Consumer Stocks: Valuations Hit 20-year High

Sanlam FOUR's Colin McQueen examines the cost of popular consumer stocks, and asks whether investors are paying too much for what they love

External Writer 2 August, 2016 | 2:23PM
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Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Colin McQueen, manager of the Sanlam FOUR Global Equity Fund urges investors to look beyond consumer staples as valuations hit 20-year high.

The spread of valuations across the market is very wide at the moment. Back in February, the spread of valuations was almost as wide as what we witnessed during the tech bubble. When you find this sort of phenomenon, typically it suggests investors need to pay a lot more attention to valuations. Investors today are paying a pretty full price for what they love, but there are some wide discounts on offer for companies out of favour.

For example, the forward P/E ratio of the consumer staples sector is at a 20-year high. Free cash flow yields for most consumer staples, such as Nestle (NESN), are trading in the range of 4-5%. It is not catastrophically low, but it is very low by historical standards. However, if you cast the net wider and look at companies such as Microsoft (MSFT), Oracle (ORCL) or some of the healthcare services names – there are free cash flow yields in the region of 6-7% or more.

Why We Like Healthcare Stocks

Unlike many other strategies in this space, which hold significant positions in the consumer staples area, the largest exposure in our strategy is healthcare. The implementation of Obamacare opened up a lot of opportunities, but as for Hillary and her position on healthcare, what we have found over many years watching this space is that it is often very difficult for any President to get any major changes through the US Congress and Senate – despite it being a hot topic for candidates to mention. US political views are incredibly polarised right now, which means it is difficult to enact any meaningful change one way or the other when these people come together. We believe the rhetoric is much louder than what the reality will be.

More and more healthcare services have been outsourced by both Democrat and Republican administrations over recent years and we see no reason why this trend will not continue. Healthcare is a great demographics story, but it imposes a cost on society to deliver it. Our positions in this space are quite evenly split between pharmaceutical and biotech names, medical device companies and services businesses.

While you could argue pharma companies are often held up by politicians as increasing costs associated with healthcare, services companies are part of the solution in keeping costs down – so we like to have a spread of names in our portfolio.

One company we are bullish on right now is Medtronic (MDT), which is seeing its top-line is growing at about 5-6% per annum. Its penetration into emerging markets is at an early stage – accounting for about 15% of its business, but this is growing at 15-20% a year. People seek out better healthcare as wealth increases and these markets are far less penetrated for healthcare than for companies offering shampoo, for example. We see a strong growth path for the company and a free cash flow yield of about 6%.

...And Oracle

Outside of healthcare, we continue to have high conviction in the prospects for Oracle – which is managing the migration of customers from license-based revenue to higher margin software as a service revenue. Oracle is a stable company with a wide economic moat and strong free cash flow It is currently being priced for zero to low growth.

Even if Oracle’s economic moat is slowly being eroded, the stock is too cheap. The market is underestimating stickiness of the customer base and the extent to which Oracle has expanded its product portfolio to encompass new technologies, new platforms, and the way it is managing its transition to the Cloud. While in an earlier stage of its transition, we believe Oracle can see a similar shift in market perceptions as Microsoft.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Medtronic PLC86.09 USD-0.52Rating
Microsoft Corp425.24 USD0.42Rating
Nestle SA76.68 CHF0.26Rating
Oracle Corp182.88 USD-1.06Rating

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