U.S. consumer staples stocks performed well in 2015. In aggregate, this defensive sector returned nearly 7%, as measured by the performance of 
Consumer Staples Select Sector SPDR ETF (XLP). This was meaningfully higher than the S&P 500's 1.3% return. In general, consumer staples companies tend to outperform during recessionary periods and, to a lesser extent, in late-cycle periods.
Morningstar's equity analysts believe that what drove staples firms' performance last year is the same dynamic that has fueled their valuations during the ultralow-interest-rate environment of the past few years: The sector's healthy dividends have captured the interest of income-seeking investors. Historically, consumer staples stocks have been sensitive to interest-rate hikes because most staples firms can't grow their earnings fast enough during economic expansions to offset the negative impact of rising rates. However, during this most recent expansion, rates have remained at historically low levels.
Meanwhile, staples firms have enjoyed robust cash flows stemming from U.S. growth, a slow recovery in Europe and cost-cutting measures. The upshot in 2015 was that staples firms in the United States were generally sporting dividend yields in the 2.5% to 3.0% range, even as their stock prices rose. In fact, XLP's dividend grew 9.5% in 2015.
What's next for staples firms isn't clear. If growth slows and the United States falls into a recession, investors may retreat to the safe haven of the staples sector and its perceived durability. In addition, the staples sector always has the potential to produce healthy performance from innovation, product extensions, prudent acquisitions and cost-cutting.
On the other side of the coin, the space currently trades at the high end of historical valuation multiples, and with the slowdown in emerging markets, many large-cap staples firms have been struggling to hit their historical benchmark of 5% organic growth. In addition, further interest-rate hikes would be bad for staples firms, because when rates rise, investors might revise their required returns upward, compressing valuations. The result could mean investors head elsewhere for yield.
The lay of the land
Companies in the consumer defensive, or consumer staples, sector make products consumers generally buy regardless of economic climate, such as tobacco, toilet paper, laundry detergent, toothpaste, groceries and diapers. Such firms typically have relatively steady revenue growth and cash flows. In contrast, consumer discretionary firms rely on consumers spending on bigger-ticket items; these include restaurants, media companies, apparel firms and makers of luxury goods.
Four similarly sized subsectors make up the vast majority of the consumer staples sector. The largest subsector is food and staples retailing, where the biggest firms are Wal-Mart (WMT), CVS Health (CVS), Walgreens Boots Alliance (WBA) and Costco (COST). This is followed by the beverage-making subsector, led by Coca-Cola (KO), PepsiCo (PEP) and Constellation Brands (STZ). Slightly smaller than those two subsectors is the household products subsector, anchored by Procter & Gamble (PG).
The final subsector of any size in the consumer staples sector is tobacco; the largest firms here are Philip Morris International (PM), Altria (MO) and Reynolds American (RAI). While tobacco firms long have been under pressure from increased marketing restrictions and higher taxation, tobacco firms are operating in harvest mode in mature markets, where demand is lower, and instead focusing on developing markets such as Asia, Africa and Eastern Europe, where populations are growing and restrictions on tobacco marketing are looser.
From a fundamental standpoint, there are several important dynamics that affect the consumer staples sector. Income-seeking investors count on consumer staples firms to provide consistent cash flows; right now, the sector's dividend yield is hovering around a healthy 2.5%, slightly higher than its historical average. Another factor that investors considering staples firms should keep in mind is foreign currency, as many large U.S. staples firms sell into overseas markets. A stronger U.S. dollar has meant currency headwinds for consumer staples firms with strong overseas sales, while a weaker dollar has historically been a boon for those firms.
While the staples sector has seen some merger and acquisition activity in recent years--such as the merger that created Kraft Heinz (KHC), Anheuser-Busch Inbev SA's (BUD) proposed acquisition of SABMiller (SBMRY), Walgreens Boots Alliance's pending acquisition of Rite Aid (RAD), and the recent deal that took Keurig Green Mountain private--investors also should pay close attention to recent pressures that some staples firms have faced to split apart, in an effort to drive greater focus, share gains, and ultimately earnings growth. Potential breakup targets include Unilever (UN), Nestlé (NSRGY), Procter & Gamble and PepsiCo.
Market-cap-weighted consumer staples ETFs
Among the large exchange-traded funds focused on the U.S. consumer staples sector, three of them track market-cap-weighted indexes. Not surprisingly, all three ETFs have produced very similar long-term performance.
By far the largest and most liquid staples ETF is XLP, which holds all 38 consumer staples firms found in the S&P 500, from Procter & Gamble all the way down to Whole Foods Market (WFM). Because Sector SPDR ETFs draw from the S&P 500, they are generally made up of high-quality firms. This is evidenced by the fact that 89% of XLP's assets are invested in firms with Morningstar Economic Moat Ratings of wide or narrow. XLP's largest holdings are Procter & Gamble, which makes up more than 12% of assets, Coca-Cola (9%-plus) and Philip Morris (8%). XLP charges an annual fee of 0.14%.
An even cheaper option is the broader Vanguard Consumer Staples ETF (VDC) (0.10% expense ratio), which holds 100 companies. Unlike XLP, VDC has a larger weighting in small- and mid-cap staples firms, which together make up close to 14% of VDC's assets versus 5.5% for XLP.
Most investors should avoid the third market-cap-weighted staples ETF, iShares U.S. Consumer Goods (IYK), chiefly because of its relatively high expense ratio (0.43%). The only reason for investors to consider IYK would be if they wanted consumer staples exposure while eschewing large, defensive drug and discount retailers or if they wanted staples exposure with an added helping of automotive-related firms. IYK holds virtually no retailers (which make up more than 20% of the assets of other market-cap-weighted consumer staples ETFs). But it does hold automakers, auto components manufacturers and automotive retailers, while other cap-weighted staples ETFs do not. Auto-related firms make up about 10.5% of IYK's assets.
Strategic-beta consumer staples ETFs
There are also a handful of strategic-beta ETFs covering the consumer staples sector. By far the largest is First Trust Consumer Staples AlphaDEX ETF (FXG), which is also available in a version that trades in Canada, called First Trust AlphaDEX U.S. Consumer Staples Sector ETF (FHC), though the asset base of the Canadian version is much smaller. This fund holds 40 stocks and tracks a proprietary benchmark that uses two factors--value and momentum (First Trust calls it "growth," but it is really momentum)--to select stocks. The Canadian version charges a 0.79% annual fee, while the U.S. version charges 0.62%.
Another strategic-beta option is Guggenheim S&P 500 Equal Weight Consumer Staples ETF (RHS), which charges 0.40%. The fund equally weights all of the consumer staples firms found in the S&P 500. Put another way, RHS and XLP have the exact same holdings but weight them differently. RHS' equally weighted portfolio offers investors a bit more of a mid-cap tilt, as mid-caps make up 18% of its assets versus just 5.5% for XLP.
Finally, there is PowerShares DWA Consumer Staples Momentum ETF (PSL). The fund holds 31 firms and charges a fee of 0.60%. It tracks an index of consumer staples firms that have been showing relative strength, or momentum. It's worth noting that this ETF only devotes about two thirds of assets to firms classified as being in the consumer staples sector. The remaining assets are invested in an odd assortment of consumer discretionary firms, such as ServiceMaster Global Holdings (SERV), industrials firms such as Amerco (UHAL) and information technology firms such as Stamps.com (STMP).
Strategic-beta consumer staples ETFs largely have outperformed cap-weighted consumer staples ETFs in recent years. For example, FXG has meaningfully outpaced cap-weighted competitors during the past three- and five-year periods (although it's lagged them during the past year). RHS and PSL have outperformed all cap-weighted consumer staples ETFs during the past one-, three- and five-year periods. One caveat: It's hard to judge PSL's longer-term performance, because the ETF was recast in February 2014 to begin tracking a Dorsey Wright-managed index based on momentum. However, its early performance has been promising.
Sector valuation
The U.S. equity market has had a bumpy ride in 2016. Despite recent market volatility, however, the consumer staples sector remains richly valued relative to almost every other U.S. equity sector.
According to Morningstar's equity analysts, XLP was trading at 102% of its fair value, as determined by the asset-weighted fair value estimate of the stocks covered by Morningstar that are held in the portfolio, as of March 7, 2016. Apart from the utilities sector, other U.S. equity sectors were trading at between 86% and 100% of fair value as of March 7, placing the consumer staples sector far above the median of the sector valuation spectrum.
While the sector appears richly valued right now, income-oriented investors might want to keep a close eye on it in the event that the market's slide results in more-compelling valuations.
