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.

Stock stories and Risk-Reward bargains

Earnings season for Q4-FY2011 is now over. It was a mixed bag and these are the best times to accumulate fundamentally sound stocks when liquidity is running low and market is in nowhere-to-go zone. We have discussed valuation basics here. We now take a macro view on relationship between understanding stock stories and attendant valuation risks:

1. For very easy stock stories like strong Brands & mature FMCGs, the valuations remain very high vis-à-vis future business growth which may be average.
2. For easy stock stories like emerging Consumer plays, valuations are uncomfortably high with issues of sustainability of future earnings growth and/or risks of expansion or roll-out not happening as anticipated.
3. For nearly easy stock stories like established Pharma, valuations are high vis-à-vis muted revenue uptick, off-patents risks by 2012 and dependence on new research break-through.
4. For moderately easy stock stories like IT, valuations are tricky given defensive nature and good business models but affected by global uncertainties, attrition issues, poor volume growth, cuts in spend by clients.
5. For less than easy stock stories like Metals and Commodities, valuations may never catch up if your entry into the stock is at the wrong end of the economic cycle or ill-timed.
6. For difficult stock stories like Infrastructure/power, valuations are tough to comprehend in view of project execution challenges, land acquisition & environmental issues, capex requirements, longer gestation periods and reliability of fuel linkages.
7. For very difficult stock stories like Turnaround case or good company but management facing court case/ inquiry, valuations are also difficult since past earnings are no indication, financial impairment is difficult to assess but rewards can be equally big.

This is what makes equity investing interesting. I believe in bottom-up stock picking where valuations are fair to attractive, and in some cases they are compelling.

At this point, risk-reward trade-off favours the patient investor. Make the most of it!

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".