A common investment thesis of constructing a minimum risk portfolio is that investors should focus on consumer staple rather than discretionary stocks. While common sense serves as the initial groundwork to differentiate between these two sectors, a more indepth analysis involves close examination of product/service demand elasticities.
TUTORIAL: Microeconomics 101
High Elasticity Service
The demand for elastic products is variable; during an economic boom the producing companies will typically do well, but during a recession the industry experiences immense hardships as demand dries up. Houthakker and Taylor determined that the demand for airline travel has an associated elasticity of 5.82. In other words, as income levels decrease by 1%, consumers decrease their airline spending by 5.82% (and vice-versa). As a result, major airlines such as United Continental Holdings (Nasdaq:UAL) and Delta Air Lines (NYSE:DAL) have relatively high return volatilities of approximately 5.5%.
Low Elasticity Products
Food demand, on the other hand, has a much lower sensitivity to income movements. A comprehensive analysis in the study, "What Determines The Elasticity of Industry Demand?" by Emilio Pagoulatos and Robert Sorensen provides a breakdown of the elasticities associated with various consumer staple products. In their research, they noted that cigarettes, macaroni, soft drinks and cereal & breakfast foods have elasticities of 0.107, 0.102, 0.042 and 0.031, respectively. When looking for products with a demand that is practically uncorrelated with economic conditions, producers of the aforementioned goods are a prime place to start. Cigars, fish and cheese, however, are slightly more elastic with respective figures of 0.756, 0.695 and 0.585.
Soft Drinks and Tobacco
Coca Cola (NYSE:KO), PepsiCo (NYSE:PEP) and Dr. Pepper Snapple Group (NYSE:DPS) are the dominant players in the soft drink industry, with Coke and Diet Coke occupying the top two positions in terms of market share. Two major factors which determine the demand elasticity of a product are availability of substitute goods and amount spent on commercial advertising. Although it can be argued that substitutes exist for the three dominant soft drink manufacturers, alternatives typically are of inferior quality and possess much less brand equity. Additionally, Coca Cola spent $2.9 billion on advertising in 2010 (costs also include SG&A expenses), which easily triumphs the market cap of most competitor firms. The stocks of Coke, Pepsi and Dr. Pepper have an average volatility around 1.5%.
Cereal and other breakfast food suppliers such as Kellog's (NYSE:K) and General Mills (NYSE:GIS) also provide substantial protection against shrinking income levels. However, the surge in corn, wheat and soybean prices may have future detrimental affects on food manufacturers' margins. Cigarette companies may actually serve as safer investment. Due to the steady demand of tobacco products, the major cigarette manufacturers are able to support strong dividend yields. Altria Group (NYSE:MO), for example, recently announced its 43rd consecutive dividend increase. In a similar manner, Reynolds American (NYSE:RAI) will be increasing its dividend payout ratio to 80%. Despite the seemingly risk nature of the cigarette industry, MO and RAI have surprisingly low volatilities of less than 2%.
The Bottom Line
During the recession, as the national unemployment rate nearly touched 10%, the airlines were among the hardest-hit industries. While soft drink, tobacco and breakfast food manufactures definitely felt the impact, the extent wasn't nearly as severe. To properly gauge the diversification benefits of an investment, demand elasticity must be considered. (The concept of elasticity of demand is part of every purchase you make. Find out how it works, in Why We Splurge When Times Are Good.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!