Price is what you pay. Value is what you get.

Warren Buffett

Even peace may be purchased at too high a price.

Benjamin Franklin
Indian equity investors are purchasing the peace of certainly in uncertain market by investing in the FMCG stocks for last few years. Are they paying too high price for purchasing the peace? In the past five years, the consumer sector has outrun market by a whopping 200%. BSE FMCG indexs PE ratio is now quoting at multiple of 2.67x of Sensexs PE ratio, against a 10 year average of 1.58x. Meanwhile, FMCG sectors weight in the Sensex has increased to ~15% in May13 from ~6% in Jan07. The sector is one of the most overbought by institutions.

300 250 200 % Change 150 100 50 0

S&P BSE FMCG Sector

SENSEX

Graph: Sensex vs BSE FMCG return

PE -3SD PE -1.5SD PE Ratio PE +1.5SD PE +3SD

3 2.5 2 1.5 1 0.5 0

Graph: PE ration of Sensex and BSE FMCG

After market peaked at 21,200 on 10 Jan08, the consumer sector has outrun it ~200%. Owing to the sharp global slowdown, steep inflationary pressures & interest rates, and unstable political conditions, most companies in other sectors have reported poor financial performances, reflected in their dismal share prices. FMCG companies even in this grim environment have registered CAGR growth of ~13% during FY09-12. It will continue to post healthy, over 10% earnings growth in FY14 as well as in FY15. However, due to rich valuations and share-price returns are likely to be low key. We believe that, with the possible turning of the tide in favour of stable but higher-beta companies, the consumer sector may not continue to outstrip the broader market. Owing to the underperformance of other sectors, weight of the consumer sector in Nifty has expanded. Outperformance of other sectors could result in greater weights for them and investors may be compelled to sell consumer stocks merely to align with the Sensex or Nifty weightings. Almost all stocks in the consumer sector have seen an increase in institutional ownership. In the past 10 years, the consumer sector has traded at an average TTM-PE of 26x; it is now trading at a PE of 40x. We believe returns will extend only to those with earnings growth plus dividend yield, but any returns from re-rating would be restricted. Multiple expansions will only be possible for certain midcap companies and may not amount to more than 10% from present valuations. Prices of primary articles (key input for most FMCG companies) softened in Mar13 to a 13-month low of 7.6%, significantly below 11.4% in Jan13. Assuming a normal monsoon this year, we expect prices of primary articles to slide further to 5.4% by Aug13.

Valuation To evaluate the risk-return matrix of the banking industry, we considered BSE FMCG for our calculations with composition as follows Company Weight in Index(%)

ITC Hindustan Unilever Nestle India United Spirits Godrej Cons Colgate Palmolive Dabur India United Brew-$ TATAGLOBAL JUBL FOOD

57.27 16.9 6.23 5.91 3.11 3.05 2.77 1.84 1.7 1.22

To arrive at the best case, worst case and base case scenarios, we have used Relative Valuation based on Price/Earnings (P/E) multiple. We have considered a time span of 5 years (FY06 to FY12) which takes into consideration both, high and low growth periods for the industry.

EPS Calculation: To ascertain current EPS, we used standalone trailing 12 month EPS for each index component. Our estimate for base case growth in EPS is based on the Bloomberg consensus FY14 EPS for each index constituent companies. We have considered the historical standard deviation (SD) of PAT for considering the best case and the worst case EPS growth considering the base case as the mean. Multiple calculation: Using historical values (FY07 to FY12) for each index component and considering weighted average of historical multiples, with higher weight to the near years, we ascertained base case P/EPS for the index. we assign a SD of +/- 1.5 on base case P/EPS to arrive at the best and worst case P/EPS for the index . Calculating the standard error across the constituents, we have provided for some smoothening for United spirit and Tata Global for our calculation as they have experienced a regime shift in the period under consideration. Results:
Projected returns for different PE & Growth PE

Best Case
30.13

Base Case
28.70 -18.1% -22.0% -25.9%

Worst Case
27.27 -22.1% -25.8% -29.6%

EPS Growth

Best Case Base Case Worst Case

11% 9% 8%

-14.0% -18.1% -22.2%

Our calculations indicate that at a base case, the sector is overvalued. Under all case in the RiskReturn matrix, the sector appears to be overvalued based on the index calculation. The valuation in the sector is sustained based on capital flow and investors risk aversion mentality. However, as earning expectation of the analyst and investors diverges and it may get revised upward during the year. This doesnt ruled out the entire FMCG sector from the investors map as few quality midcap stocks with stable business and strong earning visibility available at reasonable valuation, which may give steady return to the investors in the next one year.