rather like J&J it has a large consumer healthcare division. It amounted to about 19% of its turnover last year (no small part!). May be worth a serious look.

    Anyway, thanks for the write up. Very interesting.

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    Replies
    1. Hi DD,

      The companies you mentioned seem like some good consumer staples to consider for further review. I like Diageo, and would love it at cheaper prices. I have honestly not reviewed GSK in detail. Maybe I should add it to the list. I own Unilever too, but no Imperial Tobacco or Britvic.

      Thanks for stopping by!

      DGI

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    2. My pleasure. Thanks for the fascinating posts.

      Some of those mentioned are traded in the US as well. Not all though. GSK is well worth a look with your "consumer staples investor" hat on. Its pharma side tends to whitewash the significant consumer health element which underpins it. Really shouldn't though!

      You may be in luck. This side of the Atlantic all of those I mentioned above have taken a price hit today. Diageo has dropped below my £18 target, Unilever is back to a predicted yield of 3%+ and GSK took another little dive. All are now looking very attractive (esp. Diageo and GSK!).

      Too many attractive companies to consider!

      Thanks for taking the time to reply. Much appreciated.

      Delete
  2. DGI,
    According to a recent article by Tim McAleenan Jr., Consumer Staples trailed only Healthcare as the S&P 500 sector (out of 10) with the highest average yield over the last 50 years. You have nailed the reasons why in your discussion.

    My question to you is, do you ever consider investing in companies that are almost never cheap (barring the Great Recession - an event which may not occur again in our lifetimes) like Hershey or Colgate-Palmolive? I have positions in both that I started the last 2 years when short term corrections allowed me to add small amounts of stock. I understand that this can be a risk and that better valuations might occur, but since these are small positions I would be glad to double or triple the share counts if opportunities arise. I do see that you have a position in CL. Did you have the foresight to buy these shares in 2008-2010? I know that you stick to your guidelines, and you are wise to do so. But some companies never look cheap, and paying 21x forward earnings for HSY right now, or 23x forward earnings for CL might not be a bad investment. Neither are grossly over your target of 20x forward earnings.

    Thanks. Always look forward to your responses.
    KeithX

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    Replies
    1. Hi Keith,

      Have you read this article I posted on the performance of the best companies from the original S&P 500? http://www.dividendgrowthinvestor.com/2015/03/the-perfect-dividend-portfolio.html

      It discusses the sectors where the best performer came from. Tim leverages the same source that I quote.

      As for your second question, you might want to check this article I wrote when HSY was selling north of $106 :-) http://www.dividendgrowthinvestor.com/2015/02/buying-quality-companies-at-reasonable.html

      And for CL - I bought it quite extensively between 2008 - 2012. Haven't bought since. I think a lot of questions you might have could be answered by checking the archives, though sifting through over 1000 articles is probably time consuming ;-) : http://www.dividendgrowthinvestor.com/2013/03/complete-list-of-articles-on-dividend.html

      Best Regards,

      DGI

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  3. Cant go wrong with adding staples to any DGI's portfolio. Surprisingly, my exposure is a bit limited, but I am looking into adding in this sector. Like you mentioned, the sector players are overvalued and do not come cheap. I suppose, I will have to pay a higher premium if I need them in my portfolio.

    Best wishes
    R2R

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  4. At the moment, I'm underweight in utilities but that doesn't bother me too much. Your article and comments gave me a lot to think about. Thanks for sharing!

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  5. One of my favorite sector that's for sure. Great companies that have proven their quality year over year. As you mentioned though, many are overvalued and it is sometimes hard to find opportunities. Thank's to JNJ (and some others), many have been able to add some in their portfolio this year!

    Cheers DGI!

    Mike

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  6. DGI,

    Great write-up, I agree completely.

    What attracts me to consumer staples is their recurring business. I think you'd be amazed if you counted how many times you bought the same products over and over, year-in year-out. Just like you, I've been using the same brand of tooth paste and shampoo for years. No reason to change now, is there?

    That's why you'll find that my portfolio leans heavily toward defensive consumer stocks. Their predictability and lack of volatility offers me a good night's sleep all year round.

    Best wishes,
    NMW

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  7. Technically jnj is part of the health care sector, not staples. Still a wonderful company.

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