While high dividend-yielding financials have so far captured the spotlight in the strong rise in the share market since mid-last year, it may surprise some investors to know that one of the other better performing sectors has been one of the most challenged since the global financial crisis: consumer discretionary.

This sector was further buoyed by news this week that consumer sentiment was on the rise. The Westpac-Melbourne Institute measure of consumer confidence was up 2% in March after a solid 7.7% gain in February.

Consumer discretionary is one of the most cyclically sensitive sectors in the market, and especially attuned to consumer spending. The sector covers major media firms such as News Corporation, Fairfax, Seven West Media and the Ten Network. It also includes leading department stores David Jones and Myers, together with specialty retailers like JB Hi-Fi, The Reject Shop and Flight Centre. Gaming firms like Crown, Tatts and Tabcorp are also included.

Households hold back

Thanks to falling interest rates, rising asset prices, strong employment growth and credit liberalisation, consumer spending powered the Australian economy in the two decades prior to the global financial crisis. Since the GFC hit in mid-2008, however, household spending has never quite been the same.

The savage sell-off in equity prices and modest decline in house prices saw households begin to worry for the first time about the high levels of debt they were carrying. Consumer confidence slumped and the household saving rate surged to around 10% – or to levels prevailing before the debt-fuelled explosion in house prices in the decade to 2005.

As if that weren’t enough, traditional retailers and media companies have faced increasingly tough competition from online upstarts, thanks to the wider take up of high-speed internet services.

From the mid-1990s to around mid-2008, real consumer spending grew at an annual rate of around 4%. Since then, consumer spending growth has slowed to around a 3% pace – and was close to flat in the second half of last year. Forward earnings for the sector have been on a downhill slide since mid-2006.

Yet get this: over the past 26 weeks, the S&P/ASX 200 index has lifted by 18.4%, led by a 26.4% gain in the financials (excluding listed property). The next best sector has been healthcare, rising by 23.4% – but the consumer discretionary sector was not far behind, rising by 23.0%. Over the past three months, consumer discretionary has been the best performing sector, lifting by 19.2%.

Sentiment shifts

Why the turnaround? Obviously a rising tide helps lift all boats, and the sector has not been immune to the recovery in market sentiment since mid-2012. As for the market overall, attractive valuations have also played a role. At its nadir in late 2011, the consumer discretionary sector traded at a price-to-forward earnings ratio of only 9.6 – compared to a long-run average of 16. By mid-2012, the PE ratio had recovered to around 13 (though largely due to falling earnings, not rising prices) but that was still below average.

With the recent recovery in prices, the sector ended February at a forward PE ratio of an above-average 17. That might suggest the sector is fully valued, which would be true if earnings were not expected to recover. However, there are tentative signs of an earnings turnaround. With the reduction in interest rates over the past year, consumer confidence has started to recover and is now slightly above long-run average levels. Household wealth is improving, with house prices and share prices firming over the past year. Retail sales – while often volatile – were better than expected in January, and some retailers suggest activity levels are picking up.

At the same time, many companies have responded to the challenges in the sector by cutting costs, meaning any pick up in sales could quickly flow through to the bottom line of major media and retailing companies.

According to Thomson Reuters estimates, analysts expect sector earnings to grow by 12% next financial year, after suffering a decline of 13% this financial year. Earnings are then expected to grow by around 10% in 2014-15.

Most major companies in the sector have enjoyed good gains of late. Over the past six months, the best performing stocks have been Seven West Media
(80%), JB Hi-Fi (75%) and Myer (56%), while the worst performing have been Billabong (-40%) and GUD Holding (-18%). Even long-blighted Fairfax is up by 50%.

Given the stronger performance of their counterparts to date, News Corp,
David Jones and the Ten Network are examples of companies that might be due for a catch-up.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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