A perspective on Indian FMCG Stocks (2021)

Due to the current uncertainty in the market, it’s important to be defensive with respect to some part of your stock portfolio. I believe Indian-FMCG would be a great candidate for this defensive bit.

Here are a few of my reasons:

1. During economic downturns, FMCG companies do see a fall in demand, but the impact is far less than riskier sectors like banking.
2. In India, the FMCG market is pretty consolidated, with top 15 companies owning most of the end market share.
3. Almost all of these companies have been in business for decades, have products with solid brand reputations, and most importantly, have a well-entrenched distribution.
4. Improved infrastructure in India (especially roads and electrification) will help these companies save substantially on supply chain and distribution costs leading to an improved bottom-line.

There are many more reasons. However, we need also to understand that the market has factored in these reasons to quite some extent. In such a situation, we cannot expect the FMCG stocks to deliver momentum to your portfolio: we should instead look at them as steady growth stocks.

FMCG Stocks Selected for the analysis:

For this analysis, I have chosen almost all the major FMCG players in India: HUL, ITC, Dabur, Marico, Colpal, Emami, Nestle, Brittania, Godrej Consumer, Hatsun Agro & Varun Beverages.

Stocks that I left out:

Ruchi Soya: Due to the messy holding pattern

Adani & Wipro: Conglomerates with a significant chunk of business in Non-FMCG. Despite being a conglomerate, I included ITC as most of their business is FMCG.

The Theory behind the analysis:

( You can skip this section if you are comfortable with financial ratios)

The goal is to create a portfolio that can deliver good returns in a time horizon of 5 years. Let’s break it down to mere fundamentals. A stock can increase in value due to one of the two factors:

1. When the company grows. It is captured by the returns that they are delivering.
2. The premium that a buyer is willing to pay to own a part of the business.

The metric used to understand valuation is the P/BV ratio (Price/ Book Value Ratio). In simple words, Book Value is the value of total assets that a company owns. However, to buy a piece of the business, you end up paying an amount different from the Book Value. That is because the price that you pay is a consequence of a negotiation between the buyer and seller. Thus, a business with a total book value of $1M can be sold for $10 M or $0.5 M. The P/BV in the first case would be ,ten and in the second case, it would be 0.5.

Does it make sense to always buy shares that have a low valuation? Definitely, not. Remember what Warren Buffet said: it’s better to buy a good company at a good price rather than a bad company at a cheap price. (or something like that)

So what’s a good valuation? It’s simple: If a company has a P/BV of 10 when it is worth much more- it’s a good buy. On the other hand, a company with a P/BV of 0.5 could be worth much less.

How can we find out the true worth of a company? Valuation itself is a vast topic, and I wouldn’t try to explain all the details in one paragraph. However, there is a simple ratio that we can look at, for FMCG companies: ROCE ( Return of Capital Employed).

Other sectors may have different ratios that are better indicators. So what is ROCE?

It is the ratio between Profit (Returns) and Capital Employed. Capital Employed is equal to the difference between Total Assets and current liabilities (similar to short-term loans). So if a company has total assets that are equal to $1M but the current liabilities are $100K, it can effectively employ only $900K to the business. That is the capital employed.

So a company having a ROCE of 20% is getting 20% returns from the capital that it employs. If shareholders feel that it’s a good return, they would be willing to pay a higher price to buy a piece of the company. In other words, the Valuation will go up. The reverse is also true.

In the case of FMCG, the ROCE is an excellent indicator to determine a company's fair value. Imagine a company has a ROCE of 20% & a P/BV of 10. If the average ROCE of the industry is also 20%, but the P/BV average is 15 — then the company is possibly a good buy.

Metrics used for the FMCG sector

To analyze the Indian FMCG sector, I considered both the P/BV (for valuation) and ROCE (as a driver of the valuation). However, in the case of ROCE, I decided to look at the change over five years. It’s also essential to see the difference in assets over the five years (because asset value impacts both P/BV and ROCE)

So what does the chart look like?

There seems to be some bit of correlation between ROCE Change (Measured as ROCE CAGR) and P/BV. However, it’s noisy: The main reason is that the total assets have changed substantially in quite a few cases. Take the case of HUL. The CAGR of 34.35% could explain why the ROCE dropped.

To make the analysis clean, I decided to create a few metrics:

1. What would the current ROCE be if the Capital Employed stayed the same as what it was five years back? (Let’s call it ROCE- Rel)
2. What would the P/BV be if the total assets stayed the same as five years before? (Let’s call it P/BV- Rel)
3. Now let’s see the change in ROCE in 5 years.

What does this imply? It tries to look at ROCE and Valuation while negating the impact of change in assets. Here’s what the data looks like:

Here’s what the plot looks like:

There clearly seems to be a correlation this new P/BV and ROCE CAGR.However, you may have noticed that relatively for HUL & Nestle the P/BV is simply too high. I will consider them as outliers and try to plot the remaining stocks (moreover, Nestle & HUL are both good to hold and thus may not need such in-depth analysis):

Wow! we are almost close to a predictive formula for Valuation using ROCE CAGR.

So I tried a couple of regression, first a linear one & then a 2nd degree polynomial one. Here’s how it looks like:

In case of the second degree polynomial regression, the R-squared is 0.699. In other words it’s significant.

Visually here’s what we could tell:

1. Emami, Varun Beverage & ITC are below the curve. In other words, their valuation is lower than it should be. If you think about it, ITC & VBL both have a similar crisis. Their core revenue comes from products where government policies could act against the shareholder interests. In case of ITC, it is Cigarettes. In case, of VBL it is alcoholic beverages. (In recent years, ITC has been increasing it’s revenue in other FMCG products significantly. As the market starts appreciating that, we can expect the stock to soar. ) Emami is a tricky one. It clearly has been punished for the poor ROCE growth. However, is it over-punished ? I think, slightly. However, it surely isn’t the “gem” that many analysts are swooning about.

2. Hatsun Agro is way above the curve. We can safely eliminate it from our portfolio.

3. All the other stocks are pretty much around the curve, we could consider them for now in our portfolio.

To analyze further, I decided to calculate the P/BV in both Scenarios (linear & Polynomial) using the generate equation. Then, let’s look at the deviations from the actual value to get a numeric understanding :

Here are some easy observations:

(Positive Deviation: Undervalued, Negative Deviation: Over-valued)

1. Godrej consumer, Brittania and Hatsun are heavily over-valued. I will remove them from my list.
2. ITC, VBL and Emami are undervalued. Since I have to make a limited number of choices I would remove Emami (negative ROCE).
3. Dabur and Marico are in interesting positions. As per the linear they are undervalued and as per the polynomial model they are slightly over-valued. These would definitely be in my list as they are close to their true worth.
4. Colpal is slightly over-valued as per both the models, however we could still keep it.

So in the portfolio we are left with the following: ITC, VBL, Marico, Dabur & Colpal.

For a quick validation let’s look at another metric: Piotroski score. It’s a measure of the financial health of a company. (Lowest: 0 & Highest: 9) -

Dabur is pretty low on this & Colpal scores the highest. However, we don’t see any red flag.

Arriving at the mix:

1. Marico & Colpal seems to be the best fit overall. Colpal valuation is slightly on the higher side but the financial health is the best possible. Marico is at per with industry in terms of financial health & the current valuation is good. I would allocate equal percent to both.
2. ITC & VBL are both good buys but we need to be aware of the investor concerns. I would want to keep both. Allocate more to ITC than VBL. That is because ITC is more under-valued than VBL & the non-cigarette business growth hasn’t been factored in yet.
3. Dabur has a good valuation but scores low of Piotroski. I would allocate lower % than Marico or Colpal but higher % than ITC & VBL.

My final mix would be :

COLPAL : 30%

Marico : 30%

Dabur : 20%

ITC : 15%

VBL : 5%

Disclosures:

1. I am not professionally qualified to provide advice on picking stocks. I invest myself. Thought of sharing my own investment thought process
2. After completing this analysis I have invested in all the following stocks: Colpal, Marico, Dabur, ITC & VBL.