October 7, 2013 - Reduce Your Risk with Consumer Staples
In the world of investing, there are no "sure things". Even the best stocks today can run into trouble tomorrow, but there are some stocks that are safer than others.
There are many different ways to try to isolate "less risky" stocks, but one of the ways that I prefer the most is to scan for companies that sell goods or services that are in high, constant demand. The first place to look for these companies is the consumer staples group.
To understand why this is the case, we need to first understand what type of company falls into this classification.
So what exactly constitutes a consumer staple? Consumer staples are companies that sell products that people have to buy. These items can include food and beverages, tobacco and alcohol (while no one really needs these products, they still fall into this group), or your day-to-day household goods such as cleaning supplies or light bulbs.
The beauty of this class of stocks is that the overall economic situation plays little to no role in shaping demand. The economy can be in its best or worst possible condition and people will still need to buy these products.
Not only will demand stay high regardless of the economy, but people will be forced to pay whatever price they have to in order to purchase these goods. That is not to say companies can charge anything they want, there is too much competition to just recklessly raise prices, but the point is that inflation does not pose a threat to these retailers.
When the economy turns south, retailers that deal in goods such as autos or clothing can face slowing demand for their goods, and these retailers are referred to as consumer cyclicals. They are solid buys when the economy is running on all cylinders, but that is not exactly the world we live in today.
The economy is improving, but at a slow pace, with plenty of reasons for investors to worry about the future. Unemployment is still a concern, and the eventual Federal Reserve tapering poses a major risk to the housing market.
Because of the uncertainty surrounding the overall economy, my favorite category of stocks right now is the consumer staples group. There are plenty to choose from, but I prefer to diversify my investments over a wide range of stocks. This is why I like the Consumer Staples Select Sector SPDR (XLP) exchange traded fund.
XLP is designed to track the performance of securities in The Consumer Staples Select Sector Index, so you get a wide range of stocks. Included in XLP's top holdings are Procter & Gamble (PG), Coca-Cola (KO), Philip Morris (PM), Wal-Mart (WMT) and CVS (CVS).
As you can see from the above list of stocks, each company sells products that people will buy no matter what direction the overall economy takes.
Chart courtesy of stockcharts.com
A nice hedged trade on XLP would be the January 34/37 bull put credit spread. In this trade, you would sell the January 37 put while buying the same number of January 34 puts for a credit of 25 cents. This trade has a target return of 9.1%, which is 31.3% on an annualized basis (for comparison purposes only). With XLP currently trading at $39.72, this trade has 6.2% downside protection.