As the value of the U.S. dollar continues to slide, many investors have embraced commodities as an opportunity for generating solid returns in an uncertain environment. ETNs and ETFs tracking various commodities have performed extremely well over the past few months, as concerns over QE have combined with ongoing supply worries in a variety of important commodities to send many products surging higher. For example, the iPath Dow Jones-UBS Coffee ETN (JO) is up more than 50% over the past 26 weeks, while the iPath Dow Jones-UBS Sugar ETN (SGG) has roared higher by a whopping 140% in the same time period.
While this commodity surge has been great news for those who have invested in the sector, consumer staple companies are likely cringing at the thought of higher input prices. This is especially true given the current state of the economy, with 9.6% unemployment and extremely weak consumer confidence that has caused many loyal customers to jump to cheaper brands. It doesn’t help matters that the American consumer staple market is extremely mature and is relatively saturated; most consumer product companies battle in extremely low margin businesses fraught with competition, meaning that any raw material increases are usually eaten by producers or are passed onto final consumers [also read Many Uses Of Commodity ETFs].
While passing these costs on to consumers might normally not be such a bad thing, an extremely weak economy coupled with sharply rising prices could be the beginning of the end to many customers’ tolerance levels with a host of popular brand names. “There is a much stronger sensitivity to price than we’ve ever experienced, but there are some areas you can’t afford not to pass on those costs,” says Kevin Srigley, a senior vice president at grocer Giant Eagle Inc.
Many investors might shrug this off given the low CPI levels that the economy is currently experiencing but many food company CEOs are taking the commodity increases seriously. According to the WSJ, companies ranging from McDonald’s to Kellogg have begun to signal that prices will soon be rising and that consumers will have to shoulder more of the burden in the future. “The big challenge will be, how much can we swallow and how much can we pass along?” said Jack Brown, chief executive of Stater Bros. Markets, a 167-store grocery chain in southern California. While some have resorted to drastically cutting portion sizes in order to keep margins high and the prices the same, that move often has a limited effect, especially in environments where commodity prices jump very quickly. Thanks to this new reality, many companies that use large amounts of these commodities are likely to face significant challenges over the next few months as they adjust. Below, we highlight two ETFs that could see top components face smaller margins or lower sales levels from continued strength in commodity markets [also read Inside Five Surging Commodity ETFs].
PowerShares Dynamic Food & Beverage ETF (PBJ)
This fund tracks the Dynamic Food & Beverage Intellidex Index, which is comprised of stocks of U.S. food and beverage companies. The underlying index is designed to provide capital appreciation by thoroughly evaluating companies based on a variety of investment merit criteria, including fundamental growth, stock valuation, investment timeliness and risk factors. Its top holdings include Starbucks (5.2%), which is likely to be heavily impacted by surging coffee futures, Yum Brands (5.2%), which could take a similar hit thanks to rising livestock costs as a result of corn’s surge, and Coca-Cola (5%), which could be impacted by corn’s surge as well as the higher prices for sugar. Despite these concerns, PBJ has managed to post solid returns so far in 2010 with a gain of more than 25% so far year-to-date and a 14% surge over the past 26 weeks [see An Unexpected Hurdle For The Food & Beverage ETF].
iShares Dow Jones U.S. Consumer Goods Index Fund (IYK)
This iShares fund takes a similar approach to PBJ but offers a wider level of exposure through its 125 holdings (compared to just 31 for PBJ). Despite its far greater number of holdings, IYK remains heavily concentrated in its top components, with Procter & Gamble (13.6%) taking the top spot, trailed closely by Coke and Pepsi which make up 9.9% and 8.4%, respectively. While Coke and Pepsi have relatively obvious commodity exposure in the form of corn and sugar prices, some might initially discount the impact rising raw material costs have on a personal product company like P&G. However, in the company’s most recent earnings report, commodity costs were cited as causing a 70 basis point contraction in gross margin levels for the firm. Thanks to this lack of strength from P&G, IYK has underperformed PBJ so far in 2010, posting gains of just 14% so far on the year. However, if commodity prices begin to severely curtail sales at some of the big name firms in either this ETF or PBJ, look for these positive returns to shrink pretty quickly across the board in the consumer staples sector heading into 2011 [see which ETFs offer the most exposure to your favorite company with our ETF Stock Exposure Tool].
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Disclosure: Eric is long PBJ.