10 July 2018

FMCG Sector - Return Expectations Too High

The long term movement of a stock price is the result of two factors - EPS and PE Ratio. The PE Ratio is that "multiple" which the market is paying for a company based on it's earnings per share. Usually, the market factors in the EPS growth rate and if the expected growth rate is high, then the market is ready to pay a premium to today's earnings. Consider this example:

The EPS grew at 30% p.a. and thus the PE Ratio cooled off. So that is why we have investors and analysts valuing a stock at forward earnings (FY19E earnings, FY20E earnings, etc).

The FMCG Sector

Defying the bearish sentiments on the street, the FMCG sector is touching record highs and bluechips like Hindustan Unilever,  Britannia, etc have given stellar returns on a YoY basis. Most of these stocks are trading at PE levels of 50+ on the back of heightened expectations in the pace of recovery of rural economy, higher GDP growth leading to more spending by Indians, post GST benefits to the organized segment, etc. The below table shows you the premium investors were paying to the premium they are paying now

The above two heavy-weights are pulling the FMCG index and the buzz-word around FMCG stocks is back.

Should you invest in FMCG stocks right now?

No. Why? Because the valuations that you will end up paying now will result in very low returns for you over the next few years. Many FMCG names are trading at a premium to their historical valuations and sooner or later the PE will revert back to it's mean. Assume that the earnings of HUL and Brtitannia grew by 15% p.a. over the next 5 years and the PE reverts back to the historical mean - What will investors earn?

Let's assume that HUL's earnings per share doubled over the next five years. An investor would still lose out on returns if the PE ratio contracted to ~ 55 from the current 69.4. So then why are investors paying such a high premium for FMCG stocks?

i) Either they are expecting that the PE ratio will sustain at such high levels for many more years (and maybe even expand) OR

ii) They are expecting a very high growth rate sustaining over the next 5 years. Let's try to reverse calculate.

Assume that an investor wants to earn atleast 15% p.a over the next 5 years from HUL's stock. He is aware the PE ratio will revert back close to the mean. So this means, if he does buy now he is expecting earnings to grow at a CAGR of ~ 21% p.a. over the next 5 years. It becomes simpler to decide now whether or not you want to invest in HUL's stock?

  • Do you expect Hindustan Unilever's EPS to grow at 21% CAGR over the next 5 years. If yes, then BUY.
  • If No, then do not invest in HUL.
Similar is the case with most FMCG stocks. Infact most FMCG stocks have been trading at elevated PE levels since 2014-15 and have delivered very low returns over the last 3 years.

Will FMCG stocks crash?

No, we do not see a crash in FMCG stocks coming. Infact, our view is that the share price will appreciate but at a lower pace than earnings growth. At current valuations, the prospective returns look very low and thus we will not invest in the FMCG stocks.

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