The FMCG sector (or consumer staples) has been the silent star performer of the Indian equities market. The index is up by 17.9% CAGR over the last ten years, compared to 12.2% CAGR for the Sensex over the same period. To put it in perspective, the value of Rs 1000 invested in the FMCG index is Rs 5190 now vs Rs 3162 in Sensex. The reasons for the outperformance can be traced to the challenges the Indian economy has faced since the global financial crisis.
Loose fiscal policy in the earlier part of the decade, high credit growth, policy paralysis and loose global monetary conditions led to multiple challenges for the Indian economy. An unsteady fiscal and monetary policy led to high inflation and domestic conditions and high commodity prices led to high current account deficit. Lastly, decline in growth rates and policy paralysis led to creation of nonperforming loans which were not recognized until much later.
All of this meant that the rate of capital formation declined considerably, and growth in personal consumption was the major driver for growth in the Indian economy and a major contributor to growth in corporate earnings in an otherwise lackluster corporate financial performance. This drove the FMCG index to outperform the broader market.
The tide, however, is turning as the FMCG sector is likely to underperform in the broader market over the next couple of years. One of the reasons is valuations, the BSE FMCG index trades at a 12 month forward Price to earnings ratio of 31.9X which is extremely high and is at a considerable premium to the Sensex which trades at a 12 month forward Price to earnings ratio of 18.4x.
The Indian economy has improved in terms of macroeconomic stability; Inflation has declined considerably and is unlikely to become a problem. The current account deficit has declined as well. Reforms like IBC have meant that the NPL problems have peaked and banks are in a position to lend again. Gross fixed capital formation expanded by 10.6% for Q3FY2018-19, indicating that capital formation may start picking up. Cyclical sectors should benefit from now on.
There are a few dark clouds on the horizon though. India is facing a cyclical slowdown. The slowdown is on account of tightening of liquidity, following a crisis in the NBFC sector as well as FII outflows in 2018 and early 2019. Global liquidity conditions had tightened following tightening by the US Federal Reserve, and the global economy has slowed down. Lastly in India, ahead of the uncertainty on account of general elections, companies are in a wait and watch mode regarding decisions to expand capacity.
This would normally be positive for a defensive sector like FMCG. However. consumer expenditure has slowed down and is below historic levels. The growth in PFCE (at current prices) stood at 10.6% over 2017-18, vs historic levels of ~ 12% in the most recent three years. Additionally, extended winter, tight liquidity and the recent monsoon forecast have been dampeners. While rainfall is expected to be in the range of 96% of the long term average, doubts remain over the even distribution across regions. As a result, Nielsen projects revenue growth of 11% – 12% in the FMCG segment in CY2019, down 2% from CY2018, with volume growth in the range of 8.5% to 9% for FY2019.
We believe the Indian economy is likely to recover by Q2 FY2019-20. The RBI has acted to improve liquidity, which should have an impact with a lag. The global economy may recover as impact of fiscal and monetary actions in China feed through. The US Federal Reserve slowing down monetary tightening is positive as well. Trade wars and oil remain a risk.
Lastly, household savings rates have been dropping, and are in the range of 17% in FY17 and FY18, vs historic levels of ~23% as a % of GDP seen in FY12 and FY13. We believe that with a recovery in demand for capital for investments, savings should rise. In this backdrop, we believe investors should look at the following options to invest with a horizon of one to two years.
As an asset class, we believe that equities should outperform. A favorable election result should rekindle animal spirits in the economy and capital formation rates should improve. We advise investing in cyclical sectors, namely banks, capital goods and autos.
Mid caps should outperform large caps. Mid and small caps tend to outperform when markets are in a risk on the scenario. Secondly, valuations of mid caps are favorable, in terms of the 12-month forward price to earnings ratio, the mid cap index is at par with the Sensex vs a historical premium of 12%. The conditions for mid and small caps to outperform are, thus, falling into place.
We also believe fixed income is an attractive investment, while we wouldn t like to assume significant credit risk, given high real interest rates, government bonds or G-secs (and mutual funds which invest in G-secs) are an option for investors, especially if liquidity in Indian markets improves, bond yields can decline. We would prefer to invest in duration, i.e. in the longer end of the yield curve.
To conclude, while the appeal of FMCG stocks has declined, we do believe an investor should own them as part of their portfolio. However, we would advise them to buy more of cyclical stocks, and mid caps. In addition, investors should add long-term G-Secs as well.
(By Rajiv Singh, CEO-Stock Broking, Karvy)
(Disclaimer: These are the views of the author. Please consult your financial advisor before making any investment)