About 4 months ago we discussed discretionary spending and why we like the consumer discretionary sector for the long-run. In that newsletter, we looked at a graph of the share of after-tax income Americans devoted to food, energy and financial obligations, a figure that reached a 40-year low in November 2012. We opined in that newsletter that most of the decrease in the share of after-tax income devoted to those three expenses was likely due in large part to decreasing debt payments (since food prices, energy prices and tax rates have not changed enough to affect the statistic drastically). However, without seeing the data over time for each of the three categories as well as after-tax incomes, we couldn’t be sure that Americans’ debt payments were actually decreasing steadily (and leaving them with extra spending cash)….until now.
On March 14, the Wall Street Journal published recent Federal Reserve figures showing that Americans spent 10.4% of their after-tax income on debt payments in Q4 2012, the lowest level since the government started tracking this in 1980.
Correctly assessing why Americans have steadily been able to spend less of their after-tax income on food, energy and financial obligations is just step one. For our thesis to be correct, consumers will have to devote more of their savings to discretionary spending.
Investors categorize consumer purchases as either discretionary purchases or staples purchases. A common shortcut to differentiate between the two is to think of discretionary purchases as buying things you want while staples are things you need, but in reality the distinction is more complex. Companies that sell discretionary goods & services tend to outperform the broad market during prosperous economic times; companies that sell staples goods & services tend to outperform the broad market during economic downturns.
Staples include household & personal products, food & staples retailing (retailers, manufacturers and grocery stores), beverages (alcoholic and non-alcoholic) and tobacco. Defying the conventional logic that staples are things we need are categories such as alcohol, soft drinks, tobacco and beauty products—all considered staples because they still sell in bad economies. There are some companies that investors do not agree on their discretionary/staple status, for example Whole Foods (NASDAQ: WFM). We categorize WFM as discretionary because of the stock’s behavior in downturns (ie. 2008-09 downturn) as well as the availability of close substitutes (local supermarkets, other food retailers) when budgets tighten, but for the most part the distinction between discretionary purchases and staples is clear.
Will more money in the bank lead to increased spending on discretionary goods?
That is the million-dollar (or, more likely, the billion-dollar) question that will dictate whether or not our bullish position on consumer discretionary companies is well-founded. While the Federal Reserve data only applies to the US, we expect consumer deleveraging to take place around the world and not just in the US, and this is important because most large companies now have a major international presence and some depend greatly on international sales for their top-line earnings.
Consumer overspending was a large contributor to the economic downturn of 2008, and while discretionary spending was certainly a large contributor to the overall problem, it would be naïve to think it was the sole driver of the credit crisis. When property values fell sharply, homeowners found themselves liable for mortgage balances far greater than their property values. Workers were also laid off in droves, and while their income was cut off (or significantly reduced) they still had to keep up with their financial obligations like car payments, their kids’ schooling and other expenses. And when it came time to cut expenses, discretionary purchases came first, as they should. We believe this has created a significant amount of pent-up demand for discretionary goods.
Here is how we break down the sub-categories of the consumer discretionary sector:
(1) Hotels, Restaurants & Leisure: When people lose their job, the first major financial change they make is to curtail the amount they eat out. They also take less trips and do less fun/unnecessary activities like taking their kids to Disney (NYSE: DIS), out to the movies, etc. And if you used to get your coffee at Starbucks (NASDAQ: SBUX), you now get it at the grocery store when you buy all of your food for the week. This is one example of how consumer dollars are transferred from discretionary purchases to staples purchases in an economic downturn.
(2) Airlines: Air travel is expensive, and airlines take a big hit when people stop spending money. Additionally, businesses reign in the spending and the airlines are hit twice as hard.
(3) Automobile & Components: Wealthy people usually buy a new car every 3 years, but when money is tight people are hesitant to finance (or shell out all that cash) for a new vehicle when their old one is still working well. Auto sales have already started to pick up and we think that trend will continue over the long-term.
(4) Homebuilding: There are home repairs which are necessary, but home improvements are far more expensive (and rewarding). Thus, consumers have resisted the urge to shop at home-improvement stores like Home Depot (NYSE: HD) and expensive furniture stores such as West Elm.
(5) Consumer Durables & Apparel: Retailers like Saks (NYSE: SKS) and Macy’s (NYSE: M) were crushed in 2008 as female shoppers stopped buying new shoes and outfits simply because they felt like it. Guys buy new clothes too, and Nike (NYSE: NKE) was hit hard, but didn’t take nearly the hit that Saks and Macy’s did.
(6) Retailing: As a retailer of nearly all discretionary goods, Amazon.com (NASDAQ: AMZN) is a prime example of how quickly people stop online shopping for things they don’t really need. Amazon’s price fell by almost 50% in a matter of months and it bottomed out around $42 in late 2008, but is now sitting pretty above $256. Anyone else sensing a recovery in the discretionary space?
(7) Media: After house payments, car payments, tuition, utilities and everything else, people didn’t have as much left over for companies like DirecTV (NASDAQ: DTV) and Time Warner Cable (NYSE: TWC). We believe that once people find themselves with some extra cash to spend on things they want, cable and movies will be at the very top of the list.