It’s well-known that valuations of India’s fast-moving consumer goods (FMCG) companies are outrageous. This column had pointed out last month that valuations look out of whack especially when you bring earnings growth into the picture. Dabur India Ltd’s shares, for instance, trade at 43 times forward earnings, even though earnings growth in the past two years has been puny at 6% and 4%. Of course, cheerleaders will point out that investors are pricing in future growth potential, but we’ll come to that canard in a bit.
For now, here’s some more evidence that FMCG stocks are living in a parallel universe of their own. Analysts at Bank of America Merrill Lynch point out in a note dated that 19 June that valuations of FMCG or consumer staples firms have diverged materially compared to similar firms in other emerging markets (EM). For most other sectors, there remains a strong correlation between valuations of Indian stocks with their EM peers.
It’s not that investors and fund managers go scrutinizing every deviation between Indian and EM valuations, although in this case it must be said that India’s consumer staples stocks really stand out. What gives?
To cut to the chase, what all of this means is that at current levels, the Indian markets offer investors precious little in terms of stocks that are high quality and are also reasonably valued. There is a fair bit of uncertainty on the global macroeconomic front, which coupled with the edginess around India’s own upcoming elections is leading to a pursuit of high quality and so-called defensive stocks.
The numerous accounting and other scandals have only matters worse in terms of the investible universe for institutional investors. FMCG stocks, with valuations of 40-60 times earnings, are providing strange comfort in these times. So are some other stocks such as private banks, for instance.
In the case of consumer staples, investors are betting on a revival in growth based on an expected upswing in rural demand. But the head of research at a multinational brokerage points out that this belief isn’t grounded on available evidence. While there are recent signs of a pickup in demand, investors should be careful about extrapolating it for all companies, he says.
For instance, tractor sales have been strong, pointing to strong rural demand. But this has been partly driven by outsized subsidies by some state governments; as such, it will be foolhardy to expect rural sales to pick up for all companies.
Consumer staples, in particular, have also gained from the cut in goods and service tax (GST) rate from 28% to 18% in some categories. This translates to effective price cuts, which has also led to volume increases as well as margin increases for some companies. Hindustan Unilever Ltd’s recent results show how it has made the most of the new GST regime. But GST related gains can be temporary, and it remains to be seen if volume growth remains strong once the base effect wears off.
Most importantly, rural incomes are under pressure because of poor realizations for many crops, and this factor may most influence rural demand.
The most likely reason FMCG stocks don’t reflect these concerns is the so-called TINA (there is no alternative) factor. Among various concerns investors are confronted with, it appears they are willing to live with concerns on the valuation front as long as other risks are relatively low.
What all of this means is that the markets are precariously placed—after all, if a company growing earnings in single-digits is being valued at over 40 times forward earnings, it’s obvious that the margin for error is very, very thin.
But who knows, this trust in future expectations may well get pushed out further into the future, if things don’t exactly work out the way investors expect them to. That’s how things have been the past couple of years, in any case.