The consumer staples sector is composed of companies whose primary lines of business are food, beverages, tobacco and other household items. Examples of these companies, include Procter & Gamble (NYSE:PG), Colgate Palmolive (NYSE:CL) and Gillette. These types of companies have historically been characterized as noncyclical in nature as compared to their close relative, the consumer cyclicals sector.
Like all the other areas of economy, even when the market goes down ,the demand for the products made by consumer staples companies does not get slow. Some of the staples, like discount foods, liquor and tobacco, see increased demand during slow economic times also. In line with the noncyclical nature of the demand for their products, the demand for these stocks tends to move in similar patterns.
Staples and Supply and Demand
Remember the function C+I+G = GDP, where gross domestic product (GDP) is the aggregate of consumption, investment (often referred to as business spending) and government expenditures. So, if consumption comprises such a large component of GDP, why is the sector weighting of consumer staples in the U.S. stock market only around 10% or less historically? The best explanation of this relationship is the noncyclical nature of the demand and earnings of those companies.
Staples tend to have a low price elasticity of demand. This means that the demand for these products does not change with the change in its prices .There are no substitutes for the products themselves.This gives the suppliers of staples little room to raise prices or increase demand for their products. Suppliers do, however, have the ability to differentiate their products by the taste, appearance or results of using their products. This leaves the producers of staples in the cross hairs of the main costs that go into making their products:
If the demand for consumer staples does not grow by much, how do the producers or sellers of staples grow their businesses and ultimately their stock prices? They have a few options:
1. Reduce costs
2. Reduce prices
3. Differentiate their products.
Cost Reduction
Companies in the business of consumer staples can grow their profits and ultimately their stock prices by reducing costs. They can reduce their commodities costs by buying larger quantities, using hedging techniques, merging with or buying other companies, and creating economies of scale via horizontal integration or vertical integration.
Price Reduction
We have already described the demand of staples as being low in elasticity. We also know that with competition, the same box of pasta at a high-end retailer will sell for more than at a low-end retailer. This price differentiation will be much more apparent during slower economic times when the consumer steers toward the low-end retailer.
Product Differentiation
This strategy to increase demand is used by the staple and cyclical ends of the consumer business. From cars to razors, each consumer product company tries to differentiate its product as superior in order to increase demand and give the company the ability to control the item’s price.
Conclusion
It’s safe to say that the business of consumer staples and investing in them is boring to some people. The demand for these products does not swing up and down and they don’t exhibit the flashy characteristics of their close relative, the consumer cyclical.
They do, however, offer investors an opportunity to diversify into a sector that is easy to understand, has a relatively low beta and a low correlation to the overall market. So the next time you go to buy a razor when the stock market is in a tailspin, take a look at the company that makes that razor: it might be a good time to buy its stock.