Are These Consumer Goods Stocks Over-Valued?

Bob is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Consumer goods stocks have been some of the market’s best-performing stocks of all time, and it’s not hard to see why. Companies that sell their products year in and year out, effectively ignoring the fluctuations of the broader economy, aren’t likely to go out of business when a recession hits.

Furthermore, the financial stability of companies like McCormick & Company (NYSE: MKC), The Hershey Company (NYSE: HSY), and Tootsie Roll Industries (NYSE: TR) is accompanied by reliable dividend payments every quarter.

These companies have demonstrated long histories of paying and raising dividends for many years. After considerable rallies over the past couple years, these stocks now enjoy lofty valuations. As a result, this begs the question: are these stocks over-valued?

Models of consistency

As previously mentioned, these stocks have proved their worth by providing investors with reliable returns for many years.

To illustrate, consider that spice and seasoning kingpin McCormick is a darling among the dividend community for its impressive dividend streak. Indeed, the company has an enviable record of paying dividends to shareholders for 89 years in a row, and investors were treated to a 10% dividend increase this year.

Meanwhile, although you might not think chocolate is big business, Hershey and its $20 billion market capitalization would suggest otherwise. Hershey recently delivered a savory first-quarter, reporting 5.5% sales growth and 22% earnings per share growth in the three-month period.

The rest of the year isn’t likely to be as promising as the first quarter results would indicate, but 2013 should be a good year nonetheless. Hershey is expecting full-year net sales to increase at least 5%, and adjusted diluted EPS growth to come in at about 12% versus the prior year.

Staying on the topic of chocolate, there are undoubtedly many positives to Tootsie Roll’s business. 2012 proved to be a record-setting year for the company. Tootsie Roll reported a record $546 million in sales, realizing 3.3% growth year over year. In addition, the company’s net earnings per share increased an impressive 20%.

At the same time, Tootsie Roll is firmly committed to rewarding its shareholders with dividends and share buybacks. Last year, Tootsie Roll paid a $0.50 per-share special dividend and distributed its 48th consecutive stock dividend. Not only that, but the company spent $24 million buying back its own shares during the year.

Valuation a concern

The question being raised in this article is not whether these are strong businesses. Each of these companies has a demonstrated track record of consistent profitability over many years. Moreover, because they are in the consumer goods industry and their products are purchased regardless of the prevailing economic conditions, their businesses should remain sound for many years to come.

At the same time, however, investors cannot ignore price. Even the best companies in the world can amount to poor investments over time if too high a price is paid. For instance, new investors are paying 23 times trailing earnings for McCormick, 29 times EPS for Hershey, and a whopping 37 times Tootsie Roll’s full-year 2012 earnings per share.

Put simply, there aren’t enough margins of safety to justify such lofty valuations for these three companies. Investors are asking for trouble paying such high prices for companies with relatively modest sales growth. Profits are being grown at higher rates, thanks to cost cuts, but cost cuts can't continue to juice EPS forever.

Moreover, while each of these stocks has paid a dividend for decades and will raise their dividend from time to time, none of these stocks yields more than 1.9% at recent prices, which is less than the yield on S&P 500 Index.

In the end, while each of these three companies represents a solid business, Foolish investors should wait for much better entry prices before jumping in. Specifically, I wouldn’t be willing to pay more than the market multiple for firms with these growth profiles. That means I’m not going to pay more than 16 or 17 times earnings for these businesses, and I’d recommend cautious investors to act similarly.

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Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends McCormick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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