Time to lighten up on consumer stocks:: Business Line

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The market's dalliance with consumer goods companies has pushed up the stock valuations to unsustainable levels. It may be time to take profits in select stocks.

Even as it has taken a cynical view of most other investment ideas, the stock market has pursued the consumption theme with single-minded devotion over the last two years. Sectors such as fast moving consumer goods (FMCGs), retail, white goods, foods, fitness — all things, in fact, that cater directly to the ravenous appetite of the young Indian consumer — have seen their stock prices zoom. Price-earnings multiples have expanded, with institutional investors making a beeline to accumulate them.

But with these stocks delivering big gains for three years running, will the market's romance with consumer stocks last? We believe that, over a one-two year time-frame, it may not and suggest consumption-themed stocks where you should now take profits. Here are the four key risks to consumer stocks that investors may need to watch out for and the stocks that appear vulnerable to them.

SKY-HIGH VALUATIONS

While other sectors have woven in and out of market favour over the last three years, consumer stocks have firmly remained hot favourites. Evidence of this is available from the extent by which consumer sector indices have beaten the broader market.

The BSE FMCG has turned in returns of 25 per cent, the BSE Consumer Durables (CD) Index 23 per cent and the BSE Auto Index 36 per cent on a compounded annual basis in the last three years. That is three-four times the Sensex return of 9.5 per cent. In the last one year, while auto stocks have cooled off a bit, both the CD and FMCG indices have accelerated further, zooming by 28 per cent even as the Sensex barely moved 3 per cent.

All this out-performance, however, has come at a price. Valuations of stocks belonging to select consumer themes have shot up and now trade at a huge premium over the broader market.

A prime example of this is the BSE FMCG index, which now trades at nearly twice the price-earnings multiple of the Sensex.

Based on consolidated trailing 12-month earnings, the BSE FMCG index is at a lofty 35 times and the BSE Consumer Durables index at 23 times, compared to the Sensex' 17 times. In mid-2009, consumer durable stocks actually traded at a discount to the Sensex while FMCG stocks enjoyed a moderate 20-30 per cent premium.

This expansion in PE multiples has not been accompanied by any sharp change in profit growth rates. The basket of companies making up the consumer durable and FMCG indices managed a sales growth of 20 per cent, with a healthy but not spectacular profit growth of 15 per cent on a compounded basis in the last three years.

Above numbers prove that the stellar show from consumer stocks was led more by expanding PE multiples than by accelerating earnings. This flags two key risks for investors. One, with sky-high valuations, companies from these sectors have to step up the pace of profit growth over the next two-three years if they are to meet investor expectations.

Two, given their premium to the market, they will have to deliver much better growth than the broader listed universe as well.

Neither of this seems an easy task under the current circumstances.

CRACKS IN CONSUMER CONFIDENCE?

The investment case for consumer stocks was founded on the belief that Indian consumers, helped by the demographic shift towards a younger and more affluent population, will continue to drive strong volume growth. Several price increases taken by consumer companies in the last year have reinforced the view that they enjoy pricing power to pass on costs, without denting demand.

Both arguments are true in some measure, and have helped consumer companies deliver double-digit profit growth over the past year.

But with the challenges of high inflation and rising EMIs (pegged to interest rate hikes), whether consumers will ramp up their purchases or digest further price increases, is open to question. This suggests that most consumer goods makers may find it difficult to improve upon their current sales or profit growth.

Signals on flagging consumer sentiment are already palpable from the recent June quarter numbers and the outlook provided by companies.

Players in FMCG segments such as soaps, detergents, biscuits and shampoos have faced distinct slippage in their profit margins over the past few quarters because consumers in these segments clearly resisted price increases.

Retailers such as Trent and Shopper's Stop note that pronounced inflation is prompting buyers, especially in the mid market segment, to cut back on their discretionary purchases. Shoppers' Stop has seen a drop of 5 per cent in volumes in its department stores the latest June quarter with sales driven exclusively by price increases.

Even jewellery major Titan Industries warns that profit growth at the current pace (76 per cent in the June quarter) will be difficult to sustain. With both gold and diamond prices shooting through the roof, footfalls into stores have slowed.

For some consumer companies, input cost pressures remain an irritant too.

Marico Industries which has had to take hefty price increases on its hair oils over the past year, has seen a sharp contraction in margins in the latest June quarter; this trimmed profit growth to 15.3 per cent.

The above challenges suggest that consumer companies may find it difficult to deliver on the high expectations of the market.

This makes it a good time for investors to trim their bets, especially on stocks that trade at particularly stiff valuations.

LIQUIDITY RISK

A final aspect that pegs up the risks associated with consumer stocks is the liquidity factor. Though they have been feted by the markets and ardently pursued by institutional investors, consumption-themed stocks feature low float (non-promoter holdings).

Fund managers admit that even well-known names within the consumer space — Nestle India, GlaxoSmithKline Consumer and Britannia Industries — don't offer sufficient liquidity for institutions to accumulate them without causing a ripple in the stock price.

Low liquidity can pose twin risks to investors in a stock. When a thinly traded stock is actively chased by institutional investors, prices can rise disproportionately with demand.

Premium valuations too may hold up, not because investors believe the company's earnings prospects to be that bright, but because the large institutional investors would simply like to ride a rising tide.

Should institutional investors decide to take some profits, the fall can be equally sharp, as such sales will have a high impact on the stock price.

Stocks that appear vulnerable to the risks of low liquidity and float at this juncture are P&G Hygiene, Panasonic Home, Gillette India, Page Industries, Trent and Emami.

Each of these stocks featured promoter holdings of over 60 per cent and saw trading volumes of less than 50,000 shares on any given day last month.

Do they all offer ‘quality'?

If the market fancy for consumer stocks was triggered by fundamental factors, it has been further fuelled by the market's penchant for ‘quality' and ‘good governance'.

True, with few policy issues impacting their operations and no scam or controversy tainting their outlook, investors in stocks from sectors such as FMCGs, durables or retail may not need to grapple with the regulatory issues that sectors such as real estate or telecom do. But this perception has led to an indiscriminate marking up of consumer goods stocks, irrespective of their sector, parentage, market-cap range or quality.

Investors may need to exercise caution on several facets here. First, do small- and mid-cap stocks in the consumer space deserve to trade at similar valuations to large-cap stocks, given that mid-cap stocks have been pushed into a deep discount in the broader market context? Agro Tech Foods (PE of 46 times trailing 12 month earnings), for instance, trades at a premium over ITC or Hindustan Unilever.

PREMIUM UNJUSTIFIED

This can hardly be justified in light of the company's size (Rs 718 crore in sales against ITC's Rs 22,000 crore) or market capitalisation (Rs 1,041 crore to ITC's Rs 1.55 lakh crore). By the same yardstick, high multiples should also be unsustainable for stocks such as VIP Industries (27 times) Hawkins Cookers (30 times) with a market capitalisation of less Rs 2,500 crore.

Also, not all stocks in the consumer space may deserve a governance premium purely on the basis of multinational parentage. Though they have piggybacked on the consumer wave, companies such as P&G Hygiene (PE of 49 times) and Panasonic Home (73 times) in the listed space have only partial access to their parent's product portfolio, with promising categories (detergents, in P&G's case, and air-conditioners in Panasonic's) routed through unlisted subsidiaries of the parent.

Several companies in the retail space have uncertainties relating to restructuring of their operations or stake sales hanging over them.