At Home and Abroad, Consumer Defensive Firms With an Edge Are Poised to Win

• The consumer defensive sector trades at a premium, but pockets of value exist, particularly among firms with a vast competitive clout.
• Multiple factors should be considered when screening for companies best-positioned to capitalize on the growth potential of emerging-market consumers, each of which ties directly into the sources of its economic moat.
• Shifting bargaining power trends between consumer packaged goods firms and retailers persist, given further retail consolidation.

While the consumer defensive space is far from trading at a bargain-basement valuation, we contend that pockets of value remain. Overall, the sector appears slightly overvalued, at a median price/fair value of 1.04, but we note that the fundamentals for this group tend to outperform during cyclical downturns because of the competitive edge these firms have amassed (as evidenced by the fact that approximately two thirds of them maintain a narrow or wide economic moat). As such, we recommend that investors looking to gain exposure to the space consider companies with established economic moats--those operating with structural supply chain and distribution advantages, economies of scale, sufficient resources to extend brand reach, and pricing power to withstand softness in volume growth.

Growth prospects remain bleak in mature, developed markets, highlighting the appeal of emerging regions for consumer product firms. We believe consumer staples companies with established economic moats can leverage their existing supply chain and distribution assets (to an extent) relative to smaller emerging-markets peers, have easier access to cheaper capital, can foster brand awareness and loyalty across multiple pricing tiers, and typically utilize sensible go-to-market strategies.

For investors looking for consumer staples names less reliant on a single economy that can withstand the economic shock from any particular region, Coca-Cola (KO), Diageo (DEO), Unilever (UN), and Philip Morris International (PM) may be attractive. With geographic diversification, there is a trade-off in reduced exposure to regions with faster-growing populations and higher disposable income potential that names like Marico, Wuliangye Yibin, and ITC offer. But Yum Brands (YUM), SABMiller (SBMRY), and United Breweries (CCU) offer both growth and diversification, as they've sufficiently broadened their geographic exposure while also establishing more concentrated positions in markets like China, Africa, and Latin America, respectively.

Consumer product firms and retailers have longed maintained an interdependent relationship, as retailers need brands to drive store traffic and brands need avenues for distribution. But retail industry consolidation has shifted some power away from consumer product firms over the past several years, and consolidation appears likely to persist.

This is particularly evident in the dollar channel lately, as both Dollar Tree (DLTR) and Dollar General (DG) have bid to acquire Family Dollar (FDO). At present, Family Dollar's board of directors is siding with Dollar Tree's lower offer (at just $74.50 per share in cash and stock), since regulatory hurdles are perceived to be less of an impediment. In response, Dollar General made a tender offer (which will expire Oct. 8) to acquire Family Dollar for $80 per share in an all-cash transaction directly to shareholders. This saga is far from over; from our vantage point, a deal between Dollar General and Family Dollar could result in synergies that lower Dollar General's costs and strengthen the firm's competitive position. Subsequently, if a deal is ultimately struck, we would reassess the combined company's narrow-moat prospects.

Top Consumer Defensive Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Tesco		GBX 300.00	None	High	GBX 180.00
Procter & Gamble		$93.00	Wide	Low	$74.40
Whole Foods Market		$45.00	Narrow	Medium	$31.50
Data as of 9-12-2014

Tesco (TSCO)
Rivalry remains very high in the U.K. grocery market, as the resurgence of discounters Aldi and Lidl in the United Kingdom, as well as the emergence of high-end grocer Waitrose, has left Tesco (and other traditional grocers) stuck in the middle battling for share. We still think Tesco will remain a dominant player in the U.K. grocery market and believe the shares are undervalued. Once market trends stabilize (which may not be in the cards over the near term), Tesco should be able to run enough volume through its distribution network to generate healthy cash flows. However, we recommend Tesco only to investors who not only are looking for exposure to the U.K. grocery market but also have long investment horizons and high risk tolerance.

Procter & Gamble (PG)
P&G operates with a portfolio of leading brands across the household and personal-care arena, making its products essential for retailers to drive traffic in their stores. Although the firm recently announced that it intends to cull more than half of its existing brand portfolio, we still believe P&G will carry significant clout with retailers and think these actions will actually enhance P&G's brand intangible assets and its cost advantage. The brands it will keep (including 23 that generate $1 billion-$10 billion in annual sales and another 14 that account for $500 million-$1 billion in sales each year) already account for nearly all of the firm’s sales and profits. As such, we don't anticipate P&G will sacrifice its scale edge, but it should be able to better focus its resources (both personnel and financial) on its highest-return opportunities.

Whole Foods Market (WFM)
Whole Foods Market is the largest retailer of natural and organic foods and is also the first certified organic grocer in the United States. With the potential to nearly triple its store base and operate more than 1,200 units, Whole Foods has a long growth runway in a segment of the grocery market with limited (but increasing) competition. As Whole Foods increases its store density across major markets, it lowers per-unit costs. Higher private-label penetration should further allow Whole Foods to increase its industry-leading margins, given the attractive profit profile of these products. With the shares trading at a discount to our fair value estimate, we’d suggest investors take a look at this narrow-moat name.

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