The Consumer Staples Select Sector SPDR ETF (XLP) offers targeted exposure to the sector constituents within the S&P 500 Index (SPY). The companies here are large-cap leaders in their respective segments recognized for quality and generally strong fundamentals. The attraction of investing in consumer staples is that the sector is seen as less exposed to changes in the economic cycle and thus “defensive” against the risk of a recession. This year, the group has proven to be resilient amid the disruptions caused by the COVID-19 pandemic as consumers shifted spending patterns towards essentials, supporting the operating environment for many companies within XLP. We think this is a quality fund benefiting from several positive trends that can continue, while offering an attractive 2.7% dividend yield.

(Source: Finviz)

XLP Performance in 2020

XLP is currently down about 2% year to date in 2020, compared to a 1.6% gain in the broader S&P 500 which has been driven by larger gains in tech stocks as evident by the Technology Select Sector SPDR ETF (XLK) up 20% this year. What XLP investors can appreciate is that the fund exhibited a smaller selloff during the period of extreme market volatility in March. While XLK and SPY declined by 34% and 32% from its previous high to the lowest level in Q1, XLP suffered a narrower max drawdown of 25%, indicative of its more moderate risk profile. XLP’s dividend yield of 2.7% is also well above the 1.8% yield in SPY and 1.1% in XLK.

ChartData by YCharts

The story this year for consumer staples has been the divergence of returns within the group, as some companies were directly negatively impacted by the COVID-19 pandemic, while others benefited. The table below presents the performance of all 33 holdings in the ETF. Based on our data, 13 stocks have a negative return year to date.

(Source: Data by YCharts / Table by BOOX Research)

Amid global lockdown orders and social distancing regulations, several industries faced challenges that may have been difficult to imagine just one year ago. That’s the case with restaurants and entertainment which were forced to close. Some of the casualties here include Sysco Corp. (SYY), Lamb Weston Holdings (LW), and Tyson Foods (TSN), which count on the foodservice industry as an important sales channel. Indeed, a 35% decline in shares of SYY, 32% drop in TSN, and LW down 22% for the year are among the worst performers in XLP and highlight the challenges of the weaker operating environment for these companies.

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One the other hand, the big winners in XLP are the companies that saw a surge of demand in late Q1 through Q2 with consumers stocking up on household essentials. A clear beneficiary has been Clorox Company (CLX) with its line of disinfecting products that gained importance during this pandemic. CLX is the biggest gainer thus far in 2020 with shares up 51%.

Supermarkets and grocery stores saw record levels of sales in the early stages of the pandemic, and XLP includes several stocks that captured these dynamics. Walmart Inc. (WMT), Costco Wholesale Corp. (COST), and The Kroger Co. (KR) are up 12%, 11%, and 18% respectively. Companies involved with snacks and pantry items have also fared well. General Mills (GIS) up 24% in 2020.

In terms of dividend yields, tobacco giants Altria Group Inc. (MO) and Philip Morris International (PM) are two of the highest-yielding stocks within the ETF at 8.1% and 6.2% each respectively. The overall lower fund yield is based by the top holdings from Procter & Gamble Co. (PG) and PepsiCo Inc. (PEP), which together represent 27% of the fund and have more modest yields at 2.4% and 2.9% each. It’s worth noting that this concentration in the fund’s weightings is higher than we would like, but reflects the importance of these companies to the sector based on their global scale. Nevertheless, the “top-heavy” weighting in XLP is a weakness in the ETF profile.

XLP Underlying Holdings Valuation and Growth Outlook

The other aspect we’re looking at is the trends in growth and valuation among the underlying holdings of the fund. What we find is that on average, XLP is reasonably priced considering 2020 earnings estimates at the company level.

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The fund manager, State Street Global Advisors, reports a forward P/E ratio for the fund at 20.2x. Within that number, about half the stocks are trading at a premium to that level related primarily to company-specific factors. Generally, companies that are presenting positive growth this year are being rewarded by larger gains in their share price driving a higher valuation. The table below presents the forward P/E and forward P/S ratios for each company based on its current year consensus estimates against a 5-year average for each multiple.

(Source: Data by YCharts / Table by BOOX Research)

Sorted by the current earnings premium, Brown-Forman Corp. (BF.B), currently trading at a forward P/E of 41.3x, is the most expensive or “richly priced” stock within the XLP ETF according to this one metric. The company’s P/E ratio is approximately 33.3% above the 5-year average of 31.0x. Part of this bullishness implied by the market associated with Brown-Forman is based on its market leadership position in whiskey through its Jack Daniel’s brand. Despite some weaker trends in sales this year, investors seem to be looking ahead towards 2021 in the hopes that the company can reclaim its growth trajectory. The stock is trading about flat in 2020.

In terms of growth estimates, Clorox Company and Church & Dwight Co. Inc. (CHD) lead the group with expected revenue growth of 8.4% and 7.1% in 2020. Both of these companies which produce cleaning products are also trading at a premium in terms of their earnings and sales multiples.

We highlight Kroger Co., with estimated revenue growth of 5.9% this year, as standing out for being attractively valued. KR is trading at a forward P/E of 12.0x, which is 14.3% below the 5-year average P/E for the company at 14.0x.

Analysis and Forward-Looking Commentary

XLP does a good job of capturing the various market themes across consumer staples. While some of the underlying stocks have outperformed, there is a value in the diversified exposure to several different companies in the fund.

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In the context of the current macro outlook, conditions have stabilized in recent months, but the U.S. and the global economy continue to face significant challenges in the recovery process. There are uncertainties related to the timetable for when the pandemic will be contained and when trends in consumption will normalize.

While taking a cautious view on equities, we think consumer staples and XLP can outperform the broader market. Staying true to the sector’s calling card of being a defensive play, we believe the leaders in household essentials and packaged foods, in particular, should continue to benefit from positive trends in demand. From a bottom-up perspective, some stocks in the group appear expensive but balanced by others that are still reasonably priced.

The risk here is that the economic outlook deteriorates further, setting up a scenario for a “double-dip” recession. In that case, even as consumer staples are less exposed to changes in economic activity, weaker consumer spending and higher unemployment can pressure growth and earnings. Still, we would expect XLP to outperform the broader market to the downside on any significant selloff. To the upside, an environment of steadily improving economic conditions should be positive for the underlying companies, generating positive returns for the ETF.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.