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Updated daily. All values annualized from Jan. 2008.

Coming in at #3 in our Magic Formula Business Sector Rankings is the Consumer Goods sector. This sector accounted for 542 stock days tallied by 24 different stocks. Morningstar's industry breakdown for this sector is pretty specific, and the MFI stocks line up like this:

Morningstar Industry	Stock Days	Unique Stocks
Toys/Hobbies	121	4
Appliance & Furniture Makers	77	3
Apparel Makers	57	5
Shoes	57	3
Jewelry/Accessories	56	1
Paints/Coatings	51	1
Recreation	48	2
Photography & Imaging	27	1
Household & Personal Products	24	2
Tobacco	18	1
Audio/Video Equipment	6	1

It's interesting that the Toy business led this category, and by a wide margin. The 3 largest U.S. toymakers, Hasbro (HAS), Mattel (MAT), and JAKKS Pacific (JAKK), were all on the screen for significant periods of time. I think this is another illustration of how the Magic Formula does a lot of the work of digging up beaten down sectors for us. The first quarter is generally a weak one for toymakers, as most of their profits come in the Christmas season (as much as 60%). Add this to the PR problems Mattel faced last year with lead paint, and you have an unwanted sector, with some interesting potential investments.

I find it difficult to break these industries down into manageable sub-sectors. The original thought was to separate between Consumer Staples (items that we must buy regardless of our financial condition) and Consumer Discretionary (luxury goods). However, many of the industries above would be ambiguous. For example, we need shoes (making them a staple), but in tight times we may decide to buy a store brand instead of more expensive Nikes (NKE), adding a measure of discretion to the purchase. Therefore, this article will just discuss how a company can build durable competitive advantages in the Consumer Goods sector in general, as these businesses all target the same audience - you and me.

So how does a Consumer Goods company build itself an economic moat? Think of why you would purchase one company's products over a competitors. Why do we choose Coca-Cola (KO) over a store brand when we buy soda? Why do women desire to own Coach (COH) purses instead of something from Target (TGT)? Why would your wife or girlfriend (if you're male) be less enthused about jewelry from Kohl's (KSS) than something from Tiffany (TIF)? After all, is there that much difference in materials or practical worth? The answer, of course, is brand cachet. We choose Coca-Cola because we're familiar with and like the taste. Coach bags are considered stylish, while a Target bag is not. Strong and respected brands allow a company to charge more for essentially the same product, which leads directly to outsized return on capital, one of the two requirements to be a Magic Formula stock. For all of the above industries, a player with a strong brand will outperform a competitor without one.

Brand is unquestionably the strongest form of competitive advantage in Consumer Goods. However, it's important to also judge the durability of the brand. For example, Coke is a brand known around the world, and has endured over 100 years of competition to still enjoy the top spot in the soda category today. That's a durable brand. Compare this to Gap (GPS). Ten years ago, Gap and it's spin off stores Old Navy and Banana Republic were considered fashionable and chic for the all important teen and college set. Today, the store is avoided by those same groups, lest their fashion sense be ridiculed by friends. That's a fickle brand. It's important to be able to separate a fad from a juggernaut.

Distribution is also important in the Consumer Goods sector. A company with a wider distribution network can leverage economies of scale to earn more on their fixed costs. An especially attractive arrangement is when one of these companies has an exclusive deal with a large distributor. Take Anheuser-Busch (BUD), for example. While this firm has an incredibly strong brand, they also require exclusivity from distributors. This allows them to lock out competitors like Molson Coors (TAP) and Miller, protecting profit margins. The soda companies also do this well. Have you noticed that McDonald's (MCD) only sells Coke products, while Pizza Hut (YUM) only sells Pepsi? With these exclusive deals, competitors are blocked from those roads of distribution, protecting profits for the established companies.

Consumer Goods - Summary

We've established the two best methods for sustainable high returns on capital for these firms - a strong and durable brand, and distribution advantages. Also, we've seen how it's important to be able to separate a fad from a lasting trend. Consumer goods companies can make great long term investments - just ask Warren Buffett, whose investments in Coca-Cola, Anheuser-Busch, and Proctor & Gamble (PG) are legendary.

Magic Formula Business Sector Countdown

#9 - Energy

#8 - Software

#7 - Media

#6 - Consumer Services

#5 - Hardware

#4 - Industrial Materials

#3 - Consumer Goods

#2 - Healthcare

#1 - Business Services

MFI Business Sector Project

Disclosure: Steve owns COH

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