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FMCG: Buffett's pick

Feb 25, 2009

Their resistance to economic cycles has historically helped FMCG companies fetch relatively better valuations as compared to other sectors during economic downturns. But this is not the only reason why this sector has endeared itself to some of the most discerning investors like Mr. Warren Buffett. The legendry investor has been holding the stocks of several large international FMCG companies like Coca Cola, Procter & Gamble (P&G), Kraft Foods Inc (KFT), Hershey Foods and Wrigley William Jr. in his portfolio of investments for Berkshire Hathaway. In this article we reason as to what gives FMCG companies the edge to score over other sectors in terms of strong investment rationale.Easy to understand
FMCG companies' business is easy to understand. It is relatively simple and stable in character. A complex business causes difficulty in predicting future cash flows. The nature of the FMCG business supports Buffett's investment tenet of producing a robust projection. The products have a quick turnover, and relatively low input cost. The consumers think less while purchasing FMCG products as they are meant for daily requirements.

Low capex requirements
FMCG companies typically require very little incremental capex. They do not have to invest huge new capital in assets to grow earnings. That is what makes these companies so discreet in terms of capital efficiency. Further, they also have strong cash flows and a low debt to equity ratio. Most of the FMCG and food companies are debt free, thus not affected by interest rate cycles.

Strong competitive advantages
Mr. Buffett has a liking for companies which have durable competitive advantage as compared to being a price competitive or commodity type of business. As per his investment tenet, a business should be stable, simple and have sustainable competitive advantages over peers. Companies with these characteristics are highly likely to generate materially higher cash flows with the passage of time. These criterions are usually fulfilled by the FMCG companies. Their strong brands and multiple product innovations help them sustain their revenue stream over long periods. Also, the consumers buy the same product several times in a year.

Dividends
FMCG companies are also known to be generous payers of dividend due to their strong cash flow and minimal capex requirement. If the company decides to retain its earnings for future expansion, the retained amount should create equal market value. Buffett labels this as a 'one-dollar' premise.
Mr Buffett is especially proud of his investment in companies like Coca-Cola, whose brand has been successful for over 100 years due to its durable competitive advantages.
Further, the company enjoys global reach, economies of scale and high capital efficiency.

Vis-a vis
CompaniesBrandsTopline growth (%) Dividend payout (%) RONW (%)Capex as % of sales
HULWheel, Lux, Dove, Sunsilk, Ponds6.683.080.61.2
Nestle IndiaMaggi, Nescafe, Polo, Kitkat,Cerelac12.680.085.03.2
P&G IndiaVicks, Whisper8.071.042.01.3
GSK Consumers IndiaHorlicks, Boost15.036.022.01.5
Coca-ColaCoca-Cola, Fanta,Kinley8.552.929.74.6
figures are for average 5 years

As seen from the table, we have compared Coca-Cola with some of the Indian FMCG companies. These FMCG companies like their global peers have developed some strong brands, sustained stable growth, high dividend payout and high return on net worth (RONW). Also, the average 5 year capex to sales ratio is low indicating that these companies do not need huge capex to grow.


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