Investors focused on U.S. packaged food stocks have been largely concerned with inflation since roughly 2004-2005. This is in contrast to the 20 years prior where benign to no inflation in agriculture existed. But with persistent inflation over much of the last 10 years, management teams and investors have come to expect mid-single digit increases in cost each year. Pricing has been taken and productivity programs ramped up to deal with the challenge of inflation. Yet with emerging markets slowing and possibly less consumers entering the middle class (typically with richer diets), improving stocks-to-use ratios for major crops and the potential for a stronger $US dollar along with moderating corn-based ethanol usage, it appears that 2014 and beyond could bring about no agriculture-based inflation and, in fact, a high likelihood of deflation.

Given this potential scenario, we decided to examine the issue of deflation in more detail. This report includes the following: (1) historical graphs that present data from 1995 to the present with periods of inflation and deflation as measured by moves in the corn crop, (2) U.S. packaged food stock performance versus the S&P500, (3) examination of select company gross and operating margins over the long term, (4) a closer look at 2010 which was the last period of material deflation for the industry, (5) implications to 2014 stock performance and discussion on valuation. In summary the data suggests that deflation is consistently negative for U.S. packaged food stock relative performance while periods of inflation are consistently positive.

Looking back over the last 20+ years, U.S. packaged food stocks have only moderately out-performed vs. the S&P500. While there are many reasons for the sluggish relative performance during extended periods, one critical question has been whether food brands still have pricing power? This is a key question given the rise of WalMart, increase in private label market share, fragmentation of consumer purchase behavior (i.e. low income dollar stores vs. high income organic-focused retailers) and lingering impact from the last U.S. recession (less pantry loading)

Eoin Treacy's view In an environment where prices for food commodities have been at historically high levels for a sustained period, packaged food companies increased margins by reducing the size of products and to a lesser extent passing on costs through higher prices. Additionally, globally oriented companies in the sector have benefitted enormously from the growth in the number of people with disposable income in Asia and the associated demand growth for snack foods. Logically, the extent to which lower future commodity prices impact consumer perceptions of food prices is likely to have a bearing on the ability of processed foods companies to continue to increase margins.

Campbell Soups (Est. P/E 17.62, DY 2.52%) generated 69.5% of its revenue from the US in 2012. The share posted a large weekly downside key reversal in May and continues to range below that peak. It will need to continue to hold above the 200-day MA if the benefit of the doubt is to continue to be given to medium-term upside.

Hershey (Est. P/E 25.3, DY 2.06%) generated 83.9% of its revenue from the US in 2012. The share encountered resistance below the psychological $100 last week, following an impressive rally, and a process of mean reversion appears to be unfolding. JM Smucker (Est. P/E 18.54, DY 2.15%) generated 90.1% of its revenue from the USA in 2012. The share has a similar pattern to Hershey.

Kellogg (Est. P/E 16.55, DY 2.94%) generated 67.2% of its revenue from North America in 2012.The share completed a multi-year base last year and has been consolidating that advance since May. It found support this week in the region of the 200-day MA and a sustained move below $60 would be required to question medium-term potential for additional upside. Conagra Foods (Est. P/E 14.33, DY 2.88%) generated 90% of its revenue from North America in 2012 and has a similar pattern to Kellogg.

Mead Johnson Nutrition (Est. P/E 23.58, DY 1.77%) generated 25.3% of its revenue from North America in 2012. The share has been largely rangebound for the last year following a sharp pullback in 2012. It will need to continue to hold above $65 if medium-term potential for additional higher to lateral ranging is to be given the benefit of the doubt.

Kraft Foods Group (Est. P/E 18.42, DY 3.77%) spun off its international operations into Mondelez International (Est. P/E 20.1, DY 1.79%) last year. Kraft Food Group has returned to test the region of the 200-day where it has found at least short-term support. Mondelez International has found support in the region of the 200-day on successive occasions since 2009 and a sustained move below the trend mean would be required to question the consistency of the medium-term advance.

Dean Foods (Est. P/E 19.19, no dividend) generated 97.1% of its revenue from North America in 2012. The share bottomed in 2011 following a steep decline and has trended higher for almost two years. It posted a large downside weekly key reversal three weeks ago and is now testing the region of the 200-day MA. It will need to find support in the current region if the medium-term uptrend is to continue to be given the benefit of the doubt.

Flowers Foods (Est. P/E 22.6, DY 2.04%) derives all its revenue from the USA. The share held a relatively mild upward bias from its IPO and accelerated higher October. It has at least paused in the region of $24 since May in what has been a relatively steady process of mean reversion. The benefit of the doubt can probably continue to be given the medium-term upside potential provided it continues to hold above the 200-day MA.

Regardless of whether the above companies are US or internationally focused, the most relevant consideration is that a process of mean reversion is underway and that valuations are comparatively high. This could potentially lead to some relatively lengthy ranging.