The consumer discretionary sector is one of the most dynamic segments of the market. It is also one of the most vulnerable to cyclical downtrends and changes in consumer sentiment, which means income investors should navigate carefully when entering the sector.
The following article provides a high-level breakdown of the consumer discretionary sector, its composition and its dividend potential.
Composition of the Consumer Discretionary Sector
The consumer discretionary sector is one of the 11 primary segments of the market tracked by the S&P 500 Index. In terms of size and composition, the sector is in middle of the pack with a total market capitalization of $4.84 trillion as of Dec. 4, 2018. By comparison, consumer staples are worth a combined $3.42 trillion and financials, which are the largest, are worth $7.15 trillion.
Consumer discretionary shares are further broken down into ten categories or industries based on their underlying business:
- Auto components
- Diversified consumer services
- Hotels, restaurants and leisure
- Household durables
- Leisure products
- Multiline retail
- Specialty retail
- Textile, apparel and luxury
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From the perspective of income investors, Dividend.com groups consumer discretionary stocks with other consumer goods companies. As a result, consumer discretionary companies are listed as consumer goods on the Dividend.com sector classification system. However, this sector is further broken down into 32 components comprising consumer discretionary and consumer staples companies. A full breakdown can be found here.
Consumer discretionary companies play an important role in the economy. Because they provide non-essential goods and services, their performance is often tied to the general well being of the consumer. That is, consumers spend money on discretionary items only when they have sufficient income. This makes the sector highly cyclical and subject to the underlying performance of the economy. For example, periods of rising employment and economic growth are associated with greater discretionary spending on durable goods, apparel, entertainment and automobiles. These factors play into the hands of consumer discretionary companies.
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In terms of dividend-earning potential, the consumer discretionary sector yields right around the S&P 500 average. This means the sector doesn’t have any intrinsic qualities that make it more attractive for income investors (on the other hand, REITs and utilities offer unique benefits for dividend seekers).
At the time of writing, the consumer goods category had an average yield of 1.95% compared with 1.92% for the broader S&P 500 Index. This is much higher than healthcare (0.65%) and technology (1.09%), but significantly lower than financials (3.11%) and basic materials (2.42%).
Within consumer goods, cigarette companies and tobacco producers have the highest yields at 5.27% and 3.49%, respectively.
Like any other sector, investing in consumer discretionary companies has its advantages and disadvantages. In terms of pros, consumer discretionary is among the best performers during strong economic cycles, which makes it easier for investors to gauge their entry into the sector (basically, if employment and economic growth are positive, it may be a good time to consider investing). Consumer discretionary companies also benefit from the holiday season, which can help investors time their entry into the market. Let’s also not forget that more than three-quarters of the U.S. economy is driven by consumption. This means discretionary shares are always poised for a breakout when economic conditions improve.
On the opposite side of the spectrum, discretionary shares may leave income seekers at a disadvantage. With so many higher yields to choose from, the discretionary sector typically isn’t top of mind for dividend earners. A slowing global economy and rising interest rates on the home front have also tempered pro-growth optimism, which means discretionary companies don’t have a solid outlook to rely on. As such, the sector is not considered a good hedge for inflation and is prone to volatility in a rising rate regime.
That being said, high-yielding discretionary stocks do exist. For starters, investors may want to look at Brinker International Inc. (EAT ), The Gap Inc. (GPS ), Johnson Controls Inc. (JCI ) and McDonald’s Corporation (MCD ).
The Bottom Line
Consumer discretionary is a high-flying sector during periods of robust growth and positive consumer sentiment. However, optimism for the sector should be tempered by the expectation of cyclical downtrends, which are not uncommon for a post-crisis economy. Against this backdrop, investors should tread carefully.
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