Mean reversion is one of the most powerful forces in investing. The idea that over time valuation multiples will revert to the mean, or simple average. Right now the valuation multiples in the consumer staples sector are near record highs. We take a look at what is driving them and why it might be a good time to review the weighting of investors’ portfolios to this part of the market.

Peak p/e ratios

The stock market is a complex mixture of a discounting machine for future profits and a mad collection of people desperate to make a profit. It is these two factors which underlie the basis of mean reversion. Firstly the profits in a company will rise and fall with business cycles. Secondly investors make emotional decisions about investing in stocks that fall in and out of favour. Most importantly, and over time, they will average out.

The consumer goods sector is enjoying a valuation peak right now. Some of the biggest and safest names on the FTSE 100 have seen their shares steadily rise for the past two decades leaving their price to earnings, or p/e ratios also at extreme levels. Reckitt Benckiser is currently trading on a forecast p/e of 24 times, Unilever is on 21 times earnings and Diageo is on also on 21 times.

PE ratioReckitt Benckiser price earnings history20042006200820102012201420161015202530Friday, Feb 26, 2010● PE_RATIO: 16.9497

However, the macro economic forces and financial engineering that allowed the earnings multiples to reach record levels are now beginning to turn against these giants.

Deflation bites back

When the world economy hit a road bump back in 1999, and the dotcom bubble unravelled, the central banks turned on the money supply taps to keep consumer spending buoyant. This was a boon for consumer staples giants as they could steadily push through price increases backed by huge marketing budgets which pushed branded goods. This allowed steady revenue increases from the core portfolio of brands at Dove, Domestos and Lynx owner Unilever, and also at Durex and Gaviscon maker Reckitt Benckiser.

When the 2008 financial crisis came along, it knocked the consumer groups hard, but more money flooded the system and allowed consumer spending and prices to quickly recover. What’s more, it also provided the basis for extreme cost cutting, which in turn helped profit margins soar. As revenues increased and profit margins expanded the earnings multiples used to value these companies also steadily increased from around 12 to more than 20 times earnings.

However, the central bank largesse is now going into reverse and as the money dries up the prices of consumer goods are now falling in developed markets across Europe and North America.

Emerging market slowdown

As the developed markets slowed the baton was picked up by rapidly expanding emerging markets such as Brazil, India, Nigeria and China. The growing middle classes in these regions demanded branded products due to concerns over the quality of local equivalents. The double digit rise in sales and ability to push through price increases easily offset the slowdown in developed markets at first. This underpinned the revenue and earnings growth needed to justify the ever increasing valuation multiples.

However, this success story is now also unwinding. The sharp rise in the value of the dollar during the past 18 months has seriously hit the spending power of emerging markets. The emerging market economies have also been battered by a commodity selloff. Spending power now seriously denuded these regions will struggle to provide the sales momentum required going into next year.

Financial engineering

Another feature of the past two decades has been the extraordinarily low and falling interest rates. This has allowed FTSE 100 companies with solid balance sheets to borrow incredibly cheaply. Cheap borrowing has inflated valuation multiples in two ways. Firstly it has funded the takeovers necessary to keep revenue and earnings growth at the levels required to justify valuation multiples. Secondly as the interest payments on the debts have fallen the benefits of excess profits accrue to the holders of equity.

% YieldUK 5yr Gilt yield an indicator of the cost of debt2002200420062008201020122014201601234567

The interesting feature on the debt side is that while interest rates look set to increase extremely slowly, the cost of debt may increase at a much faster rate. The commodity collapse is causing default rates to steadily rise, and as this happens investors will demand higher rates of return on debt. The cost of corporate debt can therefore increase independently of central bank interest rates.

Time to rebalance

The process I have described took place over more than two decades as investors increasingly viewed consumer staples as a one way bet to returns.

The problem for those approaching retirement is that they can ill afford to chase the 2-3pc dividend yield in a consumer staple trading on 24 times earnings, only to watch that rating unravel over the next five years. Applying a more prudent rating of 14 times earnings would equal a 42pc loss of capital on your pension pot, for example.

(p) pence per shareUnilever shares are near all-time-highs201020052015500100015002000250030003500Wednesday, Mar 14, 2007● Last Price: 1 402

There is no need for drastic action. The unwinding of these factors is likely to be a gradual process. However, investors should take a good look at how much of their savings is in these consumer stalwarts such as Diageo, Reckitt Benckiser, Unilever, PZ Cussons and Nestle. Now might be a good time to bank those excellent returns.

SOURCE: John Ficenec – telegraph.co.uk