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!

Related Articles
  1. Stock Analysis

    Will J.C. Penney Come Back in 2016? (JCP)

    J.C. Penney is without a doubt turning itself around, but that doesn't guarantee the stock will respond immediately.
  2. Investing Basics

    Why Interest Rates Affect Everyone

    Learn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
  3. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  4. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  5. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  6. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  7. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  8. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  9. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  10. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  1. How do you make working capital adjustments in transfer pricing?

    Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

Trading Center