Two top stocks to profit from the 'lipstick effect'

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What is the 'lipstick effect' and how can investors profit?

If you want to measure the health of an economy, examine the lips. While perhaps not quite accepted economic science, the 'lipstick effect' is a theory that postulates when consumers face economic hardship, they are more willing to buy inexpensive luxury or discretionary goods.

We can see this effect repeated through history from the Great Depression, where cosmetic sales thrived, to more recently, where US beauty care sector grew in the recessions of 1990 and 2001.

RAB Capital also demonstrated the effect shows up in stockmarket returns; its data showed European personal products sector outstripping the broader market by an average of 100% in the recessions of the early 1980s, early 1990s and early 2000s.

This shows there is plenty of potential for anomalous gains in conditions where consumers are reining in expenditure, but still spending on inexpensive luxuries.

A case of history repeating?

As fears of political and economic uncertainty rise, we can see the effect taking hold on the British consumer. This week Visa announced UK consumer spending fell for the third month in-a-row in July.

I believe we will now see the effect accelerate, as consumers forego big-ticket purchases, such as furniture items or new cars, while maintaining or increasing expenditure on less expensive discretionary spending items.

We are already seeing signs of the effect hitting the stockmarket. Recently, DFS Furniture's (DFS) share price dived by more than 20% after its CEO blamed uncertainty around the general election for a profit warning.

The sofa giant saw a 'significant' reduction in store visits by consumers. New car sales have also been weak for four months, the longest series of declines since 2011.

Luxuries evolve to necessities

We are also seeing an evolving hierarchy of needs among British consumers. Once considered luxuries, treats, such as coffee and chocolate, are now necessities. Fortunately for investors, there are number of ways of gaining exposure to the lipstick effect.

Fever-Tree (FEVR) and Patisserie Valerie (CAKE) are classic examples where there is strong underlying growth potential, which is almost irrelevant to consumer expenditure, unless there is a serious economic downturn.

Fever-Tree is a radical market disrupter of the beverage mixers market. The business is driven by a passion to source the finest ingredients, in contrast with Schweppes which contains artificial saccharin.

While Fever-Tree's share price hit a recent record high, I believe huge growth opportunities remain.The overseas market offers huge potential. US expansion is perhaps the most interesting with current market share minimal but growing at 29%.

The recent introduction into Walmart (WMT) should increase this rate significantly. New product innovation continues with the company releasing its own premium cola. Its rating remains high with a price/earnings (PE) of 57 times 2018 earnings, but forecasts look very conservative and substantial upgrades are likely.

In the eyes of the British consumer, spending 50p or £1 more on tonic if you are also buying a premium spirit is still seen as feasible in the current climate. The same case can be made for the coffee and cake market exploited by Patisserie Valerie.

Cocoa and coffee: grinding out returns

The core Patisserie Valerie brand continues its roll out and the format has further developed from the high street into Debenhams (DEB), service stations and other locations.

The company also has a number of other smaller brands in the early stages of potential roll out which adds to the growth mix. Management is high quality and backed by serial entrepreneur Luke Johnson as chairman.

As cash builds in the business, either a special dividend or more likely acquisitions are a possibility. On normal deal metrics and given the level of cash in the business any acquisition would be materially earnings enhancing.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.