A consensus is building—valuations of FMCG companies have gone through the roof and one should avoid them now.
Before you make a move and start offloading FMCG stocks from your portfolio or avoid buying them in future, it’s time to run a reality check. After all, a helicopter view is important but often isn’t enough to take balanced and well-informed decisions.
The average of Price-to-Earnings (PE Ratio) of top 7-8 FMCG companies is 57. Therefore, valuations are frothy, undoubtedly. But when you see these valuations on the backdrop of historical performance and governance record of these companies, they don’t look out of the world. These companies have delivered moderate yet steady growth under challenging economic environment that prevailed even before the pandemic. Most of them have robust balance sheets, excellent pedigree of management and stability in business operations.
In short, valuations are expensive but to a large extent backed by impressive fundamentals. No other industry in India earns such impressive return on Equity (RoE) as these top 7-8 companies do.
Will the performance of all FMCG companies quoting at such lofty multiples be lackluster going forward? Or will there still be some winners (read outperformers)?
To find answers to these questions, one must look beyond just balance sheets and dive deeper in their businesses.
Coronavirus pandemic is reshaping business dynamics even for the most stable industries, such as FMCG. During the pandemic, consumer preferences have undergone a sea change. Now companies are busy analyzing how much of that would last beyond the pandemic and what should be their response to changing customer behaviour.
As you must have noticed, almost all companies have been sensing a huge opportunity in the health and hygiene segment. The established brands will have the tailwinds of market experience, brand name and already developed distribution channels. Some companies have been slashing prices, at a time when, the market is likely to turn cost-cautious, thereby making it difficult for the late entrants.
Food accounts for approximately 35% of India’s GDP of which just 20% is packaged food and 10% is value-added. According to BusinessWire—a Berkshire Hathaway company, the Indian fruit and vegetable processing industry will become a Rs 25,600 crore industry by FY23—which translates into a compounded annualised growth of 8%. Despite India being one of the largest producers of fruits, vegetables and milk, the food processing industry is still extremely underdeveloped.
HUL derives 20% of its revenue from the food and refreshment category while the segment accounts for 16% of Dabur’s revenues. Won’t these companies focus more on the food segment if they sense greater opportunities?
Labour shortage, closure of small retail shops, roadside pan shops and tea-stalls might disturb the math of some companies. Try to recall which FMCG products people bought the most from these channels—right from Re 1 candy to Rs-5 small biscuit packs and Rs-10 snacks items. Local manufacturers, road-side eateries are likely to lose out some market share to organized players offering packaged food.
In the personal care segment too, consumers are expected to become cost cautious. Premium brands may take some knock and thus might try to diversify into other product segments—a trend which is evident even now. Essentials is a subjective term and its interpretation changes from one market to another. For example, hair dyes and room fresheners might be luxury products for some consumers but might be essentials for others.
The claims of under-penetration in the rural areas don’t hold much ground if you analyse the reach of the top 7-8 FMCG companies even to the remotest part of the country. The higher per capita consumption, especially in the rural areas, might come only with a rise in income. Until then, higher rural penetration for companies in the rural areas would mean cross-selling and eating into one another’s market share or grabbing some share from the unorganized sector.
Besides stability of businesses and balance sheet strengths, higher PE multiples of FMCG companies also reflect the huge untapped opportunity. The market disruption caused by the pandemic has forced companies to go out of their comfort zones and try out new ways of sustenance and future growth—like what happened in the banking space about a few years ago. Many banks and NBFCs quoted at valuations never seen before; however, as long as they registered higher growth, remained lean on costs and kept their governance record clean, markets rewarded them.
Will that be the case with FMCG companies? Looks like. That said, when the valuations are high, one has to keep expectations moderate and more realistic. If you look upon FMCG companies to give stability to your portfolio and generate average returns; they might not disappoint you but hoping to see them generating supernormal returns may be too much of an expectation.
Please don’t forget, returns come through two components: PE expansion and higher growth. In the case of FMCG companies, there’s not much scope for PE expansion; therefore, the future growth has to be in line with expectations.
Be selective, not biased.
You may also like to read: Banking stocks to bank on during and after coronavirus pandemic
Please Note (read as a disclaimer): None of the stocks discussed in the article is the recommendation to buy, hold or sell. This could just be the starting point for deeper analysis that you might want to carry out on your own. You may also take professional help as you feel appropriate.
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.