Optimistic Valuations

There are pockets of too much optimism in the Indian market. Buyers are extrapolating the past into foreseeable future. However, high growth rates cannot be sustained forever. Ultimately the growth rates come down to earth and that leads to disappointment. High PE multiples then become difficult to justify. Buyers of securities then suffer losses.

FMCG companies

FMCG companies have been darling of markets for long. A large part of the love for shares of these companies is justified. They have generated steady growth over decade (in case of Lever it has been decades) while requiring minimal or no external capital. The free cash flow generation for these companies have been huge given that there have been little working capital requirements or capex requirements.

However, price paid has to justify the value that is being delivered. If too high a price is paid then returns might suffer. The loss might not be due to fact that company itself has performed badly. It could be due to the fact that it did not perform as well as expected. Hind Lever was a high flying stock in 2000. It had given huge returns to investors in last 20 years and it commanded a PE multiple of close to 50 similar to its current valuation. However, the days of huge growth were behind it in 2000 as it had covered almost entire length and breadth of India. It s growth fell to ground in next decade. The result was that the stock just moved from Rs 100 to Rs 200 in next 8 years. The price of Hind Lever in 2008 was around Rs 200. That return was lower than Fixed Deposit return, given that FD rates were in double digits in 2000. Also in relative sense there was an opportunity loss. In same time Sensex increased by a factor of almost 4. Buyers of Hind Lever shares suffered a 50% loss compared to general market.

The reason for under performance of Hind Lever was simple. Markets was expecting that company would continue to grow at fast pace as it had in 90s. It did grow, however the pace was much slower than in 90s. Hind Lever is at a similar valuation today. The share price has increased at much faster pace than profits in last 8 years. The revenue and sales growth in last three years has been between 7–8%. One could argue that some effect could have been due to low rainfalls in last two years still growth would still be around 10–12%. That kind of growth rate still does not justify PE of 48.

Godrej Consumer and Marico are two companies which have grown at growth of more than 20% per annum in FMCG space. Given their size it is a possibility that they can maintain the same for next few years. In that case one may say that valuations are realistic though there is no Margin Safety here.

For others (Dabur, Colgate, Emami ) one will have to say that valuations are optimistic. The growth rate potential of these stocks is below 15% as indicated by their growth in last decade. That kind of growth does not justify a valuation multiple of more than 40.

Colgate especially stands out. Colgate had a growth rate of less than 8% in last decade. That seems unlikely to increase given the increased competition from Patanjali. It could lead to some pain for holder of the Colgate shares.