Sunday, January 5

Week 131 - Packaged Foods and Meats

Situation: It is currently our view that the market is overpriced. In such circumstances, many investors will consider low-volatility, high-return stocks in going forward with their investment plan. How do we know the market is overpriced? The P/E for the S&P 500 index is 20, meaning current return on the Vanguard 500 Index Fund (VFINX) is 5%. (It was also 20 on October 1, 1929, and began rising above 20 on October 1, 2007, to herald the Lehman Panic). 

However, the stock market discounts anticipated future earnings. That means the price of stocks today is based on earnings that are expected to occur over the next 12-18 months, which is why a company’s stock falls hard and fast when it’s quarterly earnings report shows lower than expected earnings. Companies that have predictably steady earnings growth, such as Coca-Cola (KO), exhibit little stock price volatility and often have a P/E higher than 20. In other words, investors know what KO earnings will be a year from now. That confidence in the future attracts investors to KO even though they know they’re paying too much and therefore cannot expect long-term total returns greater than ~10%. But when the market is overpriced investors are banking on a certain amount of growth in future earnings that is anything but certain. 

Our economy today is on the cusp of deflation which, if it were to occur, would cause a stock market crash. So, if you still want to buy stocks at these prices you’d better pick companies that can weather a recession. This means that you’re on the lookout for companies that sell products with low elasticity. These are products that consumers buy as frequently during a recession as in good times. That translates into low volatility in their stock’s price (low 5-yr Beta). No sub-industry is better than Packaged Foods & Meats in fitting that bill.

We have gone through the S&P Food & Beverage Select Industry Index and focused on the 18 companies in the Packaged Foods & Meats sub-industry with 
  a) stock records going back to the market peak on September 1, 2000, and 
  b) a market capitalization greater than one billion dollars (see Table).
As a group, these companies had 4 times the total return/yr of the S&P 500 Index (VFINX) over those 13+ yrs while losing only 21.5% during the 18-month Lehman Panic, which was a period when VFINX lost 46.5%. This gives us confidence that these same companies will be inclined to provide a solid performance in the event of another downturn. The average 5-yr Beta for these 18 companies is less than 0.5 vs. 1.0 for VFINX. Two of the companies, General Mills (GIS) and JM Smucker (SJM) have P/E values less than 20, good Finance Value (Column E in the Table), and stable or improving recent growth in sales and cash flow (Columns L & M). Both companies also have investment-grade bond ratings of BBB+ (Column O).

Bottom Line: Our view is that the market is overpriced and future prosperity of the world’s economies is open to question. Nonetheless, stocks are the asset class to focus on for growing your retirement nest egg. You have no choice but to continue dollar-averaging into stocks each month but you can choose which stocks you’ll buy. In this economic climate, you’ll of course focus on companies in “defensive” industries: healthcare, communications, utilities, and consumer staples--like housewares and food. Among consumer staples, the most defensive sub-industry is Packaged Foods & Meats. That means you’ll want to look at the 18 companies in that sub-industry that have the longest market history and the highest capitalization (Table). We find that two of those 18 have outstanding performance records combined with low risk: General Mills (GIS) and JM Smucker (SJM).

Risk Rating: 3

Full Disclosure: I have stock in HRL, GIS, PEP, and MKC.

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