Avoid consumer stocks

As the downturn takes hold in the U.S., the obvious dilemma for investors is knowing which sectors to avoid. Financial stocks are a sector obviously fraught with risk as they have already sustained enormous losses with many more to come as the downturn takes hold. However, on the other hand, Doug Kass, a famous short seller is taking a bet on consumer staples, a sector that is not particularly cyclical. In this week’s Barron’s he first addressed another unusual consumer sector, the dental industry.

“Right now our emphasis is on the consumer sector. We’ve found an undiscovered sector that has limited short interest, namely the dental industry. We wouldn’t look at traditional retailers like Target [ticker: TGT] or Kohl’s [KSS], or short the Retail Holdrs [Merrill Lynch Retail HLDRs [RTH], a retailing ETF. ETFs are the opium of the hedge-fund community because they are an excuse for lazy hedge-fund managers not to go belly to belly with companies and their managements. A dependency on ETFs as a shorting tool is simply an excuse for not doing hard-hitting and creative research”

Barron’s asked whether he was bearish on U.S. consumers and he answered yes identifying a number of consumer staple stocks that he is shorting. Consumer staples are not cyclical and are usually a defensive play. But Kass Had this to say:

“The consumer is spent up, not pent up, and more levered than during any period in history. That’s one of the structural problems facing the economy. At the same time, job growth is declining and real disposable incomes are pressured as inflation literally is eating away at the consumer’s buying power. It is frightening that the consumer has entered this economic downturn with the most levered position in history. On top of that, we’re facing four consecutive months of job losses. We’ve seen the depreciation of the two most important assets, home prices and equities. Consumer confidence is at a 26-year low. The availability of credit continues to be a problem that will plague the economy for a while. Inflation, the cruelest tax of all, is rising as energy and food prices, in particular, are soaring. And the first-quarter GDP report contained a number of ominous signs that the consumer is spent up while the housing depression continues apace.

{Barrons asks] So, which consumer stocks are you shorting?

Colgate-Palmolive [CL], Kellogg [K] and General Mills [GIS], which are trading at 17 to 18 times earnings, but have secular earnings-growth rates of 7% to 10%. These companies historically are seen as recession-resistant, but we doubt it. All three are aggressively lifting their selling prices in response to huge cost increases, but demand is starting to suffer as private-label companies and generics gain market share. Demand elasticity, or sensitivity to changes in prices, in toothpaste, soaps and other consumer products has begun to surface in the current recession, as consumers trade down to private-label products.”

I would have to agree with Kass that the consumer is worn out but I would have thought retail or consumer cyclical or technology, all of which are highly cyclical, were more likely bets. Moreover, Kass admits to being short Berkshire Hathaway, the investing conglomerate controlled by Warren Buffett. Nevertheless, Kass has a good reputation in the industry and knows what he’s talking about. But, one would have to take his advice with caution.

Sources
Confessions of a Short Seller from Barrons, 19 May 2008