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  • DECEMBER 7, 2005

FMCG: What to look at?

With the indices trading close to their all time highs and stock prices already factoring medium to long term growth prospects, investors should be extremely wary, as upside from the current juncture from a short term perspective is way lesser than the downside risk. Although one does not know the peak of the markets, anyone can get caught on the wrong foot and if discovered that the investor has entered at the peak, from that point all he can see is down, nothing up.

We are of the belief that, at the current juncture, investors need to avoid sectors that are cyclical in nature and are too dependent on government policies. Rather, defensive plays like FMCG can be looked upon. In this article, we discuss the parameters that investors should look at while investing in an FMCG stock.

Key financials and valuation ratios to look at:

  • Last 5 years revenue growth (CAGR): Look at the reason for the said growth. If encouraging growth has come about due to continuous new product introductions and growth in market share, it is an encouraging sign.

  • Operating margin trend: Determine what sort of margins the company is earning vis--vis its peers whether the trend is improving or is there a continuous decline. Find out reasons for both. If it is improving due to efficiencies in supply chain and product focus, it is encouraging. If it is declining continuously due to hike in expenses like those towards advertising, it is a sign of the company facing intense competition. However, if the margin decline is a blip and has come as a result of a new product introduction, it might be a good long-term sign.

  • Look at the company's cash flows and the working capital efficiencies. It will give an idea of the company's bargaining power as well as its ability to utilize its resources and supply chain.

    Look at the return ratios, especially ROCE (return on capital employed) trend. It will give an idea how effective the company is in optimising its resource strengths. Also, look at the dividend paying track record. A healthy dividend payout, i.e., the ratio of dividends to earnings, is also a good indicator of the company's willingness to share wealth with small shareholders.

  • It is also important to look at the P/E (price to earnings multiple) and market capitalisation to sales (price to sales), which the company is trading at vis--vis its peers. Growth oriented companies will most likely be trading at premium to peers based on these parameters. If so, then one has to gauge whether that premium is justified. If the premium is unrealistically high, then it may not be a good idea to invest at that juncture. After all, valuations have to justify the company's prospects.

  • One must also look at the past record of the management, its vision and its integrity. For it is the management finally, which is the decision maker and therefore the guardian of your interests in the company. If the management has a track record of being slow to react to market conditions, then the biggest distribution channel and the most diversified product folio may not give you your rightful share of the company's growth and profits.

  • Investment in R&D: It is known that FMCG sector is not asset-intensive in nature. All FMCG companies have to do is to make sure that their brands have a high recall value and if there is a high recall value, it is necessary to have the distribution strengths to capitalise on the same. Leave aside distribution, for a product to have a high recall value, all it takes is four P's (Price, Place, Promotion and Product). Like a pharma company invests millions into R&D to develop products, we believe that it is pertinent that a FMCG company spends adequately in advertising and sales promotion to have a high recall value with customers. To us, this is the R&D that is critical for any FMCG company.

Besides the above-mentioned points, one must also look at the company's logistic strength, product folio and its competitive strengths. The reason why these three factors also play a vital role is because, while the purchasing ability is a function of economic growth, awareness is a function of the product reach and its usability. It is in this context, that a company's logistics strength gains importance. But logistics does not only mean a company's reach in terms of retail outlets, it also means the level of sophistication of this distribution reach. How intelligent is this supply chain and how well geared is it for the company's future growth?

As far as folio mix is concerned, MNC companies form almost half of the branded FMCG industry in India. In case of MNC companies, therefore, it is relevant to look at the parent's support and commitment to its subsidiary before taking an investment decision. Again, support and commitment alone is not enough. Have a look at the parent's product profile and what are its plans for its subsidiary in India. If the parent itself is present only in a few categories globally, all its support is of little help owing to the product hindrance.

For all companies, be it domestic or otherwise, a look at the company's product introduction track record can be an eye-opener How many products has the company introduced in its years of existence and how relevant are they to India's consumer habits. Understand what are the future plans of the company.

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