Exercise caution before investing in FMCG companies right now
Valuations of fast moving consumer goods, or FMCG, stocks have run up
quite a bit and it may be time for a correction, say experts. While analysts are not denying that the sector will continue to grow, many say it's time to book profit and not invest.
For a sector that stood tall even during the dark market days after the 2008 financial crisis, and has continued to do well since, the current caution on the Street seems unfair. A closer look, and the gloom seems justified. Valuations of fast moving consumer goods, or FMCG, stocks have run up quite a bit and it may be time for a correction, say experts.
The sector is considered defensive, which means its stocks are in high demand when the markets are falling. The reason is simple. Irrespective of how the economy is performing, the demand for consumer goods, daily necessities like food and toothpastes, remains stable. During difficult times, people will reduce spending on discretionary items such as cars and air-conditioners but continue to buy basic essentials. This has held true since the 2008 crisis. But now, as other sectors revive , FMCG may not remain everyone's favourite.
LOOKING BACK
FMCG stock indices have been performing quite well with CNX FMCG index on the National Stock Exchange returning 28.94% and the Bombay Stock Exchange FMCG index rising 27.26% in the one year to 26 April 2013. Funds such as ICICI Prudential FMCG Fund and SBI FMCG Fund returned 18.08% and 26.75%, respectively, during the period. But will this rally continue?
"Most FMCG companies have discounted the 2014-15 numbers without confirmation of volume growth. The FMCG sector in India is well-poised, but you may see some negative surprises," says Sachin Bobade, FMCG analyst, BRICS Securities. Analysts say stocks in the sector are trading higher than historical valuations. Sustaining these will be a challenge. Expansion will be difficult, and the biggest risk is the price to earnings, or PE, ratio going down. The ratio, used to value a stock, measures how much the market is willing to pay for it compared to the company's earnings.
To understand why these high valuations might not be sustainable, we need to see why the sector has been in such high demand in the last few years. The main reason, say analysts, is high government spending, which been acting as a stimulus. Also, there are not too many sectors growing as fast as the FMCG sector.
"Government policies that have been positive for demand and strong economic activity until last year helped earnings of FMCG companies. Plus, there was demand for defensive stocks due to weakness in investment expenditure," says Ritwik Rai, FMCG analyst, Kotak Securities.
Another godsend has been falling commodity prices. For instance, in the January-March quarter, FMCG companies did well due to lower input costs. "Most FMCG companies that we track performed reasonably well in the last quarter despite the slowdown due to fall in input costs. This expanded operating margins. However, companies had to increase advertising and promotion spends to revive volume growth," says V Srinivasan, FMCG analyst, Angel Broking.
However, this has a flip side too. Lower raw material prices have given rise to competition from unorganised FMCG companies. This is because as raw material prices rise, companies in the unorganised space are unable to control costs due to lack of scale. When raw material prices fall, they make a comeback.
The government stimulus, too, may be running out. "Given that the government's ability to manoeuvre consumer demand is curtailed by fiscal deficit concerns, and sales are beginning to soften following inflation and weak income growth, the risks to earnings growth are rising," says Rai of Kotak Securities.
FUTURE MAP
Sustaining the present higher valuations will be challenging for FMCG companies. Also, the current base is high and so demand growth is not likely to be as high as in the recent quarters, say analysts.
Recently, valuations have been supported by promoters buying additional shares from the market. For instance, Hindustan Unilver's (HUL's) parent Unilever Plc wants to buy a 22.52% stake in the Indian unit at Rs 600 per share. The market price of the stock was Rs 595 on 13 June 2013. After the open offer, Unilever will hold 75% in the company. Similarly, in February, GlaxoSmithKline Plc increased stake in its Indian arm, GlaxoSmithKline Consumer Healthcare, from 42.3% to 72.5%. The deal, at Rs 3,900 a share, was valued at Rs 4,800 crore; the parent said it was part of a strategy to invest in the world's fastest growing market. These two deals have put further upward pressure on valuations of Indian FMCG companies, say analysts.
In addition, higher competition amid softening demand may weigh on profitability. "Competitive intensity could rise in a weakening environment as companies concentrate on volume gains, weakening profit growth further," says Rai of Kotak.
However, analysts are quick to point out that the growth will be not be bad overall, as India is still a low consumption country. It's just that the sharp rally over the last few years has made these stocks very expensive, they say. "Volume growth will stabilise and margins will expand, but not to the extent that we saw in 2012,"says Bobade of BRICS Securities.
BUY, HOLD OR EXIT?
While analysts are not denying that the sector will continue to grow, many say it's time to book profit and not invest. "We believe the FMCG sector as a whole is trading at fair valuations and hence have 'neutral' rating on the sector," says Srinivasan of Angel Broking. Others say the sector may start yielding negative surprises and hence it's a good time to reduce exposure. "Weakening profit growth due to competition could lead to de-rating. Therefore, there is significant risk that FMCG stocks, on an average, could yield negative returns in the next year or so," says Rai of Kotak.
"I think one should reduce exposure to the FMCG sector. The valuations are very high. There is risk that the rally will continue due to demand for defensive stocks, but there will be some correction going forward," says Bobade of BRICS.
While analysts do not deny that the volumes will keep growing, they are not bullish on FMCG funds. A complete exit is also not advisable due to the inherent stability of demand for FMCG goods. However, if you have a horizon of more than five years, you can hold your investments. But any fresh exposure is a NO.
The sector is considered defensive, which means its stocks are in high demand when the markets are falling. The reason is simple. Irrespective of how the economy is performing, the demand for consumer goods, daily necessities like food and toothpastes, remains stable. During difficult times, people will reduce spending on discretionary items such as cars and air-conditioners but continue to buy basic essentials. This has held true since the 2008 crisis. But now, as other sectors revive , FMCG may not remain everyone's favourite.
LOOKING BACK
FMCG stock indices have been performing quite well with CNX FMCG index on the National Stock Exchange returning 28.94% and the Bombay Stock Exchange FMCG index rising 27.26% in the one year to 26 April 2013. Funds such as ICICI Prudential FMCG Fund and SBI FMCG Fund returned 18.08% and 26.75%, respectively, during the period. But will this rally continue?
"Most FMCG companies have discounted the 2014-15 numbers without confirmation of volume growth. The FMCG sector in India is well-poised, but you may see some negative surprises," says Sachin Bobade, FMCG analyst, BRICS Securities. Analysts say stocks in the sector are trading higher than historical valuations. Sustaining these will be a challenge. Expansion will be difficult, and the biggest risk is the price to earnings, or PE, ratio going down. The ratio, used to value a stock, measures how much the market is willing to pay for it compared to the company's earnings.
"Government policies that have been positive for demand and strong economic activity until last year helped earnings of FMCG companies. Plus, there was demand for defensive stocks due to weakness in investment expenditure," says Ritwik Rai, FMCG analyst, Kotak Securities.
Another godsend has been falling commodity prices. For instance, in the January-March quarter, FMCG companies did well due to lower input costs. "Most FMCG companies that we track performed reasonably well in the last quarter despite the slowdown due to fall in input costs. This expanded operating margins. However, companies had to increase advertising and promotion spends to revive volume growth," says V Srinivasan, FMCG analyst, Angel Broking.
However, this has a flip side too. Lower raw material prices have given rise to competition from unorganised FMCG companies. This is because as raw material prices rise, companies in the unorganised space are unable to control costs due to lack of scale. When raw material prices fall, they make a comeback.
The government stimulus, too, may be running out. "Given that the government's ability to manoeuvre consumer demand is curtailed by fiscal deficit concerns, and sales are beginning to soften following inflation and weak income growth, the risks to earnings growth are rising," says Rai of Kotak Securities.
FUTURE MAP
Sustaining the present higher valuations will be challenging for FMCG companies. Also, the current base is high and so demand growth is not likely to be as high as in the recent quarters, say analysts.
Recently, valuations have been supported by promoters buying additional shares from the market. For instance, Hindustan Unilver's (HUL's) parent Unilever Plc wants to buy a 22.52% stake in the Indian unit at Rs 600 per share. The market price of the stock was Rs 595 on 13 June 2013. After the open offer, Unilever will hold 75% in the company. Similarly, in February, GlaxoSmithKline Plc increased stake in its Indian arm, GlaxoSmithKline Consumer Healthcare, from 42.3% to 72.5%. The deal, at Rs 3,900 a share, was valued at Rs 4,800 crore; the parent said it was part of a strategy to invest in the world's fastest growing market. These two deals have put further upward pressure on valuations of Indian FMCG companies, say analysts.
In addition, higher competition amid softening demand may weigh on profitability. "Competitive intensity could rise in a weakening environment as companies concentrate on volume gains, weakening profit growth further," says Rai of Kotak.
BUY, HOLD OR EXIT?
While analysts are not denying that the sector will continue to grow, many say it's time to book profit and not invest. "We believe the FMCG sector as a whole is trading at fair valuations and hence have 'neutral' rating on the sector," says Srinivasan of Angel Broking. Others say the sector may start yielding negative surprises and hence it's a good time to reduce exposure. "Weakening profit growth due to competition could lead to de-rating. Therefore, there is significant risk that FMCG stocks, on an average, could yield negative returns in the next year or so," says Rai of Kotak.
"I think one should reduce exposure to the FMCG sector. The valuations are very high. There is risk that the rally will continue due to demand for defensive stocks, but there will be some correction going forward," says Bobade of BRICS.
While analysts do not deny that the volumes will keep growing, they are not bullish on FMCG funds. A complete exit is also not advisable due to the inherent stability of demand for FMCG goods. However, if you have a horizon of more than five years, you can hold your investments. But any fresh exposure is a NO.
