KYLE WALES: Is it time to buy consumer discretionary and tech stocks?

Bear markets always present opportunities when valuation is in your favour. Investors have favoured defensive over consumer discretionary and tech sectors in a US stock market that has had its worst performance in more than 50 years, with the S&P 500 index posting an overall fall of 20.6% in the first half of the year.

However, contrary to the general market consensus we believe these least-loved sectors are starting to offer compelling value for investors with a long-term horizon, even though they may face near-term macroeconomic challenges.

A defensive investment strategy seeks to reduce the downside risks of losing some or all of an investor’s initial capital by regularly rebalancing to maintain its intended asset allocation targets. It involves buying high-quality, short-maturity bonds and blue-chip stocks and diversifying across sectors and geographies. It would hold cash and cash equivalents in down bear markets.

Consumer discretionary products are any goods that are not necessary to enjoy basic living conditions, such as high-end apparel, leisurely activities and cars.

The divergence in sectoral performance on the stock market has been the widest for some time. While the energy sector rose more than 30% in absolute terms, outperforming the overall index by more than 50% on a relative basis, the consumer discretionary sector fell almost 33% in absolute terms and underperformed the index by 13%.

Utilities, consumer staples and health care fell by single-digit percentages (but still outperformed the index by 10%). In comparison, communications services (which includes many tech names) and information technology declined 27% and 30%, respectively, in absolute terms.

Future payoffs

The stark underperformance of consumer discretionary stocks can be explained by the pressures that rising commodity prices and interest rates are placing on consumer discretionary incomes.

Tech names have fallen from lofty valuations because of the increase in higher risk-free rates, known as the discount rate. The market uses the rate, elevated by the US Federal Reserve’s rate hikes, to value distant future payoffs that rely on a period of strong growth, which is expected to be absent.

In contrast, more defensive sectors such as utilities, consumer staples and health care received a boost from heightened risk aversion among investors against the backdrop of Russia’s invasion of Ukraine and a rapidly deteriorating inflation outlook.

With investing, what has historically mattered most is what is being priced into asset valuations. Typically, the market bottoms just before the historical data prints are at their worst.

In the case of consumer discretionary stocks, near-term multiples are attractive even if you assume there will be precipitous falls in revenue earnings. In the tech space many tech names are trading at a discount to companies in the consumer staples and healthcare sectors, even though they are higher-quality businesses and their growth outlooks are more robust.

Apparel company

Percentage peak-to-trough falls in both of these sectors have also matched those experienced in the past four recessions, while milder sell-offs in most other sectors would imply there is further to go.

Capri Holdings is an example of a consumer discretionary stock that we hold in the Flagship portfolios. Capri is an apparel company that owns the Michael Kors, Versace and Jimmy Choo brands. The company trades on a blended forward price-earnings (PE) multiple of 6.7 times, well below its average since its listing of 15 times.

At its current gross margin we believe its revenue would have to fall 27% for its PE multiple to equal this long-run average. Incidentally, sales fell 27% during the Covid-19 epidemic when many of its stores were closed and spending on clothing temporarily dropped.

The business has improved over time, and is a superior and more diversified business than it was on listing, when it owned a single brand, Michael Kors. It now has two additional luxury brands in its stable, and there’s potential for these brands to grow to 40% of sales in the medium term.  

Adobe is an example of a technology company we have held in the past and recently repurchased because recent sell-offs made it attractive again. Adobe is an excellent business. Its Creative Suite product is to creative professionals what Microsoft Office is to those in the finance world. It is also one of the pioneers of the software-as-a-service revenue model, as opposed to a licence-based model, which made its revenues more resilient in a downturn.

Earnings growth

Adobe trades on a 26 times multiple. While optically high, this multiple has to be evaluated in the context of Adobe’s growth relative to other companies that trade on this multiple. Colgate Palmolive is a good example. Adobe grew its reported earnings at a compound annual rate of 34% over the past five years, while Colgate Palmolive reported earnings fell 1%. While the differential in Colgate’s and Adobe’s growth in earnings per share is expected to contract substantially, Adobe is still expected to outgrow Colgate by a wide margin.

I also have far more confidence in the earnings growth expected from Adobe (versus Colgate), given its track record of earnings growth delivery. 

In the words of Howard Marks, “the market is a pendulum that swings between euphoria and depression”. While recent moves may have brought the overall S&P 500 multiple to within sights of its long-run average, a different picture emerges as soon as you scratch below the surface.

There’s been a wide divergence in sectoral drawdowns. While some sectors remain expensive, the most unloved sectors are beginning to offer the patient, long-term investor compelling (perhaps even once-in-a-generation) opportunities to buy some excellent businesses at low prices.

• Wales is a portfolio manager at Flagship Asset Management.