Consumer Stocks – Do Product characteristics of business matter?

There is a lot spoken about the boom in consumer stocks, the hyper valuations these consumer stocks are quoting at in the markets, demographics of Indian economy, ever growing middle class, etc.  In all this noise, one aspect that I find generally ignored is that there is very little discussion on the product characteristics of business or consumption patterns from the investing standpoint.

I mean all “consumer facing” businesses cannot be clubbed into one large basket with skyhigh price multiples assigned. After all, they are different breeds and animals which will find their own paths over a longer period of time. Let us analyze this little deeper from view of consumption pattern:

1. Consumables vs Durables – The most obvious distinction to be made when discussing consumer businesses is consumer goods in contrast with consumer durables.  While both the segments are witnessing growth, it’s the consumer goods (FMCG) theme that keeps adding new product categories that were not present before. For instance, we see in the marketplace a host of anti-ageing creams, beauty products, differentiated food supplements, health drinks with a thrust on premiumisation not seen before. FMCG industry in India is projected to become Rs 4 lakh crore industry by the year 2020.
2. Brand stickiness – With rising per capita income and growing rural prosperity (relatively speaking), there is a structural shift in consumer demand towards brands and organized products. Brand play is more evident in consumer products that any other product category one can think of. The chances of your changing your toothpaste or soap brand every single time one purchases is very less. Generally, consumer tend to stick with their brands as they get conscious of the segments and lifestyles.
3. Repeat purchase – To put it simply, the consumables vanish after one use, necessitating repeat purchase. You need a toothpaste, soap, detergent, hair oil (ok, till you have hair on your head) pack after pack all your life. That sounds simplistic, isn’t it? But that’s a fact and the business opportunity these guys are looking at. On the other hand, in durables segment with longer shelf life there is an onslaught from the Koreans & Chinese making life difficult and margins thinner.
4. Fashion & technology trends – Consumer preferences change with the times and need for innovation is a constant. Growing youth population is very conscious of what they consume.  At the minimum, re-packaging in different SKUs and appealing advertising is a must. We have seen even some of the giant companies of yesteryears (like Kodak) getting marginalized due to not keeping pace with ever-changing technology.
5. Target User group – I include it here from the viewpoint of total addressable market and the ultimate growth. If you’re talking about shaving blade & products, half of the population (female folks) is straightaway not the market. Of the remaining, you have below 16s who don’t need to and beard-sporting who don’t prefer to shave. Come to think of it, a toothpaste or soap company has no such limitation on its addressable market – entire country is its market. So the point is, other things being equal, would you like to give a PE multiple to a razor company as high as to a toothpaste company.
6. Staple vs Discretionary – Another important distinction to be made is consumer staples vs consumer discretionary products. Demand for consumer staples doesn’t decline appreciably with seasons and cycles. With increase in inflation and pressure on disposable incomes, discretionary spends are the first to be curtailed by consumers. Jewellery is one such discretionary spend, except for marriage type of purposes. Of course, the recent spurt in jewellery stocks doesn’t seem to support my view, and these are rocketing like no tomorrow.
7. Market positioning – Leadership in market position backed by brand power ensures steady growth. The market leaders have generally the first-mover advantage in introducing new products and break-through technological processes given their superior product portfolios. It imposes high entry barriers for new players.  With competitive intensity in consumer space, market leader companies are constantly looking for volume growth, maintaining their market position and guarding that distance from their next competitor (in market share).
8. Pricing Power – Strong consumer companies are in dominant position in their respective categories and command significant pricing power. For example, tobacco & IMFL (I personally avoid both segments for reasons of socially responsible investing) companies demonstrate that kind of pricing power since their consumers are habit forming and keep coming back. Similarly, baby food is a near monopoly for Nestle that gives them pricing power.

There are a lot many factors however, in financial and management terms, and some of the determinants of PE we discussed in a previous post here and here.

In conclusion, I’d say it’s important for a retail investor to be mindful of the product characteristics of the business and consumption patterns while analyzing a business : the addressable market, the seasonality & cyclicality attached to the products, strong brand or absence of it, market positioning & pricing power, any moat that protects the premium positioning.

Consumer stocks – are we reaching a bubble territory?

Broader market indices are not near their all time highs as yet. But a number of consumer stocks are quoting at all time high or near that. To illustrate the point, let us take a look at few of them below:

                                                                       

S.No.	Stock	CMP as on 22/07/2011	P/E ttm
1.	Jubilant Foodworks	869	78.16
2.	Gillette India	2,247	70.72
3.	Procter & Gamble Hygiene	1,973	50.99
4.	Nestle India	4,309	47.64
5.	Titan Industries	221	45.71
6.	Page Industries	2,291	43.66
7.	Zydus Wellness	648	42.01
8.	Dabur India	111	41.14
9.	Talwalkars Better Value Fitness	243	39.56
10.	Britannia Industries	480	39.48
11.	Asian Paints	3,110	38.45
12.	TTK Prestige	3,102	37.66

                                    Source: Money control

The questions that arise in the mind of an investor then are –

• Are these stocks reaching a bubble territory or do they still have more steam left?
• If you have missed the bus, will an entry now make money?
• When will the valuation cycle reverse for these & other consumer stocks, if at all?
• If invested, should one exit these stocks at present moment?

No easy answers there and nobody can guess the precise moves of Mr Market. On top of that, how stock price behaves in the short term is guided by so many factors – volumes, technicals, sectoral triggers, liquidity besides stock-specific fundamentals. You would notice that these stocks are not capex intensive, command high capital return ratios and generally debt-free or low debt companies.

Having said that, I would say high point of valuation in consumer stocks would be marked by the following factors:

1. Peaking interest rates: We are still some time away from the peak point in the interest rate cycle. RBI will continue the monetary tightening with at least a couple of interest rate hikes looming on the horizon. What remains to be, however, seen is whether the regulator goes ahead with straight hikes in the next few months or takes a pause in between or makes use of other monetary tools at their disposal.
2. Pick-up in investment demand: Linked to interest rate cycle is the investment demand and its drivers in the domestic economy. We hear that credit offtake by Corporate India has slackened and may take a few quarters before the trend comes back.
3. Next secular run in the market: You must be wondering why I have included this as a factor. Well, at the moment, it appears as if investors are chasing same few consumer stocks which are low on floating stock. But we can’t blame investors – they find safety in these domestic companies which are debt-free and FCF positive particularly when interest rates are high. Moreover, being domestic consumption themes, these are relatively insulated from global vagaries. This leads us to the next stage. So whenever we see the next secular run in the market, we’ll find liquidity chasing more number of large cap stocks; with the result that the scarcity premia for consumer stocks will ease out and their valuation likely to stabilize.
4. Growth in earnings: As above developments roll out in next few months, the consumer stocks will be watched by the marketmen for their earnings coming as anticipated or falling short of market expectation. It is possible that a few consumer stocks involving discretionary spends could face greater pressure on earnings growth and valuation multiples might be dented in such a scenario.
5. Brand power will stay: Most of them are strong brands, some with good MNC parentage which have traditionally traded at significant premium to the index and may therefore maintain their market position.

It will, therefore, be wrong to paint all of them with the same brush. Companies that have an established track record over last many decades are there to stay. For instance, Nestle India is going to complete 100 years in the country, that’s no small achievement. The company has excellent management, very high ROE, great brands, distribution network and backed by high quality business. Such a company will always trade at premium valuations. Can this multiple soften, well it can.

The bigger concern is for some of the less established consumer names (not necessarily from above list) where investors will do well to exercise caution and keep a tab on the earnings trajectory in the coming quarters.

What drives PE of a Stock

While dealing with the topic of valuation measures in the previous post, we discussed Price-to-Earning (PE) multiple. In the simplest terms, stock price can be seen as product of EPS and PE as given below:

1.       Stock price = EPS ttm  x PE ttm

2.       Stock price = EPS forward x PE forward

In equation (1), EPS and PE ttm are trailing twelve months say for FY2011 at this point.

In equation (2), EPS and PE are 1-year forward, for FY2012 (sometimes 2 year forward say for FY2013).

EPS is known or quantifiable. For FY11, EPS ttm is already known from the financial results. On forward EPS, many companies/their managements like Infosys give guidance for next fiscal i.e. FY12. Moreover, analysts work out earnings estimates for most companies based on revenue growth, margin structure etc. In other words, forward earnings estimates are known to the markets though these estimates can go for a toss due to factors such as business under-performance, hikes in raw material price, margin pressures, equity dilution during the year and so on. Still, a broad idea on forward EPS is available.

That means in both the above equations, we have PE as the real unknown. One more way of looking at PE is as the number of years it will take to earn back the initial investment. Having said that, PE ttm in equation (1) is just a derived figure since EPS ttm is known and fixed in history. That leaves the forward PE in equation (2) as the magic number or the X-factor that makes investing difficult since forward earnings are uncertain and nobody can be sure whether markets are going to de-rate, maintain or re-rate this PE multiple with the passage of time.

So, the question is what drives this forward PE?

Well, a lot of factors including the following (listed not necessarily in order of importance):

(a) Earnings growth rate trend;

(b) Sustainability of earnings in future;

(c) Return on capital (ROE/ROIC/ROCE);

(d) Free cash flow generation;

(e) Barriers to entry;

(f)  Status within industry : leadership/also-rans/laggards;

(g) Peer comparison & positioning;

(h) Cyclical trend;

(i)  Management trackrecord;

(j)  Shareholder friendliness of management– dividend policy, bonus/rights;

(k) Sectoral outlook;

(l)  Trading volume: like index constituent, FnO trading;

(m) Market perception & sentiment.

Different determinants have varying influences and dynamics. Big money is made when you hold a stock whose PE is being re-rated by the market and one is lucky enough to spot it before that sets in, and hold it through this process. TTK Prestige is a recent example which got phenomenally re-rated by the markets in 2010.

Ultimately, it's the sum total or interplay of different factors that makes up the PE and market keeps adjusting it on a daily basis.

Understanding Valuation Measures

Valuation is at the heart of all fundamental investing in stocks. It is a science as much as it is an art. The subject is vast and fit for writing a book rather than a small post. For the moment, I will do the easy stuff, a short post for the benefit of new investors.

Let us briefly look at some important valuation measures:

1. P/E: defined as CMP/Diluted EPS where CMP is current market price & EPS is the earning per share. 

Getting it:

Price-to-Earning (P/E) ratio or P/E multiple is the most commonly used indicator. It shows the number of times that the price of a stock is trading relative to its earnings. You can generally find the PE of listed stocks in business newspapers or journals. The best however, is to work out the EPS oneself from the published financial results so as to understand the nuances. Price quote of the stock can be easily found on daily basis from NSE/BSE website or other media sources. Alternatively, EPS can be checked from financial results and/or annual reports published by the company, and P/E can be computed dividing current price by the EPS. For example, Infosys had EPS of Rs 119.40 for FY11, so at a price of Rs 2,906, P/E multiple works out to 24.3.

Making sense of PE:

Low PE ratio stocks are characteristic of either mature companies with low growth potential or companies that are undervalued or in financial distress. Conversely, high PE stocks could be characteristic of high growth companies or very expensive or risky stocks. In that sense PE gives a broad indication of how expensive a stock is, relative to its earnings. Low PE by itself is rarely a sufficient ground to consider a stock undervalued or vice versa. Above discussion is generally for earnings in past financial year or for last 12 month period (trailing twelve months referred as EPS ttm), both of which are rear view mirror.

Remember, markets are forward looking and generally discount the future – the earnings, the growth, the sustainability of earnings etc. So, drawing inferences merely on basis of trailing P/E is not proper. Forward P/E estimates for next FY are quite prevalent. In bull markets, it's not uncommon to see analysts stretching it further and justifying valuations of a stock as acceptable talking about PE on basis of 4 years into the future, say 15x FY2015 earnings estimates.

I will not comment on how high is high PE. Suffice to say, currently the PE of BSE Sensex is 21.02 and that of NSE Nifty is 21.94. Their historical values are also available on exchange websites.

Linking P/E to Growth brings us to PEG ratio that is obtained by dividing P/E by expected growth. Stocks with a low PEG Ratio of say below 1 are seen as better value, even if their P/E is higher, by virtue of the implied value of future earnings. On the same example of Infosys, if the growth rate is 10% (just for illustration), then PEG would be 2.43.

I realize covering each of the valuation measures in some depth will require a very detailed write-up or multiple posts. So I just give the definition for the rest.

2. P/BV: defined as CMP/Book value per share where denominator is Shareholder's equity/Actual number of shares.
3. P/S: defined as CMP/Sales per share where denominator is Annual sales turnover/Actual number of shares.
4. EV/EBIDTA: defined as Enterprise value /EBIDTA where Enterprise value = Market Capitalisation + Net debt + other long term liabilities like pension liabilities, deferred tax etc.
5. EV/Sales: defined as Enterprise value/Sales
6. Dividend yield: defined as Annual dividend per share/CMP.
7. FCF yield: defined as FCF/Market cap where FCF or free cash flow is Cash flow from operations – Total capex.

By no means, above list is exhaustive, and as I mentioned before this is a subject by itself. But as we say if investing could be reduced to mere ratios, quants or mathematics, everyone plugged into numbers would have been super-rich. But that's far from reality simply because valuation is not a number game. Sometime later, I will make a post on sectoral perspective to valuation. 

I conclude with a quote from Philip Fisher:

"The greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than the industry as a whole".