The Market is Completely Wrong About This Sector

Oct 13, 2017

Rahul Shah, Editor, Smart Contrarian

'It ain't so much the things we don't know that get us into trouble, it's the things we do know that just ain't so.' - Unknown

Most investors focus on making money by 'knowing' things....

What will the company's growth rate be next year?

Has the cycle turned?

Is the slowdown over?

What will GDP growth be this year?

Which is the industry of the future?

Good contrarians on the other hand...theirs is a different approach. They specialize in the art of spotting things that most investors are sure they already know, but that just ain't so.

And why I find this area particularly interesting is because of the prices it produces. The silliest, most preposterous prices (both on the upside and downside) are produced when the rank and file of stock market investors are totally and absolutely convinced of a certain thing.

Take fast moving consumer goods (FMCG) companies in today's market.

Investors seem absolutely convinced that consumer franchises with big name brands are the kind of stocks you put in the safe and throw away the key. Their consumer brands are supposed to provide them with the moat needed to generate high returns on capital, forever. Valuations - what's that?

Look what this surety has produced:

Company Name Trailing twelve month PE ratios (x)
Gillette India Ltd. 74.4
Nestle India Ltd. 69.8
Britannia Industries Ltd. 59.2
Hindustan Unilever Ltd. 56.9
Marico Ltd. 53.3
Godrej Consumer Products Ltd. 52.6
Colgate-Palmolive (India) Ltd. 50.4
Godfrey Phillips India Ltd. 49.0
Dabur India Ltd. 44.6
Agro Tech Foods Ltd. 43.4
Data Source: Ace Equity

Heck, forget individual companies - even the BSE FMCG index is trading at a price to earnings of 41x!

Now, of course such companies have many things going for them. It's an industry that is commonly considered immune to most of the disruption in the rest of the business world. And it has been so far.

But are all these things really so immune to disruption that no price is too high for their stocks?

A few changes happening now could mean that in five, ten years, such companies' positions could possibly be nowhere near what they have been all these years...

In the Indian context, these changes are being brought mainly by the internet, and the rise of big retailers. And the bigger the internet and these retailers get, the more traditional consumer brands end up under siege.

So far, their models have been built on enjoying massive economies of scale that let you have brands so big, and distribution channels so well entrenched, that budding competition didn't stand a chance. Having these two in place at such a large scale meant that no one could argue with these companies. Whether it's the guys who supply to them, or the ones who buy from them, these companies always dealt on their own terms. Profits flowed as a result.

Will FMCG Goods Keep Flying Off the Shelves Even When the Rules Change?

The internet, however, is changing the rules.

Unlike the media of the past, you don't need mind-boggling budgets for marketing here. You can start as small as you like, and still have global reach. Same for distribution. You had to have stock physically accessible everywhere before, which demanded massive scale and complex distribution channels. Now, you can stock virtual shelves around the world on ecommerce websites without moving a single box.

The emergence and success of large retailers like D-mart also mean that such companies no longer enjoy unbridled bargaining power over the guys who buy from them. They can no longer have their cake, and eat it too.

These and related subtle changes to the landscape may possibly mean a very different future for such companies. Change is happening slowly - but steadily.

Now, they aren't going to get wiped out or anything. But the kind of prosperity they enjoy currently, well, that is no longer a given.

Their valuations on the other hand do not betray these vulnerabilities. They're extrapolating the past into the future, with just an iota of doubt.

It's the thing the market knows, that just ain't so.

Editor's Note: The market may not know, but we'll tell you who does. The Insider knows. To get on his list of inside info from across our in-house research, and to get our best recommendations, get on the Insider's list. FYI, he's only open for 3 days, so this is really your chance to get in.

Good investing,


Rahul Shah
Editor, Smart Contrarian

**********

Brain Food for the Day

PE Ratio Demystified

While analysts are always going on about PE ratios, many investors - especially those who've ventured into investing recently - find it difficult to wrap their heads around this important stock valuation tool.

So here's one of the simplest explanations for this ratio I've ever found. Here's Peter Lynch.

"The p/e ratio of any company that's fairly priced will equal its growth rate... If the p/e of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year ... and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown.

In general, a p/e ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative."

Well, now you know why we're extremely skeptical of the high PE ratios of the FMCG companies.

All the companies mentioned in the essay above trade at a PE of 40x or higher. This means they have to grow at a minimum of 40% per annum in order to justify the high PE multiples they are trading at.

Of course, the high multiples these companies command reflects the quality of their business models. But even after taking that into account, PE ratios are too high and cannot be justified by the growth these companies have enjoyed historically.

Image Source: Cuentapabro/ opinionesbroker.org/ commons.wikimedia.org

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1 Responses to "The Market is Completely Wrong About This Sector"

Atul Gupta

Oct 13, 2017

Dear Rahul...Is it growth of earning or toppling or both. I understand it should be earning.

Thanks

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