As investors, we all want the best for our portfolio. We want to make the right decisions and invest in the right stock. One factor with great influence on both your total investment returns and our portfolio volatility is our sector allocation.
Today, I’ve decided to dive into the Consumer Cyclical (or Consumer Discretionary) as it is the sector that has the most industries (sub-sectors). We’ll cover its greatest strengths and weaknesses and how to get the best from it.
Do You Know Your Cyclicals?
This is an “all-you-fit-in” sector. On this blog and at DSR, we use the term “consumer cyclical”, but you can also find the term “consumer discretionary” in financial literature. The bottom line is these companies make goods that are fun to have (or consume) but are not necessary. These are the expenses you incur once you have covered the basics and you have some extra money. When the economy booms, consumer cyclicals follow. Keep in mind that Amazon (AMZN) isn’t a tech stock anymore as it is retail that is part of the consumer cyclical sector.
This is one of my favorite sectors when I want to find some growth. This is also a unique sector where you can devote over 20% of your portfolio and still maintain wide diversification. The buying process for a new car isn’t the same as for a burger or a t-shirt. You can select great companies from several different industries and build a solid portfolio. My own portfolio includes more than 20% of consumer cyclical stocks. I have companies in apparel, auto parts, restaurants, internet retail and packaging industries. Let’s just not fall in love with a single sub-sector.
Some of these industries have amazing dividend growers. The key for these companies is to build a strong brand that serves them well over time. Brands like Nike, Vans, Home Depot, McDonald’s, and Starbucks in the U.S. and A&W, Duct Tape, Avery and Canadian Tires in Canada are iconic brands. Those companies will do better when the economy booms, but they will also be resilient during recessions. The cyclical aspect of this sector will also propel your returns if you buy during downtimes.
Unfortunately, while consumer cyclical companies can show double-digit growth during good years, the winds can change directions quickly. We have seen a great portion of this sector brought to its knees due to the pandemic. Most of those companies are far from a full recovery. It will take several years for companies in leisure, lodging, resorts & casinos and the travel services industries to get back on track.
This is what I like to call “looking good on Prom night”. When people have jobs and are confident in their future, there is virtually no limit to growth. You’ll see impressive sales growth for several years in a row, giving you the impression that it will last forever. Due to the cyclical nature of this sector, however, nothing lasts forever.
E-commerce has become a great disruptor for many industries in this sector. We’ve seen many retailers going bust in the past and this trend will continue. Direct-to-consumer sales (e.g. Nike selling you shoes directly through computer or phone) has become a vital side of their business. Those who resist will fall. Brick & mortar retail isn’t dead, but it must work hand in hand with a digital sales space for overall company success.
How to Get the Best of It
While one must not get blinded by a strong brand, this is probably the first thing you should look at when selecting stocks in consumer cyclicals. When you have extra money, you want to reward yourself. Chances are, you will feel better with a pair of Nike shoes than some “Mikeymike brand” shoes at the discount outlet.
Quality matters even more when we talk about the extra dollar. This is where the margin is: perceived value brings pricing power. How do you think Starbucks can make you smile after you spent $7 on a coffee that probably cost $0.50 to make?
Following economic trends will tell you a great deal about how many industries will do. Unemployment rates, consumer confidence indices and job stats will help you to be on top of things.
Most industries are best fit for growth investors.
VF Corporation (VFC)
- Market cap: 33B
- Yield: 2.30%
- Revenue growth (5yr, annualized): -2.46%
- EPS growth rate (5yr, annualized): -10.86%
- Dividend growth rate (5yr, annualized): 11.40%
VF designs, produces, and distributes branded apparel and accessories. Its largest apparel categories include action sports, outdoor, and workwear. Its portfolio of about 20 brands includes Vans, The North Face, Timberland, and Dickies. VF markets its products in the Americas, Europe, and Asia-Pacific through wholesale to retailers, e-commerce, and branded stores owned by the company and partners. The company has grown through multiple acquisitions and dates to 1899. While VFC has a growth-by-acquisition strategy, it is not afraid to sell brands not fitting its vision anymore.
We are talking about active brand portfolio management. In a world where fashion evolves at a rapid pace and where brand power means pricing power, VF Corporation cracked the code. In May 2019, VFC spun off its jeans brands into Kontoor (KTB). VFC is now looking to sell its workwear brands to generate cash flow for new acquisitions. VFC has built a serious brand with an incredible growth potential with Vans. We also like their focus on e-commerce and branded stores to avoid dependence on third-party retailers. It enables VF to control its brands and its message. The company will go through a rough period (2020 and 2021), but we expect the company to pursue further acquisitions at bargain prices. In November, the company announced the acquisition of Supreme for $2.1B.
Magna International (MG.TO) (MGA)
- Market cap: 33B
- Yield: 2.20%
- Revenue growth (5yr, annualized): 6.61%
- EPS growth rate (5yr, annualized): 9.13%
- Dividend growth rate (5yr, annualized): 18.21%
Magna International prides itself on a highly entrepreneurial culture and a corporate constitution that outlines distribution of profits to various stakeholders. This automotive supplier’s product groups include exteriors, interiors, seating, roof systems, body and chassis, powertrain, vision and electronic systems, closure systems, electric vehicle systems, tooling and engineering, and contracted vehicle assembly. Roughly half of Magna’s revenue comes from North America while Europe accounts for approximately 44%.
MG is a leader in the auto parts industry, and this serves it well since many manufacturers tend to concentrate their processes with fewer suppliers that offer wider product ranges. This is exactly where Magna stands in the market. While MG relies on Detroit automakers for about 50% of its sales, the overall automobile business is looking brighter. Magna has done several partnerships with European manufacturers. Finally, there is a high switching cost for automakers to change manufacturers such as Magna. This makes its niche a highly repetitive and stable market.
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