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Explained: With market in correction mode, should you buy FMCG?

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Explained: With market in correction mode, should you buy FMCG?

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During turbulent times on Dalal Street, investors often take refuge in sectors like FMCG, IT and pharma. In this explainer, we focus on FMCG stocks.

Explained: With market in correction mode, should you buy FMCG?
Benchmark indices are down around 10 percent from their peaks, and market experts are advising investors to either add or increase exposure to defensive stocks in their portfolios. Investors often take refuge in sectors like FMCG, IT and pharma, which are considered a safe bet during turbulent times.
In this explainer, we focus on FMCG.
What exactly are defensive stocks, and why are they called so?
Defensive stocks are ones that decline less when the market falls and rise less when it rises. They are essentially low momentum, long-term wealth creators with sound fundamentals, a predicable market opportunity and less volatility. The Indian consumption sector is one of the defensive sectors. Our large population, the presence of strong MNCs and great domestic companies in this space, low dependence, and external factors lend the defensive tag to them. Pharma and IT services are the other sectors considered defensive by investors.
Does it make sense to buy FMCG stocks at current valuations?
The FMCG sector has always traded at a premium of more than 2.5 times to the Nifty forward price-to-earnings (PE) multiple, so it’s always been expensive. Their long-term growth opportunity, strong balance sheets, and pedigreed promoters and managements are used as parameters to justify this premium. However, due to current worries of a rural slowdown, persistent inflation, heady valuations (3-4 times Nifty forward earnings in some cases) and opportunities in other riskier parts of the market – metals, PSUs and midcaps – these stocks had lost favour. Now with increasing worries in other parts of the market due to global central bank tightening, Omicron and expanding valuations in other sectors, the FMCG basket does look relatively attractive. The sector is now trading at 1.5-2 times Nifty earnings on an FY23E basis. Hindustan Unilever, for instance, after a 20 percent correction, trades at 48 times FY23 (estimated) earnings compared to the peak valuation of 60-62 times. New-age IPOs are trading at greater 100 P/E multiples in some cases and price multiples given to sales in others. So from a 3-5 year perspective, it does make sense to enter the FMCG basket now.
How does inflation affect FMCG companies?
Inflation affects FMCG companies in multiple ways:
  • The cost of raw material increases (palm oil, crude, VAM, TDI prices)
  • The cost of packaging products increases (high density polyethylene)
  • The cost of transporting raw materials to factories and finished goods to market increases with a surge in petrol and diesel prices
  • We’ve seen gross margin erosion between 150 basis points and 1,000 basis points for all FMCG companies in the second quarter of FY22. These companies limited the impact of the gross margin pressure to some extent by cutting other costs like advertising. But everyone is feeling the heat.
    Are FMCG companies in a position to pass on higher input costs to consumers?
    FMCG companies work on the principle of price points or coinage for most products (e.g. Rs 5 chocolate, Rs 2 sachet and Rs 10 bag of chips), so they find it extremely difficult to raise the prices unilaterally. For Britannia, nearly 2/3rd of prices are passed on to consumers by reducing pack sizes instead of increasing the selling price, a term known as “Shrinkflation”. All companies manage price passage through selective, and strategic changes in multiple products and pack-sizes they operate in. For instance, increasing the price of a Rs 90 soap to Rs 100 instead of increasing the price of a Rs 10 soap to Rs 11. Companies are able to pass on at least 70-75 percent of the inflation while managing with cost cuts and some margin hit for the other 25-30 percent.
    What is the market broadly expecting from the third quarter earnings of FMCG companies?
    The market expects higher price growth, lower volume growth and rural slowdown in Q3 for FMCG companies. Companies now move into a high-base situation with the third quarter of FY21 having seen some semblance of normalcy after disruptions in Q1 and Q2. More than the earnings, for FMCG companies, the management commentary is crucial. What the companies say about inflation and the demand situation is something that analysts will be keenly listening to, more than the numbers they report.
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