Will the FMCG pack continue to outperform?

Mon, 7 Jan Pre-Open

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After outperforming the markets in 2011, the BSE-FMCG Index continued its strong momentum during 2012 as well. While it was not the top performer of the year, the index nevertheless rose by over 46%. The benchmark index - the BSE-Sensex - on the other hand gained about 26% in 2012.

The sectoral index outperforming the benchmark by such wide margin has largely been on three accounts. Firstly, the overall long term story of being part of the consumption theme continues. Second, FMCG stocks are considered as a defense play during uncertain times. And lastly, FMCG companies reported good and stable financial performances during the year.

The chart below indicates how the two indices have performed over the past ten years. It also displays the P/E ratio of the Sensex.

Data Source: ACE Equity

As you can see, FMCG stocks have underperformed the broader markets for most part of the past decade. It was only after the second half of 2011 when the FMCG pack began to gain momentum and pretty much left the Sensex behind.

It all boils down to the valuations...

As of Jan 3, 2013, the BSE-Sensex was trading at 17.85 times. On the other hand, the BSE-FMCG Index traded at a PE of 38.32 times - more than twice of that of the Sensex.

While it may be true that FMCG stocks tend to generally be valued at a premium as compared to the benchmark index - given the inclusion of a handful of MNCs and the superior quality of these businesses - whether they continue to outperform the broader markets depends on certain factors.

With the overall market and economic condition not being in the best of health - until the 'signs of recovery' came about towards the end of 2012 - valuations of the BSE-Sensex have remained below the long term averages. Even after the Sensex has begun to gain momentum, its valuations continue to remain lower than the long term average P/E ratio. This would indicate that there could be more upsides as and when positive news and data begins to flow. But mind you it could go the other way as well!

Given that most of the stocks forming part of the FMCG index are trading close to their peak P/E ratios, the focus would now go on the earnings and their growth rates. As it would only be these factors that would justify the valuations.

With the FMCG bunch increasing prices to offset the worries relating to inflation in recent times, it has helped them in keeping margins intact (or improving in some cases). But this is expected to come in at the cost of growth. As such, it boils down to whether these companies would be able to expand margins and maintain earnings growth - strong enough to justify the current valuations of over 38 times.

Although, some hope remains...

Apart from the overall ongoing consumption story, a factor that could propel growth for the FMCG players would be revenues growth from the newer segments and markets they have entered in recent times.

While inflation is also a concern, the same seems to be cooling off in recent times. Especially in the case of agri-commodities! Not to mention that inflation was aggravated by a sharp depreciation in the rupee last year. As such, if the exchange rates remain the same, there would be no additional pressure on the subsiding inflation levels. This would be a booster for the FMCG companies given that they had taken price rises. However, they would have the option of passing on lower prices. This would only help them propel the growth levels.