The current market environment has taken me by surprise. At the beginning of the year, if you had told me that the consumer staple stocks sector would fall by 20%, I would simply have laughed at you. But this is the position we find ourselves in today. After years of ‘dull’ and ‘boring’ companies being in fashion, it appears that the trend has turned. It seems that investors are no longer willing to bid up prices of stable companies when they can achieve a decent 3% risk free income via treasure bonds. As a result, many companies with strong franchises and stable performances are reaching fair value.
RB, British American Tobacco and Pepsi are all examples of consumer staple companies that have peaked my interest. These companies, after a very very long time, have found themselves on improved starting dividend yields and valuations, a trend that I welcome given their resilient characteristics. With the first two stocks being FTSE listed, I have been drip feeding cash into them via the monthly stock purchase programme. With Pepsi being an overseas American stock, I have had to make an outright purchase.
As mentioned above, one of the reasons for rotation out of consumer staple stocks is due to the risk free treasury yield hitting 3%. Income hungry investors no longer need to hold safe and stable bond proxy type stocks to get a decent income, instead, they can buy an actual bond now.
A second reason for the rotation which is purely my own view is that many investors have become interested in other more ‘exciting’ areas of the market. As the bull market continues to power, many retail investors are no longer willing o accept 8%-10% per annum performance. Instead, they want more of the shoot the lights out performance and are thus buying into racier stocks. That is why you see many growth loss making stocks today on elevated multiples.
The third reason, and by far the most important, is that the consumer branded sector is undergoing a number of threats. These competitive pressures from private label products, the growth in e-commerce as a distribution channel thus affecting search costs which consumer staple companies have historically relied on and the rising demand for more natural, healthy and authentic products – driven particularly by the millennial consumer.
I’ve written about the problems facing consumer staple industry before and that is why it is important to buy into the right companies. Factors you need to look out for when investing in this industry are as follows:
- A portfolio of very strong brands that could be exploited using digital channels – c85% of Unilever’s portfolio, for instance, is comprised of brands that are number 1 or 2 in their category.
- A willingness to be flexible, adapt and invest consistently in the future.
- Exposure to categories where private label is less entrenched (consumer health, beauty, personal care, beverages etc.).
- A well entrenched position in emerging markets (non branded goods in emerging markets are not trusted due to trading standards).
In my view, Pepsi (as well as the two earlier mentioned stocks in RB and BAT) offer a particularly good combination of the characteristics listed above. The three companies have some of the best emerging market exposure and this part of the business is ticking along nicely and will really contribute to growth going forward.
Pepsi – Part of the global beverage duopoly
PepsiCo was created from the merger of Pepsi Cola and Frito Lay 50 years ago. The company operates in the very attractive beverage and snacks market which offers double digit operating margins and returns on capital employed. Have a look at the accounts to see just how strong the company is from a balance sheet, cash flow and income statement perspective.
Looking at the company’s market position, it is the world’s biggest snacks business and has 2nd biggest soft drinks business – no shame in coming second to Coca Cola. Both are great impulse categories with consumers attributing to high brand loyalty.
As mentioned above, PepsiCo emerging market exposure makes the company a very attractive play from an investor’s point of view. 35% of revenues are from Emerging Markets. As an example of why emerging markets exposure is so important, have a look at this stat: At present, salty snacks consumption is 0.3kg per annum in Asia vs. 8.5kg per annum in the US. This is a huge discrepancy and one would expect per annum consumption in Asia to increase over the coming years as its population gets wealthier. This provides a great growth runway in the years to come.
Pepsi also has massive scale advantages giving it important barriers to entry. It is by far the biggest snacks company in the world with at least 5x the market share of the nearest competitor, as well as being 11x bigger than the #2 in the US, its most important market. This brings great economies of scale, strong cash flow and creates a serious economic moat.
As the biggest food and drinks company in the US, Pepsi is the most important supplier to most retailers, shifting the balance of power back to the manufacturer despite the consolidated retail sector.
Looking at the soft drinks side, although it is No 2, PepsiCo still has a strong market share with its brands commanding 20% of the important US market compared to 25% of Coke’s. Beverages are a very profitable business to be part of. The manufacturing costs are super low – it is essentially sugar water. Most companies around the world are forced to sell soft drinks at a price close to costs due to competitive pressure. But not coke and Pepsi. Because of their brands, they are able to have a higher double digit mark up. This makes the industry very profitable for these two companies.
The power of these brands are illustrated by Pepsi’s history of value creation and dividend growth since the merger 50 year’s ago. Pepsi has increased its dividend every year for the past 44 years, at an 11% annualised rate over the period. A person who bought £1,000 worth of Pepsi Stock at the beginning of 1990 would compounded his investment at a double digit rate and would have turned his money into £19,350 today. Not bad for a dull and boring business.
My Purchase of Pepsi
I bought 14 shares of PepsiCo at $97 each. This position has been initiated at a P/E ratio below 20 which I think is good value for a solid company like Pepsi. This is a starter position and should Pepsi continue to fall in price, I will be buying more.
This purchase adds £32 in annual dividend income to my portfolio. It could have been more but the US deducts a 15% withholding tax on dividends (30% if you don’t have a w-8BEN form). Although 15% is slightly high, it doesn’t discourage me from owning PepsiCo, especially at current levels. Opportunities to buy excellent businesses at fair valuations do not come around often and when they do you need to pounce.