SPY - Kroger's Simple Truth - Defensive During Recessions

2023-04-26 17:57:46 ET

Summary

• While the probability of a recession falls with strong economic data points, the chance remains high.
• Therefore, I believe sufficient allocation to defensive assets can be fruitful for investors.
• Kroger offers the best of both worlds, low downside during bear markets and growth during bull markets.

Economy Hanging On

An excess of monetary stimulus due to the pandemic has caused rising inflation across the world. To combat this, global monetary organizations have raised interest rates at a rapid clip. With both inflation and interest rates high, calls for a recession were common in early 2022. The markets reflected this, with a market sell-off leading SPY to fall 25% between January and September 2022. It is a rather complex reaction, as no recessionary signals had been presented in the US during that time. Now, the consensus is becoming more mixed, with a soft landing and even a lack of a recession rising in probability. As discussed by Montecito Bank & Trust in March:

We believe that key components of U.S. GDP are still expanding, despite the impact of inflation, the pandemic, and geopolitical developments. But growth is not consistent across all segments of the economy and, in many cases, growth rates are slowing. The risk of recession is real -- but a U.S. recession is not a foregone conclusion. We have raised our 1Q23 GDP estimate to 1.3% from our prior forecast of 0.2%. We look for the first quarter to start at a weak rate, but for the economy to improve as the year goes on.

They are not the only money managers with that view. Goldman Sachs only expects the probability of a recession to be 35%, with factors such as a strong labor market, already slowing inflation, supply chain recovery, and GDP growth remaining positive. Broadly, the main takeaway by reputable analysts is that even if there is a recession, it will be mild and the risk declines with each data reading that is released. Therefore, positioning your portfolio with anti-recession holdings is not a dire requirement for investors moving forward, but it is best to have some allocation set to defensive names if you desire asset preservation in the coming months or quarters.

Kroger's Advantages

I believe that one asset stands out as a unique way to lower risk: Kroger ( KR ). Food is life, plus economic weakness leads consumers to grocery stores instead of restaurants. Kroger has additional benefits as well. First, they have a wide selection of store-brand items that are competing against bigger name brands such as General Mills ( GIS ), Kraft Heinz ( KHC ), and PepsiCo ( PEP ). The cheap competition may stand out and provide Kroger with more revenues, especially due to the nearly equal quality. Just compare the relative growth rates over the past 10 years below.

Beyond that, we have the potential for a major acquisition of Albertsons, and this will create a leader in the supermarket industry within the US. With further diversification and assets, the company becomes more stable. And, cost-cutting (especially selling stores in places like California where Albertsons and Kroger are dominant) will aid margin expansion over the coming years. If the deal does not go through, Kroger still has a profitable and successful historical growth profile to rely on.

One of the best qualities of Kroger is consistency. Over the past 30 years, earnings have been extremely stable, with EBITDA margins hovering around 4-5% and Net Income Margins hovering around 1-2%. Instances of higher or lower margins have typically aligned with M&A activity, and do not signify weakness during recessions. In fact, Kroger's profits are rarely influenced by recessions. For those in for the long-term, I also expect a small degree of margin expansion from current levels, especially if the Albertsons acquisition goes through. This will be another favorable catalyst for investors to rely on over the next few years as the rest of the market may be cooling off.

Consistency Leads to Outperformance

With consistency has come market-beating performance during bear markets. The two charts below show that Kroger has performed well in protecting wealth during 2006-10 and during the pandemic. While it is true that Kroger is still an equity and can decline significantly, investors that want to see their portfolios remain afloat can decide whether adding Kroger during the current period of weakness is opportune. This ability to negate downside during bear markets is a beautiful quality, but Kroger also offers investors something more: consistent returns during bull markets as well.

Kroger has defensive qualities, but a focus on inorganic growth helps the company outperform other defensive peers. Over the past 10 years, Kroger has been able to provide investors a total return of 230%, while SPY returned 210%. Part of this is reduced downside during bear markets, such as with the example of the pandemic below. Also, Kroger keeps a strong balance sheet that can be reinvested in capex or acquisitions, boosting top-line growth in all economic situations. The recent Albertsons acquisition is arrogant to a degree but certainly highlights Kroger's ability to drive growth for their shareholders rather than remain complacent with sub-par GDP growth.

Recession or Not, Kroger Stands Out

A focus on growth has led to periods of sub-optimal volatility or underperformance for Kroger, but the underlying fundamentals remain strong. However, this is a unique quality for more conservative and underperforming defensive assets. As I highlight above, other defensive name brands such as Pepsi and General Mills have failed to drive the same level of growth, and also underperform in terms of total return. Therefore, Kroger is a company that I believe suits many portfolios as they can provide ample returns on an accumulated share basis. For this reason, I have included KR in my Craton Index alongside other companies that are true low-risk stalwarts of the stock market.

I look forward to having Kroger provide a balanced and market-leading return in this time of uncertainty. If the recession that is expected comes, the market will likely turn sour, but Kroger will continue to hold strong relative to the averages. If not, a return to a more healthy global economy will allow Kroger to continue using inorganic strategies to provide above-peer growth. While the shares may be more volatile than say GIS or PEP, this allows long-term investors to accumulate at more favorable prices, but not suffer during crashes. A trait that may come to be seen quite favorably over the coming quarters.

Thanks for reading.

Editor's Note: This article was submitted as part of Seeking Alpha's Best Investment Idea For A Potential Recession competition, which runs through April 28. This competition is open to all users and contributors; click here to find out more and submit your article today!

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