As the current bull market enters its seventh year, it’s not surprising many investors are finding few pockets of value. Many of these blue-chip companies possess enviable records of increasing dividends and often display recession-resistant revenue streams, making them ideal substitutes for yield-hungry retirees and other investors who can’t survive on CDs or other fixed-income vehicles. But do these financial characteristics justify price-to-earnings multiples in the mid-20s or higher?

Bill Fries, managing director and co-portfolio manager of the Thornburg International Value Fund, cites several problems with the consumer staples category, only one of which is valuation. Many of these companies, like Coca-Cola, derive far more than 50% of their revenues of sales abroad. Consequently, the recent surge in the U.S. dollar can dramatically impact their earnings.

Moreover, companies like Nestle, Clorox and Colgate-Palmolive pay out 70% to 75% of their earnings in dividends. If a strong dollar were to cause an earnings drop of 10%, that leaves them with precious little free cash flow beyond debt service and dividend payouts.

No one is arguing that the majority of dividends aren’t sustainable. Most of Granny’s stocks boast high credit ratings, giving them easy access to the corporate bond market where they have unlimited ability to raise capital. In recent years, it has prompted them to engage in financial engineering maneuvers like stock buybacks and dividend increases.

Investors, however, have come to expect dividends that will rise at rates exceeding both consumer staple companies’ revenues and the rate of inflation. One might question whether companies can continue to raise dividends at an attractive pace if interest rates rise and the dollar continues to appreciate.

Steve Yacktman, CIO of Yacktman Funds, explains that the real reason to own the consumer goods companies can be found in the numbers that lie beneath the public metrics like sales and lofty price-to-earnings multiples. Indeed, P/E multiples on companies like Colgate (29 times), Procter & Gamble (25 times) and Pepsi (22 times) don’t reveal the operating leverage and potential for margin expansion inherent in these franchises.

“If you normalize the S&P and look at these businesses’ margins, these stocks are cheap. If you don’t like Pepsi or P&G, you shouldn’t like anything else,” Yacktman contends. “And in 10 years, you won’t ask what went wrong.”

The younger Yacktman concedes that late in a bull market it’s normal for people to start looking for more excitement than soda, detergent and toothpaste. But anyone who is spooked by the sky-high multiples these shares sport isn’t looking under the hood. Unlike industrial companies and other businesses with more cyclical revenues that implemented dramatic restructuring programs during and after the financial crisis, most of these companies have tremendous potential to enhance value by slashing sales, general and administrative costs.

Take Heinz. In the three years since it was acquired by Brazilian private equity firm 3G and Berkshire Hathaway, its operating margins have increased by about 50%, rising from 15% to 23%, according to Yacktman. This explains why Kraft shares jumped nearly 50% after the company agreed to be acquired by Heinz.

In Yacktman’s view, the $3 billion savings in restructuring expenses at Coca-Coca, involving layoffs of nearly 2,000 employees, pale in comparison to the savings ace cost-cutter 3G engineered at Heinz. Two years after 3G and Berkshire bought the company, largely with debt, the value of their equity reportedly has quadrupled.

If the bull market and economic recovery are in the late stages of their life cycles, as some say history would indicate, then consumer staple stocks might offer investors other favorable attributes. “Most people didn’t like consumer stocks in 2006 and 2007,” Yacktman recalls. “When the market collapsed, their input costs fell much more than revenues.”

Even enthusiasts like the Yacktmans concede that entering new markets and achieving superior growth poses a major challenge to these businesses. A company like Nestle, born in 1905 in Switzerland, soon saturated its local markets and launched operations in emerging nations decades before many U.S. competitors looked to the Southern Hemisphere for growth.

For advisors who select their own equities like J. Michael Martin of Financial Advantage Inc. in Columbia, Md., and Naples, Fla., the question of whether to own consumer staples depends more on growth potential than the companies’ current valuations. 

“Europe isn’t growing and America is barely growing,” Martin says. “The bullish story has to depend on whether emerging markets growth takes off.” He isn’t convinced.
 

First « 1 2 » Next