Is There a Bubble in Consumer Defensives?

As seen in Master Investor Magazine

Some of the biggest gainers from the UK’s decision to leave the EU were internationally-focused consumer defensive stocks. This comes on the back of what has already been a multi-year bull run for consumer defensives as investors look for low risk yield in a post financial crisis world.

Like most dividend investors I am a fan of these often boring but steady growth companies. However, the value investor in me is always wary of sharply rising share prices and general enthusiasm from other investors. And now with so much post-Brexit popularity, cheerleading and soaring share prices going on, I think the time is right to ask whether consumer defensives have become the latest bubble.

Strong brands, wide profit margins and consistent growth

Consumer defensives are often summarised with the phrase “small ticket, repeat purchase”. That’s because they sell products that are inexpensive for the customer and are bought on a regular (but not necessarily frequent) basis. So think of things like beer, washing-up liquid, headache tablets and so on. These are all small items which are purchased on a recurring basis.

With low price products price is not always a key factor in the customer’s decision-making process. Instead, for many people it is more important that the result of their purchase will be as expected – i.e. that the beer taste nice and the washing-up liquid is effective. When consistency of outcome is more important than price many people will just choose a product they have used before, or know is used widely by other people. This leads to products with well-known brands such as Pepsi or Dettol being consistent top sellers, even if they are more expensive than functionally equivalent products with unfamiliar brands.

Selling products with strong brands and slightly higher prices allows the best consumer defensive companies to maintain wide profit margins. That in turn allows them to invest in advertising which drives more brand awareness and loyalty which leads to more sales at high margins.

The result of this virtuous circle is above average profitability, growth and consistency over long periods of time, which is of course very appealing to those of us who are partial to progressive dividends.

To find evidence of a bubble I’ll be looking at a collection of consumer defensive companies which focus on these strongly branded and higher margin products. These companies are: A G Barr (LON:BAG), Britvic (LON:BVIC) and Diageo (LON:DGE) from the Beverages sector; Reckitt Benckiser (LON:RB.) from the Household Goods sector; PZ Cussons (LON:PZC) and Unilever (LON:ULVR) from the Personal Goods sector; and British American Tobacco (LON:BATS) and Imperial Brands (LON:IMB) from the Tobacco sector.

Estimating future returns from yields and growth

One way to check for a bubble in a particular group of stocks is to look at dividend yields and historic growth rates, combine them into a simple estimate of future returns and then compare the result against the market average. If the group’s estimated future returns are far below the market’s, then we could be looking at a bubble.

In terms of dividend yield, those eight companies have an average yield of 2.8%. The FTSE 100, as a reasonable market benchmark, has a yield of 3.8% at the time of writing (with the index at 6,670).

On average then, these companies are relatively low yield and almost every one of them has a lower yield than the FTSE 100. Of course that’s fine if those companies can produce enough growth in the future to offset their relative lack of yield today.

Turning to growth, the average ten-year growth rate of those companies (measured across revenues, earnings and dividends) is 7.3% per year. In comparison, the FTSE 100’s growth rate has been much lower at just 1.7% per year. That is a striking difference.

However, the FTSE 100’s ten-year growth rate is impacted somewhat by the volatile booms and busts of recent years which haven’t impacted consumer defensives to anything like the same extent. In other words, ten years ago the FTSE 100’s earnings were riding high on the back of a commodities and banking boom and now both of those sectors are at low points in their respective cycles. Measuring growth from a high point ten years ago to a low point today may not be the best way to estimate the index’s future growth.

One way around this is to look exclusively at the FTSE 100’s dividend growth rate, which has been a more respectable 4.8% over the last ten years.

Using those figures we have a picture of consumer defensives as low yield, high growth companies (2.8% yield and 7.3% growth) and a higher yield, lower growth market average (3.8% yield and 4.8% growth).

Adding those together gives a simplistic estimate for future total returns of 10.1% per year for that basket of consumer defensives and 8.6% for the FTSE 100. Of course the future is unlikely to be so easy to predict, but I think that’s a reasonable way to build a big picture overview of the situation.

So what does this mean in plain English? Well, if this basket of consumer defensive stocks keeps growing for the next 20 years as they have over the past ten, then investors could see double-digit annualised returns despite low current yields from these stocks. In contrast, FTSE 100 investors might see long-term returns of around 8-9%, which is slightly above average for that index (and assuming inflation stays fairly close to 2%).

Given that a reasonable argument can be made that consumer defensives might outperform the wider market over the next decade, I don’t think there’s a bubble. To get into bubble territory I would expect these defensive stocks to have much lower yields than the almost 3% average we see today; perhaps as low as 1% or 2%, I don’t know, but certainly lower than they are today.

Having said that, as a group these stocks are clearly not in bargain territory either and nor should they be. Instead the group seems to sit somewhere in the middle between bubble and bargain, being neither a no-go zone for sensible investors nor akin to shooting fish in a barrel. Since there is no obvious bubble we may instead have a Goldilocks situation; some of these companies are expensive, some are cheap and some are priced just right. So a good follow-up question to the bubble question is: which are expensive and which are cheap?

Too expensive: Unilever and PZ Cussons?

According to my stock screen, two stocks which appear to be closer to bubble territory than the others are Unilever and PZ Cussons, both of which operate in the Personal Goods sector. These companies epitomise consumer defensives with products like Domestos, Dove and Surf (from Unilever) and Imperial Leather, Carex and Original Source (from PZ Cussons).

Both companies have produced consistently excellent results for shareholders over many years. However, recent share price gains seem to have gotten ahead of each company’s financial results.

For example, Unilever’s current share price of just over 3,500p has increased by about 100% since its pre-financial crisis peak of around 1,750p. However, in that time its revenues, earnings and dividends have only increased by around 40%, 28% and 73% respectively, so the share price has definitely grown faster than the company, even when measured from the previous valuation peak.

This leaves Unilever with a dividend yield of 2.5%, even though its growth rate over the past decade (averaged across revenues, earnings and dividends) is just 4.4%. If it continues to grow at that sort of pace then Unilever investors might see annualised total returns of approximately 7% (2.5% + 4.4%), which is unlikely to be significantly better than the return from an index tracker. On that basis I would say that Unilever is the most likely of these stocks to be overpriced.

The story for PZ Cussons is slightly different and less obvious. Its current price of 320p has improved on its pre-crisis peak of around 200p by 60% or so, but that increase has not outstripped growth in revenues, earnings and dividends over the same period (42%, 88% and 87% respectively). So unlike Unilever, PZ Cussons’ share price hasn’t leapt ahead of its fundamental performance despite the growing popularity of defensive stocks.

Its expected return is also much better than Unilever’s. The dividend yield is low at 2.5% but the company’s average growth rate has been a respectable 6.6% a year over the last decade. Using the previous yield-plus-growth model this produces an expected future return of around 9% a year, which is not too bad. There are downsides though, not least of which is that revenues and earnings are down from their peaks of a few years ago and dividend growth seems to be inching towards zero.

Of course this is a fairly superficial picture for both these stocks, but at first glance it does seem that a 2.5% yield from these companies is probably too low and their share prices probably too high.

Too cheap: Britvic and A G Barr?

At the other end of the scale are A G Barr and Britvic, both from the Beverage sector. Their brands include IRN BRU and Tizer (from A G Barr) and Robinsons and R Whites (from Britvic). Although not exactly screaming bargains (their yields are no better than the market average) my stock screen suggests they are the most attractively valued companies in this group.

A G Barr, for example, has a yield of just 2.6% which is barely better than Unilever’s, but it combines that yield with impressively consistent and rapid growth of almost 9% a year. This gives a simple estimate of future returns of almost 12% a year, which would be very welcome from such a defensive stock. So why has the market assigned A G Barr a dividend yield equal to Unilever’s even though its historic growth record is significantly better?

One reason could be that growth has been slower more recently, although the dividend was still increased by 10% at the last annual results. The current trading environment is described by management as “difficult” and “not expected to substantially change”, partly as people move away from drinking high sugar fizzy drinks such as IRN BRU towards healthier options. A newly proposed sugar levy to nudge people away from high sugar drinks is not exactly welcome news for the company either. Despite these issues I think A G Barr is worth investigating in more detail if you’re looking to add some dividend growth stocks to your dividend portfolio.

Britvic is more obviously cheap as it has a dividend yield of 3.8%, almost exactly matching the FTSE 100’s yield. However, unlike the large-cap market’s growth rate of 4.4%, Britvic has managed to grow at 8.4% a year, giving it a yield-plus-growth estimate of returns some 4% a year better than the market average. Of course, whether or not that actually happens is a different matter, but that is exactly the sort of attractive picture I like to see before diving into a more detailed investigation.

Of course Britvic has issues – otherwise it wouldn’t be attractively priced. Growth has been slower in recent years and the company has a considerable debt pile of more than £600 million compared to average post-tax profits in recent years of just £90 million. Despite these issues, with a 3.8% yield Britvic is clearly not at bubble valuations.

So while consumer defensives have recently enjoyed a run of some considerable success I don’t think that as a group they’re in a bubble. Instead some are expensive, some are fairly priced and in all likelihood some are cheap enough to be worthy of investment.