I've written several columns over the past few years on the grocery stores as defensive investments, especially The Kroger Co. (KR) and Safeway (SWY). The fundamental rationale for defining the grocery stores as defensive investments was outlined in a column I wrote concerning the relationship between the economy, capital markets, and the hierarchy of needs as described by Abraham Maslow in "A Theory of Human Motivation," published in 1943.
That column is no longer in the Real Money archives but if you would like a copy please send a request to email@example.com and I will forward a copy to you.
In this column I'll apply this same philosophy by moving one step back in the supply chain and reviewing the food producers.
I haven't discussed the food producers as defensive equity investments before because they've traditionally been priced at a premium to the food distributors. The valuation gap between the two has been closing over the past few years though, as the grocery store stocks have increased dramatically.
The result is that the food producers, relative to both the grocery stores and the market broadly, are now more attractive from a defensive position. It's also getting very difficult to find truly defensive equity opportunities, which are those that I believe may even rise as a result of an equity flight to safer equity positions during a broader market decline.
To put this in context, over the past two years the share prices for Kroger and Safeway have increased by 125% and 140%. It's been a great run, but it also means that both are susceptible to profit-taking now, regardless of their longer-term continuing potential as stable producers of income.
The prices for the three dominant publicly traded food producers as measured by market capitalization -- Coca-Cola (KO), Pepsico (PEP), and Unilever (UL) -- are only up about 8%, 28%, and 34% respectively.
The next group below them, with market capitalizations a quarter to a half of the first group and beginning to become much closer to the size of the grocery stores, haven't performed any better. Mondelez International (MDLZ), formerly known as Kraft Foods, is down by 4% in the past two years; while Danone (DANOY), Kellogg (K), and General Mills (GIS) are up 25%, 36%, and 36% respectively.
For our purposes here, I will limit the discussion to these six food producers.
In the event of a broad market sell-off, institutional investors will be looking to take profits in large blocks from their biggest gainers and they will likely be doing so by shifting into similar stocks, with liquidity allowing for large block purchases as well.
In such a situation a shift from Kroger and Safeway, as well as from other sectors, into the lesser performing but largest food producers is probable.
The three best positioned for such action, based on daily average volume of equity transactions are Coke, Pepsi, and Mondelez. They also offer dividend yields at their current prices that are competitive with the grocery stores at 2.9%, 2.9% and 1.5% respectively versus 1.3% at Kroger and 2.7% at Safeway. That means that these issues may benefit not only by way of traders actualizing equity profits in the grocery stores but by income investors doing the same and switching to associated sectors offering similar income streams.
From a pure income standpoint though, for investors vs. traders ¿ for those interested in taking longer-term positions -- the best move now, rather than waiting for and worrying about a broader market correction, would be to switch from Kroger and Safeway to Unilever and General Mills.
All four companies have similar forward-looking price/earnings ratios, but the producers have much higher dividend yields now, with Unilever at 3.4% and General Mills at 3%, again versus 2.7% and 1.3% at Safeway and Kroger.
All four also have similar daily trading volumes, making it a potentially easier and swifter switch for institutional holders in large blocks to make.
The bottom line is that the outsized performance of the grocery store stocks in comparison to the broader markets has most logically not been driven primarily by investors switching from bonds in search of income. It's been speculators looking for growth to be caused by mergers and acquisitions in the space. That also means that the traditional income investors in the grocery stores are at risk of suffering asset declines, even if temporary, as the speculators take profits.