Investors looking for safety and consistency often look towards consumer staple companies. These companies generally don’t grow rapidly, but they generate consistent returns that compound over long periods of time. Thus they are often recommended to risk-averse investors and to retirees or those who are approaching retirement. From a traders perspective, these stocks outperform when the market turns down and we see a rotation out of economically sensitive stocks into recession resistant stocks, which often include consumer staple stocks.
What investors seem to forget is that just because these investments generate stable returns doesn’t mean that the can be bought at any valuation. The fact that bond yields are so low and the lack of high yielding assets in the market place has sent investors pouring into several of these names, especially if they demonstrate even the slightest hint of growth. But while these stocks are cheaper than bonds, that hardly makes them cheap. In fact some well-known names trade at lofty valuations. This eliminates the safety factor, and you are probably better off buying some inexpensive economically sensitive stocks than you are buying these from the standpoint of a risk averse investor. Thus the stocks I list below are risky despite the fact that they have relatively consistent earnings and pay stable dividends.
1. Colgate Palmolive (NYSE:CL)
Colgate Palmolive is currently trading at an all-time high. It also trades at an incredible 30-times earnings despite the fact that earnings growth has been rather minimal over the past couple of years. Investors seem to be hunting for reasons to justify owning this stock when they simply aren’t there. For instance the lack of earnings growth is explained away by arguing that the company is growing earnings if you correct for weakness in foreign currencies. The high valuation is justified by arguing that the company has an earnings yield (i.e. the inverse of a price to earnings multiple) that exceeds Treasury Bonds.
Finally, investors like to point to the earnings number if we exclude one-time expenses. But a quick glance at the company’s income statement reveals that these one-time items occur with such regularity that ignoring them makes no sense. Ultimately Colgate is a solid company that has generated value for long-term shareholders, but that doesn’t mean that it is a good investment at $69/share and 30-times earnings on virtually no growth.
2. Church and Dwight (NYSE:CHD)
As a smaller consumer staple company Church and Dwight has had more room to grow over the years, and it has done just that. It has been a phenomenal investment that bucked the trend in the stock market over the past fifteen years or so. However, more recently the company hasn’t been growing. Last quarter its sales were flat and its earnings were down. This points to deceleration in growth as well as margin compression, and this doesn’t bode well for the company. Nevertheless the stock hit an all-tie high on Thursday and it trades at just over 25 times earnings.
While a 4 percent earnings yield looks pretty good compared with Treasuries, or even when compared with investment grade corporate bonds, the fact remains that the company’s earnings are vulnerable to the downside. Furthermore, this valuation will not appear so compelling if bond prices fall. Consequently investors need to consider taking profits in this name. It has had a great run, and it seems that everybody is bullish, making now a great time to sell.
3. Reynolds American (NYSE:RAI)
It was just a few years ago when tobacco companies such as Reynolds American traded at a steep discount to other consumer staples companies considering that investors feared anti-smoking legislation. But the managements of these firms have solved this problem. They have grown revenues by raising prices, and they have manufactured growth through aggressive stock repurchase programs. The latest stunt, which has yet to be implemented, is the potential merger between Reynolds American and Lorillard (LO), which is expected to add substantial cost savings to the industry.
However, the fact is that these measures can only go so far in generating value for shareholders. What these companies need is for more Americans to smoke and to use tobacco products. While e-cigarettes have added some interest amongst consumers, we generally see a decline in smoking, and as a result these companies should be trading at lower valuations than companies such as the two mentioned above. Reynolds American trades at 22 times earnings despite decelerating growth and margin compression. While the merger with Lorillard—assuming it goes through—will shave this number down, the issue remains that these companies have exhausted every growth prospect. Therefore this company deserves to trade a much lower multiple, and I suspect that investors will realize this soon.
Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.