08 Aug Time to buy US consumer discretionary and tech stocks?
Kyle Wales of Flagship Asset Management chats to Simon Brown on Moneyweb about tech and consumer discretionary stocks as a great opportunity now. He’s not saying that they won’t go lower, nobody knows that. But he is confident that the current valuations are very attractive and worth starting to buy for great returns in the years ahead.
Bear markets always present opportunities when valuation is in your favour.
Investors have favoured defensive over consumer discretionary and tech sectors in a US stock market that has experienced its worst performance in more than 50 years, with the S&P 500 Index posting an overall decline of 20.6% in the first half of the year.
Contrary to general market consensus, however, we believe these least-loved sectors are starting to offer compelling value for investors with a long-term horizon, even though they may face near-term macro-economic challenges .
A defensive investment strategy seeks to reduce the downside risks of losing some or all of an investor’s initial capital by regularly rebalancing to maintain its intended asset allocation targets. It involves buying high-quality, short-maturity bonds and blue-chip stocks and diversifying across sectors and geographies. It would hold cash and cash equivalents in down bear markets.
Consumer discretionary products are any goods that are not necessary to enjoy basic living conditions, such as high-end apparel, leisurely activities and automobiles.
Investors have favoured defensive sectors:
Consumer discretionary and tech bear the brunt of the deteriorating sentiment
The divergence in sectoral performance on the stock market has been the widest it has been for some time. While the energy sector rose more than 30% in absolute terms, outperforming the overall index by more than 50% on a relative basis, the Consumer Discretionary sector fell almost -33% in absolute terms and underperformed the index by -13%.
Utilities, Consumer Staples and Healthcare fell by single-digit percentages (but still outperformed the index by 10%). In comparison, Communications Services (which includes many tech names) and Information Technology declined 27% and 30% respectively in absolute terms.
The stark underperformance of consumer discretionary stocks can be explained by the pressure that rising commodity prices and interest rates are placing on consumer discretionary incomes.
While tech names have fallen from lofty valuations because of the increase in higher risk-free rates, known as the discount rate. The market uses the rate, elevated by the Fed’s rate hikes, to value distant future payoffs that rely on a period of strong growth, which is currently expected to be absent.
In contrast, more defensive sectors like Utilities, Consumer Staples and Healthcare received a boost from increased risk aversion among investors against the backdrop of Russia’s invasion of Ukraine and a rapidly deteriorating inflation outlook.
With investing, however, it comes down to what is priced in.
With investing, however, what has historically mattered most is what is being priced into asset valuations. Typically, the market bottoms just before the historical data prints are at their worst.
In the case of consumer discretionary, near-term multiples are attractive even if you assume there will be precipitous falls in revenue earnings. In the tech space, many tech names are trading at a discount to companies in the consumer staples and healthcare sectors, even though they are higher-quality businesses and their growth outlooks are more robust. Percentage peak-to-trough declines in both of these sectors have also matched those experienced in the last four recessions, while milder sell-offs in most other sectors would imply there is further to go.
Figure 3: S&P sectoral sell-off in recessions (peak to trough): Almost three-fourths of an average recessionary sell-off may be behind us. Average price sell-off since 2000.
Capri trades on a P/E multiple which is 50% below its long-run average
Capri Holdings is an example of a Consumer Discretionary stock that we hold in the Flagship portfolios. Capri is an apparel company that owns the Michael Kors, Versace and Jimmy Choo Brands. Today the company trades on a blended forward P/E multiple of 6.7x, well below its average since listing of 15x.
At its current gross margin, we believe its revenues would have to fall by 27% for its P/E multiple to equal this long run-average. Incidentally, sales declined by 27% during the Covid epidemic when many of its stores were closed and spending on clothing temporarily declined.
The business has improved over time, and today is a superior and more diversified business than it was upon listing when it owned a single brand, Michael Kors (MK). Today it has two additional luxury brands in its stable and there’s potential for these brands to grow to 40% of sales in the medium term.
Adobe, trading on a P/E multiple of 26x, compares favourably with Colgate Palmolive
Adobe is an example of a technology company that we have held in the past and recently bought again because recent sell-offs made it attractive once again.
Adobe is an excellent business. Its “Creative Suite” product is to creative professionals what “Microsoft Office” is to those in the finance world. It is also one of the pioneers of the “Software as a Service” based revenue model as opposed to a licence-based revenue model, which has made its revenues more resilient in a downturn.
Adobe currently trades on a multiple 26x. While optically high, this multiple has to be evaluated in the context of Adobe’s growth relative to other companies that trade on this multiple. Colgate Palmolive is a good example.
Adobe has grown its reported earnings at a CAGR of 34% over the last five years while Colgate Palmolive has seen its reported earnings decline 1% (refer below). While the differential in Colgate’s and Adobe’s growth in earnings per share (EPS) is expected to contract substantially, Adobe is still expected to outgrow Colgate by a wide margin.
I also have a lot more confidence in the EPS growth expected from Adobe (versus Colgate) given its historical track record of earnings growth delivery.
In the words of Howard Marks, “the market is a pendulum that swings between euphoria and depression” and, while recent moves may have brought the overall S&P 500 multiple to within sights of its long-run average, as soon as you scratch below the surface a very different picture emerges.
There’s been a wide divergence in sectoral drawdowns and, while some sectors remain expensive, the most unloved sectors are beginning to offer the patient, long-term investor a compelling (perhaps even once in a generation) opportunities to buy some excellent businesses at very low prices.
