Sector Screener: new era for consumers is great news for these stocks

Investors habitually overestimate the defensive credentials of certain sectors. For example, beverages have historically been classed as staple items that are consumed in the same, or very similar, quantity regardless of the economic outlook. The companies that produce them have therefore often been categorised as highly robust investments that offer significant defensive appeal.

However, the FTSE 350 beverages sector has delivered an extremely disappointing performance during the current period of economic difficulty. It has declined by around 18% over the past two years, versus a marginal gain for the wider FTSE 350 index over the same period, as consumer disposable incomes have come under sustained pressure.

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Indeed, rampant inflation and rapid interest rate rises have combined to create a cost-of-living crisis that means consumers are cutting back on, or even avoiding, their favourite alcoholic and non-alcoholic beverages. While this era may not yet be at an end, with inflation currently standing at double the Bank of England’s 2% target and interest rates at a 16-year high of 5.25%, the prospects for consumers, and therefore the beverages sector, are set to dramatically improve. In fact, the sector has been the fourth-best performer in the past month.

Source SharePad. Data as at 19 February 2024. Past performance is not a guide to future performance.

Greater spending power

With the UK now in the midst of a recession, and inflation expected to continue falling over the coming months, interest rate cuts are a near certainty. While the exact timing and speed of monetary policy easing remains a known unknown, lower interest rates will reduce borrowing costs for consumers and act as a stimulus on the economy. Alongside a slower pace of price growth, this should equate to improved spending power for consumers that catalyses demand for a wide range of products including beverages.

Clearly, many beverage companies operate across a broad range of territories. Although the US economy is performing relatively well, growing at an annualised rate of 3.3% in the final quarter of 2023, the Federal Reserve still expects to cut interest rates this year. And while the European Central Bank is somewhat more hawkish, it is likely to cede to widespread pressure to implement a looser monetary policy amid a lack of economic growth and falling inflation. Therefore, the prospects for beverage companies operating in key markets across Europe and the US are also set to significantly strengthen over the coming years.

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An improving outlook for advanced economies could provide a boost to the wider global economic outlook. While China is wrestling with a period of deflation that could negatively affect consumer demand in the short run, the International Monetary Fund (IMF) nevertheless expects emerging market and developing economies to expand by 4.1% this year and 4.2% next year. This could lead to an improving consumer outlook that prompts growing demand for a wide range of beverages.

Wide economic moats

While the beverages sector has produced a disappointing return over the past two years, market valuations across the sector are not particularly low on a relative basis. Many other sectors are significantly cheaper and therefore may appear to be of greater investment appeal.

However, beverage stocks generally have wider economic moats than firms operating in other consumer sectors. For example, their customers are usually loyal to specific brands and are less likely to switch to rivals. This provides beverage companies with a degree of pricing power and financial stability vis-à-vis consumer-focused firms operating in other sectors. Beverage sector incumbents also benefit from high barriers to entry due to the significant costs and challenges involved in launching new brands or expanding existing products into new territories.

While these attributes should not lead investors to conclude that the beverages sector is highly defensive, its incumbents nevertheless offer lower risk than consumer-focused firms operating in other industries. And with several beverage companies having sound financial positions, geographically diverse operations and significant market share, they are well placed to ride out short-term economic uncertainty to capitalise on an improving outlook for consumers.

Source SharePad. Data as at 19 February 2024. Past performance is not a guide to future performance.

A high-quality business

Alcoholic beverages company Diageo (LSE:DGE) offers long-term share price growth potential despite experiencing a challenging operating environment. In the first half of its current financial year, the firm’s organic net sales declined by 0.6%, largely as a result of a 23% fall in revenue in the Latin America and Caribbean region. This was mostly due to a particularly weak consumer environment in the area that contributed to a 5.4% decline in the company’s organic operating profit during the period.

Although this trend is likely to persist in the short run, the company expects sales and profit growth to improve in the second half of its financial year. And over the coming years, it anticipates that organic net sales will grow at an annual rate of 5-7%. When combined with a new productivity plan that is set to produce savings of $2 billion between 2025 and 2027, its long-term financial performance is likely to significantly improve.

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In the meantime, the company has sufficient financial strength to overcome tough operating conditions. In the first half of the year, for example, net finance costs were covered around eight times by operating profits despite their aforementioned decline. The firm also has an enviable stable of brands, including Guinness, Smirnoff and Johnnie Walker, that are hugely dominant within their market segments. They benefit from a high degree of customer loyalty and offer growth potential as the premiumisation trend among consumers returns amid a more upbeat economic environment.

Having fallen by around 18% in the past year in response to the company’s weaker financial performance, investors may be surprised to learn that Diageo’s shares trade on a relatively rich forward price/earnings (PE) ratio of around 19. However, with an improving operating environment ahead, a solid financial position and a diverse range of high-quality brands, the stock’s risk/reward ratio is relatively appealing on a long-term view.

Share price recovery potential

Fevertree Drinks (LSE:FEVR) also offers long-term capital growth potential. The AIM-listed company, which produces non-alcoholic beverages such as tonic water and ginger ale, has experienced tough trading conditions in recent months. For example, its trading update for the 2023 financial year showed that sales declined by 1% in the UK and grew by just 2% in Europe. While this was more than offset by a 24% rise in US revenue, it meant the company’s sales grew by a rather disappointing 6% overall.

Despite falling by around 47% over the past two years, the company’s shares trade on a PE ratio (using 2023’s expected earnings) of around 81. This may lead many investors to feel that the stock is grossly overvalued based on its recent lacklustre financial performance. However, the company expects earnings before interest, tax, depreciation and amortisation (EBITDA) to double in 2024 as it benefits from a lower rate of inflation, price rises and operational efficiencies.

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Furthermore, the company has a solid balance sheet that includes a net cash position of roughly £60 million. Its products also benefit from a high degree of customer loyalty, as well as market share gains made during 2023 across all of its key markets, that mean it is well placed to benefit from an improving consumer outlook in the UK and Europe.

Certainly, its short-term share price performance could be somewhat volatile due to the likelihood of continued economic uncertainty. But alongside Diageo, Fevertree offers long-term investment appeal as the end of an era of rampant inflation and restrictive monetary policy allows consumers to enjoy greater spending power over the coming years.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.