Ultimate Stock-Pickers' Top 10 Consumer Goods Stocks

While the consumer goods sector, which is a distinct Morningstar sector designation, includes everything from auto manufacturers to consumer electronics firms and clothing manufacturers, most investors tend to connect it with more traditional consumer staples industries, such as beverages and household and personal products. With most of the firms in these industries providing basic, everyday goods to consumers and relying on strong brands and relentless marketing to sell their products, it is not surprising that their corporate images (as well as their stocks) are oftentimes identified with the products they sell. Mention Coca-Cola (KO) and people think of bubbly soft drinks. Talk about Hershey (HSY) and investors think not only about the stock, but of the chocolate bars the firm sells in abundance.

Top Managers Overweight Consumer Goods
Consumer goods is one of only a handful of sectors where our Ultimate Stock-Pickers are not only overweight relative to the benchmark S&P 500 Index (SPX), but by a much wider margin than they are in business services, financial services, health care, and media. At nearly 17% of the aggregate holdings of the 26 managers on our Investment Manager Roster, it represented a much larger stake than in the S&P 500, where the Morningstar consumer goods sector made up less than 11% of the index at the end of the second quarter.

Top 10 Consumer Goods Holdings of Our Ultimate Stock-Pickers

Stock price and Morningstar Rating data as of 10-15-09.

The top 10 consumer goods holdings of our Ultimate Stock-Pickers include well-known names like Coke and Procter & Gamble (PG) and accounted for 80% of the total holdings by our top managers in the sector during the most recent period. While some positions like Coke, P&G, and Kraft Foods (KFT) are skewed somewhat by Berkshire Hathaway's (BRK.A) (BRK.B) larger stake in these names, they still accounted for the top three holdings of our Ultimate Stock-Pickers even when Berkshire's stake is backed out (with P&G overtaking Coke in the pecking order as a result).

10 Consumer Goods Stocks Our Top Managers Have Been Buying

Stock price and Morningstar Rating data as of 10-15-09.

What was also interesting was the fact that Coke and P&G were the top two names purchased by our managers during the most recent period despite already being widely held. Based on recently collected data, there were at least two new money purchases in both names during the period, with Chase Growth (CHASX) and Davis NY Venture (NYVTX) making conviction buys in Coke and Matrix Advisors Value (MAVFX) and Markel (MKL) doing the same with P&G. There was also a bit of activity around PepsiCo (PEP) and Pepsi Bottling Group (PBG), with the new money purchase of the latter made by Mutual Shares (TESIX) (which was also a big buyer of PepsiAmericas' (PAS) stock during the period). With PepsiCo looking to roll up its two main bottlers, the managers at Mutual Shares were likely playing the arbitrage available to them after the beverage and snack food giant's first offer was made in late April, in anticipation of a higher bid (which actually materialized in early August).

Our analyst Phil Gorham likes what the move does for PepsiCo's competitive position, even though it is likely to impact profit margins and returns on invested capital as the company brings the low-margin, asset-intensive bottlers onto its books. For further valuable insight, see Phil's recent article "Pepsi's Bids for Bottlers Shake Up Beverages Industry" on the ramifications of the deal for the North American soft drink market.

Making Sense of Kraft-Cadbury
This reminds us of another acquisition-related situation, which we think may have sparked buying and selling activity by some of our top managers during the third quarter--namely Kraft's unsolicited $17 billion bid to purchase Cadbury (CBY). Given the makeup of Kraft's existing product portfolio, which includes everything from cheese to cookies and crackers, an acquisition of Cadbury would further expand its lineup into the highly profitable confectionary industry (composed of gum, candy, and chocolate). As the second-largest player in the industry, Cadbury would provide Kraft with more attractive growth opportunities and perhaps even add to some of its competitive advantages.

With several of our Ultimate Stock-Pickers, including Warren Buffett's Berkshire Hathaway, holding a stake in Kraft, and a few others with shares in Cadbury, we felt that understanding how the proposed deal has played out so far would be invaluable for investors who might have positions in one of the two stocks or were thinking about building a stake in either of them in the near term. In order to gain some depth and expertise, we sat down with Erin Swanson, our analyst who covers the packaged food industry here at Morningstar, to get her take on Kraft's bid for Cadbury.

Thanks for your time, Erin. Why is Cadbury such an attractive target for Kraft?

Strategically, we believe the acquisition of Cadbury makes sense for Kraft as the firm stands to gain a larger foothold in the attractive confectionary industry (which is higher growth and higher margin than other categories in the packaged-foods space). Private-label competition is minimal in the confectionary market (in contrast to Kraft's other segments), and the deal would not only expand the firm's international presence but provide it with an expanded platform to distribute some of its existing brands.

If that is the case, how could this not make sense for Kraft shareholders?

Cadbury has rejected Kraft's initial offer and a higher bid obviously seems necessary, but we believe that this could become value-destructive if the price gets too high and may, ultimately, be limited by Kraft's desire to retain its investment-grade rating. Making things even more difficult for Kraft, which structured its initial bid with a mix of stock (60%) and cash (40%), is the fact that its shares are relatively cheap right now. At $26 per share, the company's stock is trading well below our $37 fair value estimate. If Kraft were to eventually reach a deal with Cadbury above 16 times trailing-12-month EBITDA, we feel that the upside for shareholders diminishes greatly.

Who else is in the running to potentially acquire Cadbury and how would a Cadbury acquisition affect each?

We believe Hershey, Nestle (NSRGY), and PepsiCo could make counterbids (in addition to a sweetened bid from Kraft). The best strategic fit for Cadbury lies with Hershey, in our opinion, but financing a purchase for all of Cadbury would be difficult for Hershey (although not impossible). While Nestle is focusing on health and wellness categories, it could afford a deal and may not want Cadbury to be snapped up by a competitor. As for PepsiCo, Cadbury would be complementary to its portfolio, but the beverage and snack food giant is currently working on consolidating its bottlers and is already more highly levered than its peers.

Strategically it makes sense for Kraft to make a play for Cadbury, but does the firm have the financial resources to pull off the deal?

We believe Kraft has the financial resources to acquire Cadbury, given its $1.7 billion in cash, $4.5 billion of available funding from its credit facility, and a debt/capital ratio of just 0.45. It seems likely, though, that the firm will need to increase its bid to appease Cadbury's management and ward off competing interests. While the synergies of $625 million from a combined Kraft-Cadbury would justify the 27% premium to our fair value estimate that Kraft is currently offering for Cadbury, we think that any offer beyond 16 times EBITDA would likely be dilutive to Kraft shareholders. That said, we believe the firm could counter with essentially the same offer, altering the mix of cash and stock in the deal to make it more acceptable to not only Cadbury's management team but shareholders as well.

Bottom line, do you believe Cadbury will ultimately be bought and do you see a major change to the confectionary industry from the consolidation activity?

Ultimately, it is difficult to say how this saga will play out. While we expect Kraft to raise its bid, and for other bidders to potentially emerge, it is possible that Kraft or others could walk away if the price gets too high, leaving Cadbury as a stand-alone firm. While the confectionary industry has experienced notable consolidation over the past few years, such as Mars' acquisition of Wrigley last year, the industry is still dominated by a few large players. With the top five competitors controlling about 40% of the market, we don't expect any meaningful changes in the competitive environment even if Cadbury is bought out.

Disclosure: Vishnu Lekraj does not own shares in any of the companies mentioned above.