The shifting tides of market sentiment this year raise the question of whether playing defense makes sense. As tech teeters on the ropes as the broad market is deep in the red with the risk of stagflation in the mix, exposure to resilient, mostly recession-proof names that can weather persistent inflation and capital scarcity should certainly be considered. We are thinking here of the consumer staples sector, considered a safe haven for equities.
Using the ETF filter, I found a few large and liquid industry-focused exchange-traded funds, including the iShares US Consumer Staples ETF (NYSEARCA:IYK). With an AUM of $1.25 billion and an expense ratio of 41 basis points, it ranks third after the Consumer Staples Select Sector SPDR ETF (XLP), which is more than 13 times larger, and the Vanguard Consumer Staples ETF (VDC), which has 5x AUM from IYK.
But unfortunately, while betting on defensive consumer names may seem lucrative at the moment, I must caution that exposure to the sector through this investment vehicle has some downsides.
- First, its past returns have been heavily impacted by the growth stocks the fund no longer holds. Therefore, its impressive past performance is of little relevance.
- Second, it is rather concentrated, with a pronounced tilt towards grossly overvalued equities; the weighting scheme is one of the culprits. Of course, heavy defensive plays usually invite bounty multiples, especially since the profitability characteristics of IYK’s holdings are close to perfect, which will be discussed in more detail below in the note. But between value and quality and expensiveness and quality, I’d go with the former. The latter clearly seems sub-optimal for the hawkish cycle which could turn out to be more aggressive than the market currently expects.
- And third, IYK has an expense ratio more than 4 times greater than VDC and XLP, making it a much less attractive long-term holding.
Investment strategy: A turnaround in 2021
IYK’s returns clearly illustrate how an index change can fundamentally alter the risk and reward profile of a passively managed investment vehicle. In September last year, IYK switched to a new underlying index, the Russell 1000 Consumer Staples RIC 22.5/45 Capped Index of the Dow Jones US Consumer Goods Index which it had previously used; subsequently known as Consumer Goods ETF before, IYK became a Consumer Staples ETF.
While the change may seem minor at first glance, it meant among other things selling Tesla (TSLA), an EV indicator that has been a big contributor to IYK returns in the past, especially during the 2020 tech rally that was supported by the tailwinds generated by the pandemic. For better context, the January 15, 2021 holdings dataset that I downloaded from the web page recorded by the Wayback Machine shows that Tesla was over 20% of the portfolio. A total of 57 stocks were squeezed out including General Motors (GM), Ford (F), Nike (NKE) and Peloton (PTON) while CVS Health (CVS), Corteva (CTVA) and McKesson (MCK) were added , to name a few.
As a result, Procter & Gamble (PG), an S&P 500 dividend aristocrat that barely needs a long introduction, jumped from second to first place; at the moment, its weight is slightly north of 16%. Coca-Cola (KO), another dividend aristocrat, is now the second largest investment, with a weight of around 11.3% compared to 6% in January 2021.
That being said, IYK currently has no exposure to the GICS sectors of consumer discretionary, communications, financials and industrials, which together made up 48% of the portfolio in the past. Today, it’s over 90% consumer staples, about 7.5% healthcare, and about 2% materials, with CTVA being the only name for that sector.
In this regard, the returns the fund delivered prior to its recalibration, particularly the 2020 blockbuster with a gain of ~32.6% against IVV’s 18.4% and XLP’s ~10.2%, are not more relevant today.
Notes on factors: The exorbitant price is paid for the quality
The question is, should valuation be ignored when considering defensive plays? Of course not. The recent sell-off in the market triggered by the pessimistic results of Target (TGT) has once again illustrated the need to reduce exposure to highly valued stocks.
Over 61% of IYK’s portfolio has quantitative ratings of D+ or worse, primarily because the aforementioned PG, KO, as well as the aforementioned PepsiCo (PEP), IYK’s third-largest position with a weighting of approximately 10.6%, are all valued at a premium to the sector.
It should be noted that nearly a quarter is adequately valued, with multiples mostly at or below medians or historical averages for the sector, resulting in a valuation rating of at least B- . Altria (MO) is one of them. However, this can only slightly mitigate the risks.
IYK is a mix of around 50% mega-caps, with an allocation of around 3.3% to mid-caps and the rest to large stocks. Therefore, its valuation profile is hardly a coincidence, as higher multiples are inherent in the upper echelon of stocks, especially given its strong quality.
Specifically, more than 97% of its holdings have a profitability rating of B- or better, and more than 82% are rated A (+/-). To provide more color, the scatter plot below summarizes the EBITDA and FCFE margins for 53 stocks in the basket. Beyond Meat (BYND) was intentionally removed, to improve readability a bit. BYND has margins of approximately (122)% FCF and (44)% EBITDA.
As you can see, the bulk of businesses are extremely profitable, with ample free cash flow, which should make it easier for them to cope with higher interest rates. However, that doesn’t mean it’s worth paying a premium just yet.
IYK and XLP: a quick comparison
Before I wrap it up, I’d like to make a few quick points about IYK’s counterpart, the Consumer Staples Select Sector Index-tracking XLP. First, the fund is more concentrated, with 32 holdings versus 54 for IYK. It is long Costco Wholesale (COST), Walmart (WMT) and Estée Lauder (EL), the stocks absent from IYK. During this time, he did not invest in CVS, MCK and CTVA, to name a few. Overall, XLP’s holdings have a weighting of around 85% in the iShares ETF. In terms of valuation, the fund has similar issues, with nearly 70% of holdings being relatively overvalued. The quality is even stronger; it does not hold shares in companies with a Profitability Rating lower than B-.
IYK is a very heavy portfolio to express a bullish view primarily in the consumer staples sector, while also gaining minor exposure to healthcare and materials.
IYK’s returns in 2022 so far clearly illustrate that investors have flocked to defensive plays; even after a quick market sell-off on May 18 triggered by the lackluster TGT results mentioned above, IYK is still ahead of the iShares Core S&P 500 (IVV) ETF, as well as VDC and XLP. However, the total return of the Invesco S&P 500 Pure Value ETF (RPV) is unmatched anyway.
Of course, in case it was still a long TSLA, with a massive allocation, its total return would tell an entirely different story.
In summary, while there are many things that could attract investors, especially its outstanding performance in 2022 so far and its near-excellent quality, I would point out that the fund has a few drawbacks, mainly in terms of of valuation. I’m still of the view that exposure to premium multiples should be kept to a minimum. Ideally, it’s best to avoid generously priced stocks right now, regardless of the sector.