Consumer discretionary gets a leg up as equity investors chase quality

Earnings multiple of consumer durable firms at 3.5-year high

Equity investors coming to the rescue of India’s consumption demand story have pushed up the valuation of consumer discretionary stocks to their highest in three and half years. This is despite a sharp deterioration in firms’ fundamentals over the latest quarter.

These consumer durable stocks are trading at 24.6x their trailing 12-month profit before tax (PBT) on an average, up from a price-to-earnings (P/E) multiple of 21.7x at the end of June and 20.6x a year ago.

The current valuation is just a notch below the peak of 27.7x the trailing PBT at the end of the December 2017 quarter.

The combined market capitalisation of 29 consumer durable players in the Business Standard sample has risen 6.9 per cent year-on-year (YoY), despite a 28 per cent YoY decline in profit before tax (PBT) in Q2FY20 and 8.3 per cent YoY decline in net sales. The industry PBT has contracted for three consecutive quarters.

This is the worst show by the industry in the last five years. Q2FY20 was the first in the last five years when the companies included in the sample reported YoY contraction in revenues.

The analysis is based on quarterly revenues, profits, and market capitalisation of listed firms in industries such as passenger cars, two-wheelers, domestic appliance makers, jewellers, paints and home product companies, and fashion retailers. The sample has factored in firms to have declared their results.

Among major companies in the sample are Maruti Suzuki, Hero MotoCorp, Bajaj Auto, Titan, Asian Paints, Berger Paints, Mahindra & Mahindra, Eicher Motors, Havells India, Kajaria Ceramics, and Blue Star.

Analysts attribute this growing divergence between valuation and fundamentals to the TINA or ‘there is no alternative’ factor for investors.

“I agree that most consumer durable stocks are trading at unsustainably high valuations. However, there are few alternatives in the non-consumer space," says G Chokkalingam, founder and MD of Equinomics Research & Advisory Services.

However, he clarified that valuations of many stocks are approaching the bubble, and are not sustainable, given their earnings trajectory. “Valuations in the consumer space may correct sharply, once there are broad-based economic growth returns that will push up earnings in cyclical sectors such as corporate banks, capital goods, and commodity manufacturing,” said Chokkalingam.

Others attribute this to a combination of a fall in interest rates globally and the focus on corporate governance and quality stocks. 

“Thanks to record low interest rates, investors are looking for quality stocks that provide steady earnings yield. Most of the consumer discretionary players fit the bill as they are debt-free and generate good free cash flow,” said A K Prabhakar, head (research), IDBI Capital.

The slowdown is bound to hit profitability of some of these firms. However, earnings will rebound once growth picks up, and valuations may start to look somewhat reasonable.

Analysts say that in the current market scenario, ratios such as P/E and price-to-book may matter less, as the market is fundamentally driven by liquidity-chasing quality and yields. What is more important is assessing the return on equity, return on capital employed, and overall growth potential.

Analysts added that the outlook on consumer demand was brighter than other demand drivers such as corporate capex and infrastructure segment. 

“In this phase where growth has been difficult to come by, investors have found solace in firms that are growing to at least a small extent. Second, in the last one and half years, there has been a string of bad news on companies with debt. Consumer companies don’t have these issues,” said Sunil Singhania, founder of Abakkus Asset Manager.