Identifying an FMCG stock: Do's and don'ts

Rather than look at the various segments, prospects or market shares of the FMCG sector, this week let us take a look at ways to identify a good FMCG stock. With the markets currently on an upswing, it is even more important to differentiate the chaff from the wheat. Here goes... Key drivers
As we all know, India's per capita consumption of most FMCG products is well below the global average. That is largely because of the economic conditions, i.e. the purchasing ability, and also because of lack of awareness of these products. A look at the chart below gives a snapshot of the key growth drivers for the FMCG industry.

Logistic strength
While the purchasing ability is a function of economic growth, awareness is a function of the product reach and its usability. It is in this context, that a company's logistics strength gains importance. But logistics does not only mean a company's reach in terms of retail outlets, it also means the level of sophistication of this distribution reach. How intelligent is this supply chain, how well geared for the company's future growth?

For example, Company A products reach 1 m retail outlets, but the reach is largely people intensive using the traditional dealer stockist method. Also, the retail outlets are largely small provision and shop owners. On the other hand, Company B has a retail reach of only 0.5 m retail outlets, but almost 70% of its stockists are electronically networked.

In the above case, even though Company B reaches out only to half the number of retail outlets as compared to A, it is likely to be more efficient and profitable for the company's growth going forward. For an FMCG company, once a distribution chain is set up, it is the quality of that set up that gives it an edge. Using the same chain, an FMCG company can introduce more products and brands at a faster pace and at a lesser cost, and optimize the channel benefits. In the long run, such a distribution network will be more profitable as it helps the company to keep adding to its product folio at more or less the same fixed cost.

Product folio
MNC companies form almost half of the branded FMCG industry in India. In case of MNC companies, therefore, it is relevant to look at the parent support and commitment to its subsidiary before taking an investment decision. Again, support and commitment alone is not enough. Have a look at the parent's product profile and what are its plans for its subsidiary in India. If the parent itself is present only in a few categories globally, all its support is of little help owing to the product hindrance.

For all companies, be it domestic or otherwise, a look at the company's product introduction track record is an eye-opener. How many products has the company introduced in its years of existence, how relevant are they to India's consumer habits. What are the future plans of the company?

Competitive strengths
FMCG companies' success is often attributed to their marketing and branding skills. Ability to continuously create successful brands and advertising which gets the message across often spells success for a company. Once a brand is successful, it easier for a company to piggyback on its initial success introduce more products and associate them with the known brand. As they say, 'nothing succeeds like success'.

As said earlier, the more the number of product offerings, the more each resource is utilised, be it the distribution channel, the marketing or branding strengths. It is in this context, that single or a few product companies are risky. Number one, they have to continuously be wary of competitors coming in and weaning away market share. Therefore, they have to continuously spend higher on advertising and marketing. This is a double whammy for a company under pressure. On one hand, revenues are under pressure and on the other, costs go up and margins are squeezed. Also, due to this, the company is often shy of investing in new products and expanding its distribution network. Bottomline, future growth prospects get stunted.

We talked of MNC companies earlier. One very important thing that an investor should look at is the number of subsidiaries the parent has in the same country. For example, P&G and Glaxo SmithKline, both have a few other subsidiaries, beside the listed entities. If the parent has another subsidiary, especially if it is unlisted, then it is likely that the foreign parent would be inclined to introduce new brands and products through the 100% subsidiary. As such, shareholders of the listed subsidiary will not be able to reap the rewards of the product portfolio expansion.

Investors should be wary of investing in such companies where parent focus and plans are under a cloud.

Key financials and valuation ratios to look at

• Last 5 years revenue growth (CAGR) and what is the reason for the said growth. If encouraging growth has come about due to continuous new product introductions and growth in market share, it is an encouraging sign.

• Operating margin trend What sort of margins is the company earning, vis-a-vis its peers. Whether the trend is improving or is there a continuous decline. Find out reasons for both. If it is improving due to efficiencies in supply chain and product focus, it is encouraging. If it is declining continuously due to hike in advertising spends etc., it is a sign of the company facing intense competition. However, if the margin decline is a blip and has come as a result of a new product introduction, it is a good long-term sign.

• Look at the company's cash flows and the working capital efficiencies. It will give you an idea of the company's bargaining power as well as its ability to utilize its resources and supply chain.

• Look at the return ratios, especially ROCE (return on capital employed) trend. It will give you an idea how effective the company is in optimising its resource strengths. Also, look at the dividend paying track record. A healthy dividend payout, i.e., the ratio of dividends to earnings, is also a good indicator of the company's willingness to share wealth with small shareholders.

• It is also important to look at the P/E (price to earnings multiple) and market capitalisation to sales, which the company is trading at vis-a-vis its peers. Growth oriented companies' will most likely be trading at a premium to peers based on these parameters. If so, then one has to gauge whether that premium is justified. If the premium is unrealistically high then it may not be a good idea to invest at that juncture. After all, valuations have to justify the company's prospects.

Above all this, look at the past record of the management, its vision and its integrity. For it is the management finally, which is decision maker and therefore the guardian of your interests in the company. So if the management has a track record of being on the sly or slow to react to market conditions, then the biggest distribution channel and the most diversified product folio may not give you your rightful share of the company's growth and profits.