Consumer staples: Why one analyst rates the sector as Underweight

Consumer staples (XLP) have been on a bit of a run, outperforming the S&P 500 (^GSPC) since the beginning of August.

CFRA Research senior equity research analyst Arun Sundaram notes that more defensive sectors tend to do well in September, so there is some seasonality at play. Sundaram, however, still has the sector as an Underweight, arguing that cyclical sectors are "best poised for long-term growth" given the Federal Reserve rate cuts on the horizon.

With some pockets of consumers slowing their spending, Sundaram thinks there will be winners and losers in the space, telling Yahoo Finance he likes big box retailers such as Walmart (WMT), Costco (COST), Target (TGT), and BJ's (BJ).

Watch the video above to hear what it is about those stocks Sundaram likes.

For more expert insight and the latest market action, click here to watch this full episode of Morning Brief.

This post was written by Stephanie Mikulich.

Video transcript

The consumer staples sector rising about 7% since the start of August that outpaces the S and P 500 this ahead of this week's expected fed rate cuts here to discuss what's ahead for the sector we want to bring in Arun Sundaram.

He is ac fr a research senior equity analyst.

It's great to have you arun.

So talk to us about some of the out performance that we have seen in consumer staples.

There is a notion out there a thought out there uh not necessarily uh too unique just about the fact that maybe we have come a bit too far when it comes to the valuation of some of these consumer staples stocks.

What do you think?

Sure.

Yeah.

Yeah.

Thanks for having me.

Yeah.

You know, I think um you know, yeah, the consumer staples sector has done pretty well over the last month or two months or so.

Defensive sectors in general have done pretty well over the last two months.

Uh We are in a seasonal, in a slower period.

Defensive sectors tend to do better and uh in September, um but uh we as a firm at CFR A, we are still uh underweight, uh consumer staples.

Uh you know, with the fed, likely to cut rates this week.

You know, we, we think uh cyclical sectors are, are, you know, best poised for, for long term growth.

So, you know, we're currently overweight sectors like information technology, communication services and financials and we are currently underweight uh consumer staples, energy materials and, and, and utilities.

What does that tell us about your thesis and your firms thesis on the broader strength of this economy?

Because typically I think of consumer staples as somewhat defensive, whether, you know, you've got people shopping at Walmart just because they're always going to, or God forbid we had into a recession.

It's also going to stay clean.

So what does that tell us about your broader view of where this economy is heading?

Yeah.

And there's a lot of, um, yeah, I think there's, there's some concern on the economy, the concern that the consumer spending environment uh is, is slowing.

Uh, we know we're certainly seeing that as well.

Um, especially pockets of consumer spending, you know, the lower income consumers is struggling, struggling a bit more.

Uh right now and that I think, I think that's why, you know, we do see, you know, we do believe that they're going to be winners and losers.

Um, whether it's a discretionary sector, consumer discretionary sector or the consumer staples sector.

Uh We, we do, you know, love the big box retailers, right.

Now in the consumer staples sector, Walmart target, uh Costco B J's, you know, these are the retailers that are, we think gaining market share, they have strong econ platforms, you know, ecommerce is an area that's, you know, growing really attractively right now.

Um and these retailers are all really pride themselves on convenience and value and that's where, you know, consumers are, are, are, are heading right now.

So it's these big box retailers that, you know, we think are our best position and that's why we are, you know, even though we're underway consumer staples, uh you know, we do have a positive uh fundamental outlook on the consumer staples, merchant retail sub industry and that includes Walmart and Target and bjs and Costco.

Yeah, Arron, I wanna stick on that because I noticed the pe ratios for Walmart and Costco in particular are pretty elevated compared to some of the rest of the retail sector.

To what extent is that a concern for you?

Or would you say that that maybe even is part of some seasonal defensiveness that's driving up the stock price of these names?

Sure.

No, you know.

Yeah, certainly the uh pe ratios of a lot of these big box retailers have expanded, especially Walmart and Costco.

Uh but we believe that this expansion is, is warranted.

Um You know, especially considering, you know, the, the, the margin trajectory of some of these retailers, you know, for example, uh Walmart, you know, Walmart's operating margins have, you know, somewhat been stable for like the last decade or so, but we're just starting to see pretty, you know, strong margin expansion at Walmart.

And one of the biggest reasons why is Walmart is expanding beyond its core retail business.

It's getting into higher margin service streams like advertising.

Uh It, it's fulfilling orders for third party suppliers, it's doing financial services.

Um So it's really, you know, business models for a lot of these big box retailers are evolving and I think that bodes well for margins and I think that's one of the reasons why we're seeing, you know, pe multiple expansion for, for these big box retailers arun.

What happens and then you briefly touched on this before when we talk about recessionary concerns, but even those types of retailers, how big do they at all see a hit if we do see a recession or are they then viewed as such defensive plays and because of the trade down or trade in, however you want to call it, they're actually able to weather any sort of downturn much better and, and without any notice compared to some of their other competitors.

Sure.

Yeah.

Yeah.

And certainly, you know, during periods of, you know, slower economic growth, it's these big box retailers that tend to do well, uh, they, they tend to see a trade down from consumer shopping there.

Um, you know, that, that, that bodes well for them.

I think another big thing is that, you know, consumers right now are uh eating out less, uh, you know, they're starting you and, you know, last year was really the slowdown between in this full service restaurant channel.

But now we're seeing that broadening of a slowdown throughout the food service channel.

And so more consumers are cooking, eating at home.

I think that bodes well for, you know, retailers like Walmart, you know, we recently also upgraded Kroger to, to a buy from a, from a hold and uh I think that that bode well for them as well.

Um But really, I think, you know, the one of the reasons that we're really positive, not just over the next year, but over the next 3 to 5 years is really this, this what I was talking about before, about how these retailers are expanding beyond retail and getting into the higher margin, higher margin revenue streams, like advertising a lot more advertising now, advert advertising on, on websites like walmart.com, for example.

And um that's, you know, really, I think uh positive for the long term margin trajectory of, you know, these retailers.

All right, arun, we're gonna have to leave it there.

Thank you so much for joining us.

Really appreciate it.

That's Arun Syndrome with CFR A.

Thank you.