The Fantastic Economics Of Consumer Staple Stocks Result In Outsized Returns 6

Any regular reader of this site will know that I have a preference for investing in consumer staple stocks. Consumer staple companies sell products that are essential to everyday life, such as food, beverages, tobacco and household items; goods that people are unable or unwilling to cut out of their budgets regardless of their financial situation. My investment portfolio has an outsized position in this industry having bought stocks in Unilever, Procter & Gamble, RB, Estee Lauder, Coca Cola, Britvic, AG Barr, Imperial Brands and PZ Cussons.

The consumer staples sector fascinates me because it reveals so much about human nature and the problem of economics versus behavioural economics. Over long periods of time, with dividends reinvested, the sector tends to crush most other parts of the overall market – and the best part of this outperformance is that it does it with far lower levels of risk. Being so ingrained in our lives, consumer staple stocks tend to have a stable performance whilst producing copious amounts of cash flow. If this sector fails, it is easy to argue that we are truly, totally screwed as a civilisation.

Yet, when the stock market begins to boom, they tend to be left behind. Often times, staples find themselves being outperformed in booming markets by bad businesses which suddenly find themselves on the favourable side of operating leverage leading to an exploding share price. This causes the consumer staples to tend to lag the broader market in the early stages of good times when they develop reputations for being slow “grandma or grandpa” stocks; boring firms that pump out money but won’t make you rich overnight. We’ve seen this phenomenon play out time and the again,

Everyone becomes so obsessed with falling behind the benchmark in the short-term they ignore that over 10, 15, 25+ year periods, the wealth differential is fairly enormous. In other words, many investors focus on the scoreboard rather than the playing field, to borrow an analogy from Warren Buffet. You get this outcome where, by trying to do well relative to the market in the short-term, they never stop to ask themselves, “What is going to make me the wealthiest with the lowest amount of worry over the next few decades?”. They care more about temporary measurement than substance or relative performance to friends, family and strangers than absolute performance.

In a study conducted by Dr Jeremy Seigal to find the best performing stock between 1957 and 2003, a consumer staple stock Phillip Morris came out on top. Every $1,000 invested in the company in 1957 would have grown to $4,626,402 for a CAGR of 19.75%. The company outperformed all others due to obscenely high, sustained returns on capital attained over long period of time – a trait many of the best consumer staple stocks share. Looking at the top 20 stocks during this period, we can see a striking trend: consumer staples historically outperform.

  1. Philip Morris – Consumer Staples – $4,626,402 – 19.75% CAGR
  2. Abbott Labs – Pharmaceuticals – $1,281,335 – 16.51% CAGR
  3. Bristol-Myers Squibb – Pharmaceuticals – $1,209,445 – 16.36% CAGR
  4. Tootsie Roll Industries – Consumer Staples – $1,090,955 – 16.11% CAGR
  5. Pfizer – Pharmaceuticals – $1,054,823 – 16.03% CAGR
  6. Coca-Cola – Consumer Staples – $1,051,646 – 16.02% CAGR
  7. Merck – Pharmaceuticals – $1,003,410 – 15.90% CAGR
  8. PepsiCo – Consumer Staples – $866,068 – 15.54% CAGR
  9. Colgate-Palmolive – Consumer Staples – $761,163 – 15.22% CAGR
  10. Crane – Industrial – $736,796 – 15.14%
  11. H.J. Heinz – Consumer Staples – $635,988 – 14.78% CAGR
  12. Wrigley – Consumer Staples – $603,877 – 14.65% CAGR
  13. Fortune Brands – Consumer Staples – $580,025 – 14.55% CAGR
  14. Kroger – Retail – $546,793 – 14.41% CAGR
  15. Schering-Plough – Pharmaceuticals – $537,050 – 14.36% CAGR
  16. Procter & Gamble – Consumer Staples – $513,752 – 14.26% CAGR
  17. Hershey – Consumer Staples – $507,001 – 14.22% CAGR
  18. Wyeth – Pharmaceuticals – $461,186 – 13.99%
  19. Royal Dutch Petroleum – Oil – $398,837 – 13.64%
  20. General Mills – Consumer Staples – $388,425 – 13.58% CAGR

From the above, we can see that the companies that make the “best off” list are not random – 11 of the top 20 best performing stock belong to the consumer staples sector. The sector is a breeding ground for wealth creation. Nobody seems to notice or care for this outperformance except a handful of managers (E.g. Nick Train and Terry Smith) and rich families. And that is why they have done so well over time.

Whenever firms like Coca Cola, Britivc or Ag Barr get within fair value range, all a person has had to do, historically, to get very, very rich over time is add shares and lock them in a bank vault or custody account somewhere. The business models these companies have are simple yet their profits are extraordinary. They essentially take water , flavour it, and sell it for exponentially more than the input costs. It’s a license to print money. Whenever I add these shares to my portfolio, I intend, absent some current unforeseen circumstance or opportunity, to hold it for the remainder of our lifetime.

Companies in the consumer staples sector have one major attribute that enable them to achieve high rates of returns over time – they have high brand loyalty which is a huge competitive advantage. Companies in this sector are able to create products that nobody else can legally produce and then delivers that product using super-efficient distribution channels. This results in hard-to-replicate economies of scale. The product is protected by trademarks, patents, and copyrights, allowing the company to price higher than it otherwise could, accelerating the virtuous cycle as it generates higher free cash flow that can then be used for advertising, marketing, rebates, and promotions. Most people don’t reach for the knockoff Dairy Milk bar or Coca-Cola bottle. They want the real thing, with the price differential being small enough there is no utility trade-off on a per-transaction basis. This leads to companies with established brands within this sector to command above average Returns On Capital Employed backed by real cash flows. Having these attributes leads to these companies being able to pay a growing dividend over time. It is no surprise to see that many companies in the consumer staples sector having histories of non interrupted dividend growth going back 50+ years!