Is There Adequate Reward For The Risk In FMCG Valuations?

How does one assess the investment potential of a sector that in normal cycles is seen as the ‘best defensive play’ but now, amidst the most drastic disruption seen in our lifetimes, could be one of the few spaces where growth is relatively intact? As India has spent much of the last month under lockdown, the Nifty FMCG Index has clocked double-digit percentage gains, nearly twice that of the Nifty 50. For the year 2020 so far, the Nifty 50 is still down 24 percent despite the recovery in the few days, while the FMCG Index is down less than 5 percent year-to-date. Front-line companies like Hindustan Unilever and Dabur have been in the green for the same period.

So here’s the investor’s dilemma – how to evaluate companies that are labeled ‘defensive’, but whose valuations are anything but. ‘Growth at any price’ was a truism of 2019. But it is being questioned in 2020.

Why The Caution?

The sector posted 5 percent revenue growth in 9MFY20 vs an approximate 12 percent CAGR over the last 10 years, indicating a moderation in line with the GDP slowdown. Then, there is the year ahead, which could be full of landmines. In this Covid-19-and-after setting, while FMCG companies may fare better than a lot of other sectors, is there visibility on whether their growth trajectory will remain intact or taper down? Could we see a dip in staples consumption after a while due to income weakness and possible downtrading? Companies that are perceived as more resilient to near term-disruption, particularly the ones with a higher product share of essential products—like HUL and Nestle—have already seen a smart re-rating. Hence, whatever is obvious to the common eye as a possible winner is already priced richly, leaving little room for error.

Will Covid-19 Bring Down Utilisation Levels?

The fear is of the unknown. While companies have stepped up management of distribution channels through the lockdown disruption in April, one can safely assume that companies, as well as their distributors and dealers, are operating at sub-optimal levels.

And even when the lockdown lifts, we do not yet know what kind of restrictions may remain on the kind of movement that involves all levels of staff going in and out of factories and sales channels. Will the consumer, currently buying what's needed to ‘keep going’ for the next week or two, immediately resume spending on products that cater more to tastes than essential needs? Could these higher operating costs and low pricing power squeeze margins, leading to weaker profitability on top of moderate sales growth?

The Product Portfolio

Specific companies have their nuances. As infallible as the frontline FMCG companies may appear, investors should constantly review the risk-reward in the valuations that companies like HUL and Nestle trade at. Bajaj Finance’s 50 percent fall from the February peaks offers some caution to the ‘growth at any price’ mantra.

When the time comes to review the April to June quarter, the lockdown’s impact on food companies like Nestle and Britannia may have been lower as their products are essential products that witnessed stocking up by consumers. But even here, food companies are said to be operating at 20-25 percent levels.

Companies like Marico, and Emami to an extent, have over 50 percent of non-essentials in their portfolio, and would, therefore, have been at a relative disadvantage during the lockdown, compared to a Nestle or Colgate-Palmolive.

ITC has rallied, but largely in line with the index, and in tandem with the runup in global tobacco peers like Philip Morris. The trigger of a higher dividend payout is not a major event. On the flip side, investors should worry about the impact of the lockdown on cigarette volumes.

Among non-staple consumer goods, Asian Paints and other paint companies could face a loss of sales during the first quarter, primarily due to the lockdown and the general lack of re-painting jobs in the vacation months of May and June.

Mind you, as I’ve noted before, markets can stay irrational for longer than an investor can remain solvent. FMCG valuations could surprise further, and move higher still. Many argue that in the growth starved-era that we are in for the foreseeable future, money will chase the best of the worst. The best service that any investor can do to his or her portfolio is to constantly evaluate the risk-reward, and consider moving chips the market is pricing any sector or stock to perfection. Technology in 2000, infrastructure in 2008, and this year - blue-chip financials, all cautionary tales.

Niraj Shah is Markets Editor at BloombergQuint.