Will the underperformance in FMCG stocks continue? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Will the underperformance in FMCG stocks continue? 

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In this issue:
» Will the valuation gap between HUL and Sensex narrow down?
» Big ticket realty IPOs to come out soon
» Merger of HDFC and HDFC Bank on the cards?
» Flipkart valued 10 times more than India's largest retailer!
» and more....

00:00  Chart of the day
Defensives are the fall back options during times of gloom and uncertainty. As you would be aware, till the end of last year, FMCG stocks were the preferred pack on the back of their stable growing businesses, improving financial performances, higher payout ratios, etc. Not to mention the lack other good areas to invest in at the time. And in the process, pretty much the entire sector's valuations sky rocketed.

However, in the year till date, the BSE-FMCG Index has been amongst the worst performers, rising by only 5% during this period. In comparison, the BSE-Capital Goods and the BSE-Bankex indices are up by about 53% and 34% respectively.

It seems that a little over a month of the Modi government has completely changed the sentiments. And why not? After all, there are some signs of the scenario improving. These include higher commercial vehicle sales volumes, rising IIP numbers, improving trends in the manufacturing and services PMI, higher non-oil imports, all of which point towards the economy improving from here on.

Are these a start of a long term trend or just an aberration? Well... only time will tell. But the beaten down stocks from sectors that were least preferred towards the end of 2013 - have all been buzzing of late.

And in the process, the focus has shifted away from FMCG stocks, it seems! The chart below gives an indication of how allocation towards FMCG has been on a decline by Indian mutual funds.

FMCG: Losing favour amongst institutions?

While higher valuations may be one aspect, it is believed that FMCG companies are likely to see pressure on volumes given the higher inflation levels and the reduction in discretionary spending. Readers would do well to remember that not till long ago, the rural theme was moving along very strong. But the scenario has seemingly changed completely in recent times.

And in turn, it now seems to be the time for cyclical businesses. As mentioned in the Business Standard, automobiles, auto ancillary, cement, and capital goods sectors have all seen an increased proportion in mutual funds' holdings.

So... will this trend in FMCG stocks continue?

Let's take a look at a chart to help gauge this better...

HUL vs Sensex: Will the valuation gap narrow down?
Data Source: ACE Equity

As you can see from the above chart, at the peak of the previous bull run in early 2008, the Sensex and India's largest FMCG company Hindustan Unilever (HUL) were trading at similar valuations of about 27 times their trailing twelve month earnings. Fast forward to today - the difference in valuations between the two - while not at maximum level - continues to remain very high.

While the growth in earnings has had a role to play in re-ratings, the P/E multiple crossing the 40 times mark had a good amount of the sentiment element attached to it is what we believe.

For valuations to be justified, the earnings growth of the FMCG giant or FMCG companies for that matter will have to be quite strong, especially considering that the 'uncertainty premium' will no longer be attached to such stocks. Unless and until that doesn't happen, it seems that FMCG pack is likely to underperform, and in the process could see some correction. This would not necessarily be in the form of price correction, but could also be in the form of time correction wherein the prices stay stable for some time while the growth in earnings catch up.

Do you believe it would make sense to curb exposure to FMCG stocks? Let us know in the Equitymaster Club or share your comments below.

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First it was the electoral victory of the Modi government. Then came the RBI booster of relaxation in cash reserve ratio (CRR) and Statutory Liquidity Ratio (SLR) on money raised for infrastructure financing. And finally, now it's a BRICS bank which will soon be a reality. The idea of floating such a bank was tossed by India way back in 2012. But it got a go ahead in the recent leadership summit at Brazil. The bank will be funding the infrastructure financing needs of the member countries. Considering the fact that traditional sources of bank funding were proving to be inadequate, an inter-country bank such as a BRICS bank, will help channelising funds from surplus countries to ones who are in need. Also, since infra financing needs are long term in nature, there was a constant need of some special institution like the one proposed which could be tailor made and has sufficient liquidity at its disposal.

We believe that with the setting up of this bank India's infrastructure dreams could get a further fillip. With a pro-reformist government at the Centre, India can tap liquidity needs from BRICS bank to plug its funding gap. This opens up a completely new source of funding for India. Now what matters is execution. For that, we also have a government in place. While it may be too early to comment on the execution prowess of the new government, we hope that it at least does better than the previous one on this front.

However, the fact is that the entire infrastructure pack has rallied as financing woes have been seemingly resolved. And it seems that the market is confident that execution shall take place with a decisive government at the Centre. As a result, valuations of infra stocks have sky rocketed. While prospects may be improving and strong for the infra space, investors are however advised to exercise caution when investing in such stocks now.

It is supposed to be a match made in heaven! Anybody and everybody tracking the Indian financial sector have been looking forward to the merger of two most respected names in the industry. HDFC and HDFC Bank, are not just the most reputed players in housing finance and banking respectively. They are also the most consistent and well managed companies in India's financial sector. Needless to say both command valuations that are at a substantial premium to their peers'. So ever since ICICI Bank merged its parent ICICI, a development financial institution, with itself, there is speculation that the fate of HDFC and HDFC Bank may be similar. A merged entity, which could be a bank, can have lower cost of funds since it could take deposits. However, HDFC, being a non-banking finance company currently does not have to maintain CRR and SLR. With the RBI new guidelines, possibly post merger, HDFC Bank too will be allowed to not maintain the statutory reserves for long term lending. And that will make the merger viable and profitable for shareholders. At the current stage, however, investors should not take investment decisions in any of the stocks, based on the speculations about the merger.

That real estate companies have been badly affected in the slowdown is quite well known. Quite a few of these companies have seen inventories pile up as buyers chose to stay on the sidelines. The fact that many pockets in the country continued to report high prices did nothing to bolster sales either. Sagging sales and bloated debt on their books means that real estate developers have been strapped for cash. One option to raise funds was through the IPO route. But although developers such as Lavasa and Lodha among many others announced their intention of filing IPOs, these never really took off. Indeed, as per an article in Firstpost, in 2011 six big ticket real estate IPOs were expected to raise over US$ 2.9 bn. But these plans were deferred. Volatility in the stock markets was one of the prime reasons for the same. And now that stock markets have been buoyant over the past few months, these real estate players are eyeing IPOs once again. Hence, once these IPOs hit the market, investors will need to remain cautious. Many of the IPOs typically tend to get overpriced and it is quite possible that this will be the case with real estate IPOs as well. Ultimately, the analysis for IPOs in no way defers than what you would do if you were to invest in already listed stocks. In other words, invest in the IPO only if you are convinced of the strength of the management and business model and only if the valuations are reasonable.

Is this a case of throwing good money after bad? Or maybe the investment bankers advising Flipkart for its possible American listing are seeing something we don't. A leading daily reports how the online e-commerce giant has put a value on the business of close to US$ 5 bn. Now, the first thing an investor does when presented with a valuation of a firm is figuring out the P/E ratio. However, Flipkart is still making losses and therefore this option gets thrown out the window. But what left us exasperated is the fact that its valuation is a whopping 11 times more than that of Future Retail, the largest brick and mortar retail company in India! Of course we understand that the two business models are as different as chalk and cheese maybe. Online retail is a far less capital intensive business than having physical retail operations. And the growth potential of the former is also huge. But to be valued more than 10 times when the total revenues are just half of Future Retail is taking it a bit too far we believe. The only way this can be justified is by assuming very high growth rates for Flipkart going forward. But with a company that's still not making profits with all the growth it has had in the past, there are many things that need to go right for shareholders to make any money at US$ 5 bn valuation. We for one would certainly not want to take such a risk.

The Indian stock markets remained flat during the post noon trading session. At the time of writing, the BSE-Sensex was trading down by 4 points. Barring stocks from oil and gas, auto, banking and realty spaces, all the sectoral indices were trading firm led by power and metal stocks. Most of the Asian indices were trading in the red with Taiwan being the top underperformer. European markets opened on a weak note.

04:55  Today's investing mantra
"In any business, there are going to be all kinds of factors that happen next week, next month, next year, and so forth. But the really important thing is to be in the right business." - Warren Buffett
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