Introduction

After four years of lacklustre performance in both revenues and profits, the FMCG sector managed to get back on track in 2005. However, in 2005, smaller companies walked away with larger gains, as far as return on investment in these stocks is concerned. Also, their market shares have improved considerable, mainly at the cost of their larger peers and in some cases, regional players.

As can be seen from the graph below, after almost three years, the FMCG sector managed to outperform the benchmark index this year, indicating renewal of investor’s faith. Rs 100 invested in the FMCG index would have yielded 53% return by the end of the year, while the same investment would have fetched 9% lower if invested in the benchmark index, which is indeed a feat. At the start of the year, the outlook towards the FMCG sector in general was skeptical.

What was different in 2005 as compared to 2004?

While 2004 was a difficult year owing to weaker demand and intense competition, this year, there was a reversal in trend and FMCG companies were able to get a larger share of the consumer’s wallet. Also, monsoons that play a vital role in influencing FMCG demand have been favourable. In 2004, detergent and shampoo major, P&G, decided to up its market share in the Indian market and hence, halved prices and took the battle to the market leader HLL. But in 2005, due to input costs pressures and unviable margins, both companies raised prices of detergents twice (by around 8%). The encouraging aspect is that the demand has sustained.

The sector outperformers…

As can be seen from the table above, Dabur and Pidilite were the sector performers in the FMCG space. As mentioned earlier in this article, the top four gainers are from the relatively smaller players in the FMCG sector. More so, these companies managed to outperform larger peers with the bottomline growing by 46% and 25% respectively. However, it must be noted that the latter had a stock split (face value of Rs 10 per share to Re 1), which increased investor interest in the stock. Godrej Consumers, the market leader in the hair colour segment, also managed to outperform the benchmark indices considerably. There were no laggards in the sector and even the bellwether, HLL, gained handsomely. Another development is that almost all FMCG companies (especially the smaller players) set up manufacturing units in backward areas, giving them excise and income tax breaks. This lowered the tax outgo and consequently, adding to the bottomline growth.

As can be seen from the table above, food stocks also followed the footsteps of FMCG stocks. The top three gainers outperformed the benchmark indices over two-fold (all from the tobacco sector). Despite health issues, a growing number of class-action lawsuits and higher prices, consumers still find tobacco products entirely seductive, all resulting in these companies making real fortunes. Tata Tea, the world’s second largest branded tea company, also outperformed the benchmark indices. The year saw the tea major dispose of its plantations business in the south, which was a big positive (plantations are typically high fixed cost affair). Also, the company’s investment in other group companies (adding up to around Rs 200 per share at the current market price) was also an attraction.

What to expect in 2006?

Since the growth prospects of the sector is closely linked to economy growth and income levels, investing in FMCG stocks with a short-term horizon of one year may not yield desired results. This is because, even if the macro variables are positive, there is a lag effect on the FMCG sector. For example, good monsoon in one year is unlikely to drive FMCG sales in the same year in a significant manner.

Given this background, one has to remember that the FMCG sector is a play on ‘India’s consumption potential’, which in turn is a function of competition, emerging of organised retailing and more importantly, is based on the depth and breadth of the consumption. By breadth, we mean the number of people buying soaps (from the organised sector as well as from rural markets). By depth, we mean, higher consumption by the existing consumer base (both in terms of moving up the value chain and increased usage). These are typically long-term drivers and therefore, one needs to be patient to realise the potential.

In our view, smaller companies will stand to benefit more from increased offtake, as they follow a simple strategy, give the retailer higher incentives than those given by larger brand owners, thus encouraging the retail shop owner to push their products more. But the investor has to choose the ‘right smaller company’. We suggest you to choose those smaller companies that have market leadership in atleast one segment of the FMCG sector and are expanding into new categories or aiming to increase market share.

All said and done, the environment will no doubt be competitive, but the FMCG sector is a ‘volume game’. Market leaders like HLL realised the pitfalls of focusing only on profitability in the last two years. Recent statements from HLL clearly suggest that the focus on increasing market share, even if it at the cost of margins. The implementation of VAT is another shot in the arm of the sectors. We understand that brands will become cheaper in the time to come, though the benefits will take a few years to filter in. Also, the smaller and unorganised players will lose the competitive edge, which in turn will benefit organised players.

FMCG companies need to understand that the top end of the pyramid is now deep enough to absorb expensive offerings. This creamy layer is affluent, equal to the western countries, and hence will require some kind of differentiation from the mass market. Hence, product differentiation and innovation along with technology and processes will be the critical aspects for growth. Also, Indian companies have now started to spread their wings in the overseas market and there are several examples of this. This is another growth area tapped by players, which will bear fruits in time to come.

The bottomline from an investor’s perspective is to have a balanced portfolio in the FMCG sector (large and niche players) to reap the benefits of the consumption story going forward. More importantly, the FMCG sector is not a high-return sector and to that extent, expectations have to be realistic.

To read our thoughts on year 2005 and our view for 2006, click here - Reflections 2005.