Editor’s note: Our consumer discretionary sector outlook is part of a regular series sharing our views on various sectors. It’s part of our efforts to increase communication with investors at a time of economic and market uncertainty. While the sector outlooks provide a short overview of our thinking, we invite you to contact us if you are interested in a deeper discussion.
The S&P 500 consumer discretionary sector hit several all-time highs in recent weeks, and higher valuations are likely warranted. Consider the backdrop: Consumers amassed $4 trillion in savings during the pandemic, household balance sheets are generally strong, the employment picture is starting to improve, stimulus checks are arriving in bank accounts, and credit is readily available. In short, spending should spring forward as COVID restrictions ease.
But valuations reflect many of these positives. This blog looks at some of the bright spots and remaining opportunities Dana sees within the sector, along with a few small pockets that warrant caution.
By and large, we are encouraged by tailwinds that will support most consumer discretionary businesses. One of the areas where we see the most opportunity is in companies tied to the automobile industry. Auto sales in March were the strongest in four years, and we expect strong demand to continue after many consumers paused on buying new cars during the pandemic. However, we believe auto suppliers and dealerships are a better way to invest in this trend than some of the large manufacturers.
We believe travel and leisure industries are another bright spot. There is plenty of pent-up demand to travel, much of which will take place domestically as pandemic restrictions ease. However, we believe families will start traveling more before business travel picks up in earnest, so we favor hotel franchises whose footprint is more heavily skewed to the consumer.
We also believe gaming companies should do well in the current environment. These businesses don’t just benefit from people going to casinos in greater numbers, but from recently legalized sports betting in many states.
Finally, we like the potential for publicly owned restaurant companies. Fast food chains should benefit from increased travelers on the road. Meanwhile, fast-casual and other restaurant chains face an improved competitive backdrop, as many independently owned individual restaurants had to close their doors during the pandemic.
Restaurant chains have also found ways to tighten their belts and improve margins, which should only add to profit growth going forward. Darden, which owns a number of chains including Olive Garden, Cheddar’s and The Capital Grille, serves as an example. In a recent earnings call, executives said cutting menu items, carefully managing labor costs and other efficiencies mean they will only need to achieve 92% of the revenues they received in 2019 to reach the same earnings.
A Few Areas to Watch Closely
One area that is worth keeping an eye on are e-commerce companies. Long-term, many of these business models have great growth potential as more shopping takes place from home. But in the near term, sales comparisons to 2020 will be tough to beat, as people migrate back to spending more of their budget on experiences. Meanwhile, valuations for many e-commerce companies remain high.
Investors should also be selective among retailers. Brick and mortar retailers who struggled before the pandemic may not fare much better if they haven’t found ways to improve the omni-channel experience. In addition, certain retailers that structurally benefited from the pandemic – for example those selling fitness equipment or outdoor retail products – could face tough sales comparisons in 2021.
Stocks tied to the housing market could also be worth monitoring, though they do not face near-term headwinds. Currently, the housing market is strong, supported by an improving employment picture, cheap credit and rising home prices, which can actually beget more spending on housing early in an economic recovery. However, we will be keeping an eye on how rising mortgage rates affect the market.
In Summation – The Sector’s Outlook is Favorable
Rarely, if ever, has the U.S. consumer exited an economic downturn in such good shape. As a result, we expect meaningful earnings growth for many companies within the consumer discretionary sector in the coming quarters. The challenge, of course, is in finding those companies where valuations don’t fully reflect the positive outlook.
We see the most opportunity among select businesses tied to the auto industry, companies tied to travel and leisure, and also stocks of restaurant companies, where investors may be underestimating both margin improvements1, and the desire to eat out again as life finally returns to normal.
1Margin Improvements is defined as increasing the profitability of goods or services sold.