Consumption patterns on the upswing

The outlook for 2017 is a welcome change for the sector. It faced dire prospects at the beginning of 2016, thanks to a slowing economy in China and weak economic conditions in the U.S. In addition, online shopping is a major, ongoing challenge for many consumer discretionary companies.

“The Internet is reshaping the landscape in retailing,” says Ome Saidi, vice president, investment management, global equity and income team, at Toronto-based Mackenzie Financial Corp. and portfolio co-manager of Mackenzie Global Dividend Fund. “It’s been a difficult year.”

However, the environment has improved noticeably, according to Marina Pomerantz, portfolio manager with Toronto-based Invesco Canada Ltd. and co-manager of Trimark Global Fundamental Equity Class Fund. “We’ve certainly seen an improvement in sentiment and also consumer behaviour,” she says. “We are seeing more opportunities in this space as a whole.”

That momentum appears likely to continue in 2017, according to Matthew Cain, portfolio manager with Winnipeg-based I.G. Investment Management Ltd. and portfolio co-manager of Investors Global Consumer Companies Class Fund.

“Consumer confidence is at a cycle high, and there’s room for that to move higher,” says Cain.

The U.S. has especially strong prospects for the year ahead, Cain says, with many of the policies proposed by President Donald Trump, including infrastructure spending and tax cuts, likely to bolster the domestic economy and put money into consumers’ pockets.

Given the sector’s cyclical nature, however, there are risks. The global economy is entering its seventh year of growth. “The further we go into the cycle, the more likely there is to be pressure on valuations of the consumer discretionary stocks – especially the more cyclical ones,” says Quirion. “There still are some good drivers, but we need to be mindful that the market looks ahead.”

Economic concerns already have put pressure on consumer discretionary stocks, according to Cain: “[The sector] is trading at a meaningful relative discount to where it has been over the past 10 years relative to non-cyclical consumer staples.”

Given the risks and challenges at hand, stock-picking will be important for clients in 2017. With the rise of online shopping presenting a major disruption in the retail industry, for example, choosing stocks of retailers that are adapting to – and benefiting from – that trend is important. The obvious winners are major e-commerce companies such as U.S.-based Amazon.com Inc.

“We think [Amazon is] well positioned to capitalize on secular growth trends, including e-commerce and cloud computing,” Cain says.

Quirion agrees that Amazon is a high-quality stock. However, he says, investors are paying a hefty premium for that company’s shares, given that Amazon has generated consistently strong growth in an environment of low economic growth.

“[Amazon] is a clear structural winner, and the market is paying for that,” Quirion says. “We need to be mindful of valuations.”

Quirion prefers e-commerce companies based in China, where consumer sentiment is weaker and valuations are more attractive. China-based Alibaba Group Holding Ltd., for example, is benefiting from the same trends as Amazon, but at more reasonable valuations, he says: “It’s taking a lot of market share from traditional retail.”

He notes that in China, grabbing retail market share is easy for e-commerce companies such as Alibaba, as China doesn’t have many major domestic retail chains with their own e-commerce capabilities.

“Alibaba is competing against much less sophisticated players that can’t even think of building their own e-commerce capacities,” Quirion says. He invests his funds’ assets in Alibaba indirectly, through SoftBank Group Corp., a Japan-based holding company that is the largest shareholder in Alibaba.

Another of Quirion’s portfolio holdings is China-based Vipshop Holdings Ltd., an online discount retailer for brands in China. Although slower economic growth in China has eroded consumer confidence in the past two years, Quirion says, conditions are beginning to improve.

“You’re starting to see some early signs of turnaround,” he says. “The purchasing power of the Chinese consumer is still growing at a very good pace today.”

That turnaround also is poised to benefit companies producing luxury goods, many of which were hit hard by the slowdown in China.

“China has been the driving force with all of the luxury brands,” says Saidi. “[Investors were] riding this wave, and then the wave slowed down.”

The Mackenzie fund holds shares in Financière Richemont SA, a Switzerland-based luxury goods holding company that owns brands such as Cartier and Montblanc. “Longer term,” Saidi says, “we think the company is interesting.”

Quirion favours Paris-based Kering SA, which owns fashion brands such as Gucci, Alexander McQueen and Balenciaga. Although the company has faced challenges in the past couple of years, Quirion says, Kering has turned things around: “It seems [to be] finding some good momentum once again.”

Pomerantz sees attractive opportunities in travel. “As consumers around the world are becoming a bit more affluent,” she says, “we think that leisure travel will be a good beneficiary of some of this incremental spending power.”

Quirion’s portfolio holds shares in U.S.-based online travel services provider Priceline Group Inc., which is benefiting from consumers’ growing preference to book travel online.

Quirion’s portfolio also holds shares in Hong Kong-based Samsonite International SA, a luggage manufacturer with dominant global market share. “It’s a well-positioned company with a reasonable valuation.”

Saidi sees strong prospects for Macao-based Sands China Ltd., which develops, owns and operates resorts and casinos in Macao. He says the stock is attractively valued and he expects the company to benefit from investments by China’s government to increase the region’s appeal as a traveller’s destination.

Matthew O’Dowd, director, investment research, at Investors Group Financial Services Inc. and co-manager of Investors Global Consumer Companies Class in Dublin, says U.K.-based Merlin Entertainments PLC is “a good long-term growth story and we don’t see that as captured in valuation.” Merlin operates 117 family attractions, including LegoLand, in 24 countries.

Another company Pomerantz says should benefit from consumer spending on travel is Walt Disney Co. of Burbank, Calif. Although more than half of its operating profit comes from the company’s media divisions, theme parks account for about 20% of operating profit and should benefit from improving consumer confidence.

The auto sector, meanwhile, faces a weaker outlook amid slowing global demand for new cars, but there still are opportunities. Tokyo-based tire manufacturer Bridgestone Corp., for example, is an auto-related business with limited exposure to a downturn in new car sales, Quirion says, because 75%-80% of product demand comes from replacements rather than for new cars.

Similarly, U.S.-based autoparts retailer AutoZone Inc. is the largest U.S. supplier of parts for consumers doing their own vehicle repairs, Pomerantz says. AutoZone also provides parts to many independent body shops.

Pomerantz also likes Indonesia-based P.T. Astra International Tbk, the largest automotive producer and distributor in Indonesia. She believes Astra will benefit from growing demand for vehicles in that country as incomes rise.

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