“Safe” Stocks Not Looking So Safe Anymore

“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1”

-Warren Buffett

The most important part of investing is to avoid losses.  This is why I so often use this blog to talk about the risks I’m seeing.  If you can avoid the landmines and diversify among the rest, you’ll do pretty well.  What jumps out at me today as the next potential landmines in US stocks are the Utilities and Consumer Staples stocks.  The chase for yield continues to what is starting to seem pretty irrational.  Utilities and Consumer Staples have by far been the biggest winners over the last year as investors continue to pay-up for anything with a positive yield and somewhat stable cash flows.  The chart below shows all of the major sectors relative to the S&P 500 Index as a whole over the last 12 months.  It’s a jumbled mess but all you need to focus on are the two outliers circled in yellow at the top.  The red line is the Select Sector SPDR Utilities ETF (XLU) up some 23%, and the blue line is the Select Sector SPDR Consumer Staples ETF (XLP) which is up about 14%.

As investors look to reduce risk exposure, they’re flooding into the low beta, high yielding funds that hold these stocks.  However, with dividend payout ratios now approaching, and in some cases exceeding, 100% these stocks now exhibit bond-like returns with stock-like risk.  They might not be as “safe” as people perceive and the out-performance is reminiscent of the 2000 and 2007 topping action in the market.  It’s all a testament to how much the current Central Bank policies continue to distort the asset markets.  (As a side note, Ben Hunt of Salient Partners writes a fantastic letter called Epsilon Theory.  His latest letter talks about the dilemma we’re all in with being “stuck.”  It’s an absolute must read if you’re interested in following the investment markets.  You can find it here.)

This means it’s time to take some profits.  After some big moves higher this year, I just recently trimmed our positions in Church & Dwight and Johnson & Johnson.  Both stocks have been core holdings for a few years now and despite their continued execution, the valuation is getting a bit out of hand.  JNJ is more of healthcare stock but it basically trades like staple.  As a simple illustration, here are the Enterprise Value-to-Revenue ratios for both companies:

Church & Dwight (CHD) – 10 year EV/Revenue

Johnson & Johnson (JNJ) – 10 year EV/Revenue

These are valuation charts, not simply the price of the stock.  With a valuation chart, if a company was growing sales at 10% per year and the stock was correspondingly increasing by 10% per year, the ratio would hold constant.  These both reflect how much the stocks have outpaced the underlying companies’ growth in revenues.  In the case of JNJ, the valuation is now far exceeding where it traded at its high point in 2007… before the stock fell 35%.

Every individual company is its own story but I would say that when a stock like General Mills, which has barely grown in the last 5 years, starts to go parabolic and breaks out of its all-time historical channel, caution is warranted…  “Safe” might not be so safe anymore.

-Nick