Be Cautious Investing in This High-Yielding Sector

Although the United States is in the ninth year of a strong bull market, it hasn't been an entirely even recovery. In the last five years the S&P 500 has advanced approximately 70%, led by high-flying sectors like technology, which has grown 115%; meanwhile, the consumer staples sector has advanced a paltry 24%.

Because of underperformance and a commitment by many CEOs within the consumer staples sector -- particularly the fast-moving consumer goods sector, which includes packaged foods, beverages, and toiletries -- many large consumer brands now pay large dividends, even above the current 10-year treasury yield of 3%.

However, it's likely the sector will continue to underperform versus the greater market due to a mix of long-term demographical and short-term market forces.

Consumer brands no longer carry the same cachet

The largest driver of underperformance from the consumer staples sector is decreased brand power amid increasing e-commerce and demographical shifts. While brand recognition is inherently a company-specific construct, research points to the fact older consumer brands no longer have the same cachet among millennials.

Last year marketing and research agency Enso found Procter and Gamble (NYSE: PG) was rated No. 12 among Baby Boomers when they were asked whether its values align with their own, but only No. 103 among millennials. Johnson & Johnson (NYSE: JNJ) came in No. 11 among the older demographic, versus No. 40 among millennials.

Brand equity comes at a critical time for these companies; with the rise of e-commerce, serviced by companies like Amazon and Walmart, which purchased, brands no longer have the ability to control in-store shelf-space layout. That requires more-forceful price competition, which narrows margins.

Meanwhile, key input costs are rising

Even as companies are no longer able to monetize their brands as in years past, they are being pressured by cost inflation, notably in terms of transportation, commodities, and labor. Not only are these input costs rising, they are doing so at an increasing rate. The U.S. Department of Labor recently reported that the cost of labor rose 0.8% in the first quarter, the highest since 2008. Oil rose by 50% in the prior year, dragging transportation costs along for the ride.

In March, shares of General Mills (NYSE: GIS) plunged after the company lowered its earnings forecast due to increasing input costs, including freight, that it expected it may not be able to pass along to the consumer. Commodity and transportation costs were also noted in the earnings reports of PepsiCo and Hershey Company.

The solution to inflation isn't great for staples either

Raising rates to lower inflation has a side-effect: lowering stock prices across the board. The theory is that as investors, you are paying for a stream of earnings discounted by the cost of capital. As such, an increase in interest rates raises the cost of capital and lowers the value of future earnings. Additionally, higher interest rates force companies to pay more in interest, which weighs on earnings.

However, there's another reason why consumer staples are impacted by an increase in bond rates. Most of these investments have dividend yields that are larger than those of the market, which has attracted a class of investor more concerned with income than future growth. These "bond replacements" will be under pressure as less-volatile bond rates rise and become more attractive to this investing segment.

For consumer staples, particularly fast-moving consumer goods, expect continued underperformance as inflation costs and/or bond rates continue to erode profit margins even as passing costs along to the end consumer becomes more difficult.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jamal Carnette, CFA owns shares of Amazon and Target. The Motley Fool owns shares of and recommends Amazon and Johnson & Johnson. The Motley Fool is short shares of The Hershey Company and has the following options: short May 2018 $140 calls on Johnson & Johnson. The Motley Fool has a disclosure policy.