Morgan Stanley Global Sustain Fund

Consumer Staples: Stabilising force within the portfolio

18th Oct 2024

October 2024, Morgan Stanley Global Sustain Team

At the time of writing, Consumer Staples appear out of favour and somewhat overlooked. Since the end of the pandemic in 2022, while the sector’s earnings have grown mid-single digit per year1, close to the broader market’s growth, its stock prices have struggled in relative terms.

Notably, compared to the MSCI World Index, Consumer Staples is now at a near 25-year low in terms of relative valuation and its lowest weight in the index this century2.

In contrast, investor interest has shifted toward more fashionable sectors and themes such as artificial intelligence, global mega-tech, and health care innovations aimed at combatting obesity.

Despite this trend, we believe the Consumer Staples sector still encompasses some of the world’s most resilient and dependable companies.

High quality characteristics

High quality Staples companies can play a crucial role in a portfolio by delivering consistent, reliable growth, driven by recurring revenue from the everyday products they sell. Their typical operating resilience during economic downturns serves as a key advantage, offering relative downside resilience and acting as a stabilising force within the portfolio.

Challenging times

While recent stock price returns for some Staples have not met expectations, over the past four years the sector has demonstrated impressive resilience, navigating the pandemic, soaring commodity costs, and numerous emerging market currency devaluations.

Despite these challenges, the USD sales and earnings of our Staples holdings have managed to grow at mid-single digit levels3, affirming their resilience and compounding potential.

The right company in the right categories

As investors we don’t allocate capital by sector but focus on reasonably valued individual companies with strong fundamentals and long-term growth potential. Not all Consumer Staples fit this profile.

In our view, being in the right category where brands matter and the consumer responds to innovation is key. Importantly, companies need to sustain high levels of investment in their brands in the form of marketing, research and development (R&D), supply chain capabilities and talent.

A good example of this is Haleon, a UK-based global leader in the consumer health sector that we added to the Portfolio this year. The company is sharply focused, with nine powerhouse brands across just five categories, all addressing critical consumer needs – sensitive teeth being one example. Its dominance in the therapeutic oral care category is supported by direct relationships with one-third of the 10 million health care professionals who serve as trusted influencers.

These partnerships play a vital role in driving consumer acquisition and retention, resulting in strong brand loyalty, industry leading margins, and consistent, noncyclical growth.4

Being innovative and remaining relevant is crucial

Our holdings across beauty, home care, consumer health and beverages innovate to solve consumer needs. This expands consumer usage and drives category growth. Innovations range from energy efficient laundry detergents, improved solutions for sensitive teeth, “nolo” (no or low alcohol) and zero sugar drinks, faster acting antacids, or improved sun-filtering technology to help protect skin.

These innovations are supported by well invested supply chains and high levels of marketing support, meaning the brand’s “share of voice” is above its market share. In so doing, the companies outpace their market and grow share. We avoid food retailers, which are typically low return, capital intensive, price takers – a well-known player in the space, Costco is successful precisely because it operates a high volume, low margin business – and mass food producers, whose competitive moats may face threats from local or specialist producers.

Marketing matters

When we see a period of underinvestment, we seek to act. For example, a company may choose to reduce its marketing spend, which may boost short-term earnings, but harms long-term brand strength, and recovering from this is often challenging. In such a case, we may choose to reduce or exit our holding.

Conversely, we’ve increased our position in L’Oréal, which allocates over 30% of its sales to marketing. This investment provides the company with a share of voice 1.5 times greater than its market share, enabling it to consistently outperform the market.5

Pivoting to where the growth is

Agility is a key attribute we seek in our selection of Staples. In a world of economic and geopolitical uncertainty, the ability of management teams leading global operations to swiftly allocate resources – capital, talent and marketing – to the most promising markets is essential.

China’s current economic challenges, including rising local government debt, a struggling housing market, deflation and cautious consumers, have led to a marked slowdown in a once fast-growing market. Recent and sizeable stimulus measures may help, but also highlight policymakers’ concern for the growth outlook.

Fortunately, there is another market of approximately 1.4 billion consumers set to pick up the growth mantle. After years of being the next great hope, we believe India is showing signs its time has come, with its investment in infrastructure, from roads to electricity to digitalisation, contributing to strong gross domestic product and consumption growth. Coca-Cola is investing in 40 new production lines in 2024 to capture this growth opportunity.

Why we believe our Staples can continue to compound

Looking ahead, after an exceptionally turbulent four years in which the Consumer Staples sector faced its most challenging environment in a generation yet demonstrated resilience, with mid-single-digit sales and EPS growth (albeit below market EPS growth),6 we remain confident that Staples justify a place in the portfolio for a number of reasons.

Notably, our Staples holdings are now at record levels of marketing and R&D spend,7 setting them up to outgrow their market. Further, efficiency gains are coming from investments in automation, upgraded ERP systems, digitalisation and AI.

As a result, we expect earnings growth to return to high-single-digit levels driven by a more balanced combination of volume, price mix, margin improvement and strong free cashflow. Additionally, valuations are attractive, with our holdings trading at their 20-year average, compared with what we view as a generally extended market.

 

1 Source: FactSet, September 2024
2 Source: FactSet, September 2024. MSCI World Index
3 Source: FactSet, September 2024
4 Source: International Equity Team research
5 Source: Company reports; International Equity Team research6 Source: FactSet, September 2024
7 Source: Company reports; International Equity Team research

 

 


 

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