One interesting trend in the stock market is the change in risk perceptions on two sectors, FMCG (fast-moving consumer goods) and pharmaceuticals. Both are generally seen as perennials. The reasons for the heightened risk perception are different.
The pharma industry is facing trouble both abroad and in the domestic market. Abroad, the US Food and Drug Administration has imposed a regime of continuous tough inspections of export facilities over recent years. As a result, many companies have been hit by bans. Indian bulk drug outfits often have to deal with litigation as well since there are legal challenges.
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A new danger is now visible. At the domestic level, there have been multiple bans on fixed dose combination drugs, due to which most pharma companies have taken big losses. The market has still not adjusted to this move and it is being challenged legally by some. Meantime, investors have begun selling down these stocks.
This troika of risks has changed perceptions, at least in terms of 2016-17 earnings. The industry has traditionally received extremely high valuations. It has insulation against business cycles and strong export volumes. It is considered globally highly competitive in price terms. Most pharma companies had, or used to have, predictable growth rates and stable margins and earnings. With price to earnings (P/Es) of 45-plus in many cases, the industry could see steep price declines.
The FMCG sector faces several different types of risk. One is rural distress. Growth has been driven by rural and semi-urban consumption for the past decade. As rural incomes have grown and access to rural markets become easier due to better roads, etc, FMCG volumes have seen strong growth rates. There was a hiccup in 2015-16, a second drought year in succession. Crop destruction by hail in the past six weeks could add to that distress. There is also competition from unlisted Patanjali, which has turned several conventional methods of FMCG marketing on its head and built a big distribution and marketing network in a short period. Patanjali has far lower costs and despite unattractive packaging and uncertain quality controls, has made major inroads into multiple segments. As Patanjali grabs market share, things get tougher for listed FMCGs. Growth could stagnate for many listed FMCGs in this and next financial year. FMCG is also a highly valued industry though pharma fetches higher PEs.
Investors exiting from pharma and FMCG have few choices at the moment. That money has to go somewhere if it doesn't exit the equity market. It is probably moving into highly risky areas such as cement or steel or construction. These are all beaten-down sectors, where the prospects might have improved in the recent past.
There is a deeper worry, since this is not the standard sector-rotation. That occurs in cyclical businesses. Pharma and FMCG are not viewed as cyclical sectors anywhere in the world. These industries tend to be backed by long-term investors who want steady returns including stable dividend payouts. If these two industries cease to be cash-cows, it is not easy to think of other industries which have similar non-cyclical characteristics.
What is more, many Indian pharma and FMCG outfits are local subsidiaries of global MNCs. Big sell offs in these stocks will have an unpleasant effect on global sentiment vis-a-vis India. This is especially true since, right or wrong, many pharma companies are grumbling about opaque policies and arbitrary bans. There have also been low-key rumblings about favours done to Patanjali, which may have gained sales with its instant noodles product when the popular Maggi brand of instant noodles suddenly came under scrutiny.
Does distress in the pharma and FMCG industries create an opportunity for long-term investors? Maybe it does, in a very selective way. At some stage, valuations in the pharma industry will settle down for sure. But that entry point could be some distance away. The situation in FMCG will be more nuanced. First, rural distress would have to be mitigated by at least one decent monsoon. Second, the market will have to review its valuations of FMCG in general, given the presence of a high-growth low-end competitor. This has happened before, with Nirma for instance. But it has never occurred across multiple segments. Watching that re-adjustment will be interesting.
