What to Buy in an Overvalued Sector?
The most important and the most difficult question in investment management is, “What to buy?” A stock well bought, like any other merchandise, is half sold. In the current low interest rate environment, investors looking for higher yields have gravitated to dividend-paying consumer staples stocks because they are similar to bonds in their low volatility and reliability of income. These stocks are now trading at a significant premium to their historical averages and to their fundamental characteristics. This overvaluation makes it difficult for value investors, like Diamond Hill, to find investment opportunities with a meaningful margin of safety.
We believe that investors chasing yield might be missing the big picture, as what ultimately matters is total return, not dividend yield. In other words, it is not prudent for investors to overemphasize dividend income at the risk of long-term loss of principal from a market correction. In this piece, I will look into the sources of overvaluation in the consumer staples sector and discuss the investment principles that have guided our response to the all-important question of what to buy in this environment.
Consumer staples companies, operating in packaged food, beverages, and household and personal care industries, are defensive in nature as consumer demand for these products is less affected by cyclical changes in the broad economy. Many of these companies also enjoy strong competitive advantages from brand loyalty and distribution networks. As a result, the durability and return on capital for these businesses is among the best. That said, however attractive a business or its prospects might be, at some price it ceases to be an attractive investment. Over the last three years, the average price-to-earnings ratio for consumer staples stocks has gone from 16.9x to 20.2x, while the average EV/EBITDA (enterprise value-to-earnings before interest, taxes, depreciation and amortization) ratio has risen from 10.6x to 13.2x1 even as there has been little change in growth or return profile for the overall sector (see chart below).
Over the trailing ten-year period, the yield on the 10-Year U.S. Treasury bond has fallen by roughly two-thirds from 4.7% to 1.6%1 and now compares unfavorably to the 2.5% dividend yield on consumer staples stocks. Earnings per share for the sector have grown at a 5% rate1 with limited volatility. Add the 2.5% dividend yield to this earnings growth rate and 7.5% total return looks like a bargain in today’s world.
The main problem with this conclusion is that it assumes that valuations will stay where they are. However, it is pretty hard to make that point given high absolute valuation levels relative to history. Moreover, if interest rates rise, then our estimates of intrinsic value are likely to come down as future cash flows would be less valuable at a higher discount rate, and the interest costs will rise for debt refinanced at a higher rate. It is also conceivable that some consumer staples companies will be forced to cut dividends or investments for future growth or stock buy backs to support these higher interest payments.
The other problem with the inference above is that investors expect a continuation of the past earnings growth rate in a very different economic environment. Consumer staples companies, while relatively less affected by macro-economic changes, are not completely insulated. Current levels of overvaluation exist partly because investors expect earnings to grow at a faster rate than in the past, but expect interest rates, which are lower to reflect a less favorable macro-economic situation, to remain low. This anomaly has resulted in future earnings being more highly valued than they should be. We believe it is more appropriate to assume lower earnings growth and lower interest rates, or vice versa, either of which would result in a correction in earnings multiples.
It is fairly obvious that lofty consumer staples valuation levels have more to do with external market factors, such as interest rates, and less to do with the stocks’ fundamental characteristics. That said, interest rates are a critical input for determining the intrinsic value of a business. We can neither totally ignore them nor can we extrapolate current rates for many years into the future.
As bottom-up investors, predicting the course of interest rates is outside our circle of competence. Our goal in economic analysis is to protect our clients’ portfolios from adverse outcomes, not to take advantage of economic trends. The ability to perfectly foresee the future is impossible for anyone, but we can be more certain about understanding business strengths and assessing management potential. This is precisely where we have chosen to focus our energies when looking for new ideas in the current environment. Below are some of the key principles that have guided our thinking in recent times.
Diamond Hill’s research process is bottom-up, which means we look for mispriced opportunities in individual stocks rather than evaluate the attractiveness of a market or sector from a top-down perspective. The consumer staples sector clearly looks overvalued at current levels and there are fewer opportunities to buy than in the past but it doesn’t mean that there are none.
Our long-term approach also implies that we are not looking to trade pieces of paper with superior statistical ratios but to purchase a partial ownership interest in a business. As prospective business owners, our purchase decision is based on the competitive advantages and long-term prospects of the business and not on how much it pays out in dividends. Some of our current holdings, such as Procter & Gamble Co. (PG), Philip Morris International, Inc. (PM) and Kimberly-Clark Corp. (KMB), which we have owned for many years, are great long-term businesses with high returns on capital that exemplify this facet of our investment process.
Margin of Safety
Another key tenet of our investment philosophy is that we pay close attention to the price paid for an investment and purchase only those securities trading at a meaningful discount to our estimate of intrinsic value. Diamond Hill’s investment process requires determination of intrinsic value using a discounted cash flow (DCF) framework. A DCF model values a business by discounting its future free cash flows (and not just the dividends) at an appropriate required rate of return over its lifetime. Since, in most cases, much of the value of a business is derived from its terminal value rather than near-term income, our process helps to ensure we stay away from popular consumer staples stocks that the market may be overvaluing due to their attractive yield characteristics.
We do not characterize ourselves as contrarian investors but we are always willing to take advantage of mispricing opportunities created by investors’ short-term focus or emotional responses. In the past, when the market emphasized near-term results and simplistic valuation ratios, we invested in some of our best performers, such as Post Holdings, Inc. (POST), Coty, Inc. (COTY) and B&G Foods, Inc. (BGS), whose business values expanded enormously from positive management actions. Currently, consumer staples stocks that pay little or no dividends, and have therefore been ignored by the market, but have attractive long-term competitive advantages are a potential area of interest to us. In addition, our shorting capabilities in some of our strategies allow us to take advantage of overvaluation trends.
While the current low interest rate environment has led to fewer investment opportunities in the consumer staples sector lately, we are sticking with our time-tested value investment philosophy. We fully recognize that at too high a price, even the best idea can turn out to be a disappointment as gains from dividends could be offset by capital losses. Therefore, we continue to focus on total return, not dividend yields, to preserve capital and provide adequate return to our shareholders over the long term. Importantly, since a decision to buy also involves an implicit decision about what not to buy, we are avoiding stocks that appear overvalued based on our intrinsic value framework.
1Source: Factset, Diamond Hill estimates
As of August 31, 2016, Diamond Hill owned shares of PG, PM, KMB, POST, COTY, and BGS.
Originally published on September 21, 2016
The views expressed are those of the research analyst as of September 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.