Rich valuations of FMCG majors may limit any further upside in these stocks and curb the outperformance seen on these counters in recent months. Although FMCG stocks are seen maintaining a healthy earnings growth in the coming quarters, analysts have started questioning the premiums commanded by these counters.
For the year so far, most FMCG stocks have outdone the market with the sectoral index of the NSE gaining 11% compared to a 3.5% decline in the 50-share Nifty. HUL, ITC, Dabur, Britannia Industries and GSK Consumer Healthcare have rallied 14% to 48% in 2013 so far.
These stocks are trading at a huge premium to their five-year average valuations as measured by the trailing 12-month price-to-earnings multiple. On an average, these companies are trading at 34 times their last one-year earnings, which is nearly an 18% premium to their average valuations.
Stocks like GSK Consumer and Hindustan Unilever have also gained after their foreign parents announced open offers to acquire further stakes in the Indian units. Additionally, market volatility pushed investors towards traditional defensive sectors like the FMCG.
According to Kotak Institutional Equities, the expensive valuation of the FMCG pack is a result of a ‘perceived low cost of equity’ due to easy global liquidity and a favourable view on consumption worldwide. However, any contraction in liquidity may affect investors’ willingness to trade these inflate multiples for the same set of earnings.
Kotak argues that the current prices of these stocks indicate that the market is betting on a strong economic recovery that would result in sustained consumption. ?However a revival in investment demand is imperative to create new jobs and sustain India?s consumption story,? it stated.
The popularity of these stocks remained unaffected even as GDP growth pulled down the volume growth reported by these companies during the last three quarters. In the three months to March 2013, the year-on-year revenue growth of companies like Godrej Consumer, Marico, Emami, Dabur and Nestle was on an average 50% lower than their median in last 12 quarters.
Ambit Capital believes that rising competition and saturating penetration in a few product categories would adversely affect the earnings growth and valuations of FMCG firms. It also cites a lack of further softening in raw material costs as a near-term negative. Given the frothy valuations, Ambit, in a recent research note, advised investors to sell front-line FMCG stocks.