Is There a Price Bubble Building in Consumer Stocks?

All the time, I get the question consumer stocks are trading at such rich valuations and is there a bubble building up there? I did a post on same topic in 2011 here.

“Stay away” from these is the advice from some of the analysts. Graham worshippers and “Value investors” say these stocks are absolute no-no, and cannot be justified anyway you look at them.

There can be no two opinions about ultra-expensive valuations of consumer plays. At the same time, it can be intriguing to see every other investor taking shelter in these names despite such pricey tags. 

I, however, think it is important to appreciate the overall landscape in which consumer facing stocks are being evaluated by the markets:

1. Infra companies pack has been a disaster in their capital allocations and many of their acquisition and other decisions haven’t been financially prudent. Government alone cannot be blamed for policy paralysis and their sorry state.
2. Cash flows in power and capital goods companies are unreliable, or missing in some cases. Well established names of yesteryear are languishing at lows. A recent article on BHEL gave insight into the real situation, so much for a Navratna enterprise.
3. PSU stocks have not come out of overhang of OFS and dilutions, the woes of fundamentally strong companies like Coal India, NMDC and MOIL etc in mining sector are well known. Oil & Gas sector has some minor positive with reduction in diesel subsidy but it will take long before that makes any real impression on the stock prices.
4. Auto majors like Maruti have to stop production for a couple of days every now and then to cool off the supply mismatch. Entry of one Honda has changed the 2-Wheeler market dynamics for our Bajaj auto and Hero.
5. Pharma is a mixed bag. For an ace like Sun Pharma, we also have to live with a Ranbaxy that acts as dampener. Still, market is giving high multiples to well performing Pharma guys so long as they are performing.
6. Banks are somewhat of a divided house where many PSU banks are saddled with asset quality issues and trading well below book. Private peers are already priced in overvaluation zone in excess of 2-3 times book.
7. IT with some exceptions (HCL Tech, TCS, Mindtree) have failed to live upto promise of  volume growth. The stock uptick seem to be on account of currency moves rather than real operating performance.
8. No point discussing about real estate and the likes.

All the above tentativeness in market leaves us with consumer facing businesses in FMCG and Consumer durables. Yes, we are talking about the likes of Nestle, HUL, ITC, Colgate, Britannia, Bata, Asian Paints, Berger Paints, Pidilite, Dabur, Emami, Bajaj Corp, GSK Consumer, Tata Global, Godrej Consumer, Marico, TTK Prestige, Hawkins, P&G, Gillette and so on.

Now, question is what is distinguishing these from the rest:

a.  Consistent cash flows, debt free (most of them), incremental capex is funded internally, no dilution,  high capital return ratios and decent pay-outs.

b.     Market very well knows that Nestle cannot grow at 30%+ anytime in near future but still gives it PE of 40. Such companies are like oasis in desert where “Predictability of Earnings” is the real PE decider not just the earnings growth.

c.   Domestic consumption stories are here to stay. A large middle class and growing number of consumers add to it. They can reduce some discretionary spend in inflationary times, ultimately that has to be realized in the market. After all, Chinese folks may not succeed selling hair oil and toothpaste in India.

d. Established consumer companies have strong brand power, distribution network and geographical penetration. Most of this is irreplaceable moat.

e.   Gestures from the parent shareholders to hike their stakes even at current levels like in GSK Consumer and HUL boosts market sentiment for investors (why will promoters not raise their positions when they have business growth compared to home turf, they take away high royalty payments of 1-3% and of course the dividends).

f.     In this kind of scenario, where do you think an emerging market fund looking to put money to work in India will invest, if not in these consumer stories?

In short, these consumer stories may have their ups and down and occasional performance blips. Broadly, this theme will continue to deliver earnings and premium multiples accorded by the market may not significantly shrink going forward. These are uncertain times and the way macro-economic scene is panning out, there may be bouts of sustained selling. That will again make participants look for defensives. 

No wonder, consumer facing businesses will keep the markets interested!

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.