Betting on the brand value

Steady growth, low debt, popular brands... these are good reasons to invest in FMCG companies, especially in uncertain times

Whenever there is a belief that stock markets are running ahead of themselves and look overstretched, or the economy is poised to take a turn for the worse, market players seek to find refuge by purchasing companies in so-called ‘defensive sectors’. The sectors which have become a proxy for this term are pharmaceuticals and Fast Moving Consumer Goods (FMCG or consumer staples). Telecommunication used to be considered a part of this club by some, but the belief is no longer prevalent.

The three characteristics which make this sector a good defensive bet are:

Steady Growth
The large FMCG companies such as ITC, Colgate Palmolive and Proctor & Gamble, have consistently displayed the ability to grow their top lines and bottom lines at steady, (if, at times, unspectacular), growth rates, base effects notwithstanding. The low standard deviation in growth rates imparts visibility to the sector and increases its attractiveness to investors during difficult times. There have hardly been any unpleasant surprises by these companies (barring Hindustan Unilever in the first half of this decade). A major reason for this is that the products manufactured by these companies occupy a more-or-less constant share of the consumer’s wallet and are less prone to downtrading when times are difficult.

Low Leverage 
These companies generate a lot of cash internally, and hence have much less need to take recourse to external financing in the form of fresh equity issuance or increase in long-term debt. They not only have negligible leverage, but some of them also operate on negative working capital, which further increases their attractiveness as safe bets during market downturns. Inability to service their debt has been the bane for several high-flying companies in other sectors.

Despite the low leverage, these companies enjoy a return on equity (ROE) well above most other listed companies, as many operate on low asset bases. The biggest asset is the brand portfolio they possess.

Pricing Power
The leading companies in the FMCG segment have built strong brands over the years. These brands often have an emotional connect amongst consumers, which in turn helps the companies to largely pass on any raw material cost-push and also relatively insulate them from the compulsion to become price warriors during downturns.

So, which metrics are most suitable for valuing FMCG companies? The ones employed most often are:

Discounted Cash Flow (DCF)
This involves estimating the cash flows generated in the foreseeable future and then discounting it back to the present. Future cash flow estimates are easier to derive for the leaders in the FMCG industry as compared to companies in sectors like commodities or real estate. The discount rate used is usually the weighted average cost of capital (WACC) for the particular company under focus. As debt levels are negligible, the WACC often equates with the cost of equity (CoE).

Price/Earnings Ratio
This metric is an appropriate one in most cases, as these companies are mature, with fairly predictable earnings streams. These stocks have often traded at a premium of 25-30 per cent to the broad market indices. As of the week gone by, the spread between the BSE FMCG Index and the BSE Sensex is 33 per cent. Some investors keep an eye on this spread and purchase these stocks when the spread reduces to around 10 per cent or so. Rarely have we seen the leaders in this sector trade at a discount to the Sensex valuations.

There is a perceptible gap of around 25 per cent between the P/E ratios of the large and mid-cap FMCG companies (such as Dabur, Marico and Tata Tea). The main reasons include higher volatility in growth rates, relative lack of pricing power, dependence on a single product, slightly higher leverage and illiquidity in terms of stock market-traded volumes in the mid-cap companies.

However, the market is quick to reward mid-cap companies with a P/E expansion, whenever they demonstrate their ability to effectively compete with the leaders.

Sum-Of-The-Parts (SOTP)
Though used rarely, this metric is handy for valuing companies housing diverse businesses under one umbrella. ITC is the best case in point. Here, we value the profitable cigarettes, paper, agriculture and hotels business using the P/E method and the loss-making FMCG business by the ‘Multiple to Sales’ method to arrive at a composite valuation.

Defensive stocks, by their very nature, fall less than the market during downturns and relatively under-perform during uptrends. True to this historical pattern, the BSE FMCG has risen by only 41 per cent, year-on-year, as against 69 per cent for the BSE Sensex.

The key risks to investing in FMCG companies are that they face the risk of low-cost substitutes (e.g Surf vs Nirma), spikes in advertising expenditure in an effort to maintain market share, danger of a sharp contraction in P/E whenever any negative surprises spring up and an increasingly fickle consumer populace, which means companies have to constantly strive to retain them.

The writer is a certified financial planner