FMCG stocks are having a good year; will high valuation cap near-term gains?

The road ahead

The sector is likely to stay up in the coming months, with economic activities picking up.

"With easing of restrictions and improving mobility, FMCG companies are estimated to continue to report healthy financial performance going forward," said Amit Agarwal, Vice President - Fundamental Research,
Kotak Securities.

Likhita Chepa, Senior Research Analyst at CapitalVia Global Research, said in the June quarter of FY22, the sector recorded a 36.9 percent value-based growth.

It saw an increased growth from rural markets during the period and the government actions also proved helped.

The growth in the FMCG sector can also be attributed to the e-commerce platforms, the regular channels, of late, have started digitisation. With the help of technology, distributors and retailers are holding less stock, which further enhances their RoI (return on investment), aiding the growth of FMCG industry, Chepa said.

She said the outlook of the sector is positive for the coming period.

"With the recovery in the economy and the increasing spending capacity of consumers, this sector is expected to move north," said Chepa.

As per Himanshu Nayyar, Lead Analyst–Institutional Equities, Yes Securities, the sector looks set to grow at a rate of 10-12 percent in FY22, led by a combination of price hikes and recovery in demand, especially in discretionary categories.

"Recovery in urban demand is likely to offset some moderation in rural demand growth due to base effect and lesser impact on disposable income levels. Margins are expected to see only a marginal moderation despite sharp commodity inflation and recovery in marketing spends due to timely price hikes and sustained cost efficiencies," said Nayyar.

"On the categories, food and beverages category is likely to remain resilient with penetration gradually increasing, home care should do well given continued tailwinds in health and hygiene segment and personal care should see a strong recovery from a low base."

Vinod Nair, Head of Research at Geojit Financial Services expects margins of the sectoral players to have bottomed out or inched closer to the bottom considering lower sequential inflation and benefit from price hikes.

The product mix is also expected to improve with an increase in discretionary products, Nair said.

"Demand from rural markets is positive, given normal monsoon, good growth in sowing, improvement in MSP (minimum support price) and other government rural initiatives, while urban demand is forecasted to improve slowly supported by vaccination drive," he said.

High-valuation hurdle?

With valuations back to historic highs and no incremental triggers in the near term, the sector may consolidate for now and see the relatively undervalued names in the space outperform, Nayyar said.

His top picks from a one-year perspective are, ITC, Britannia, Marico and Emami in which the valuations are well below historic highs and there are visible tailwinds along with capital allocation and promoter issues being addressed.

"If the markets were to see a sharp correction, which is not our base case assumption, we can see the entire sector outperforming strongly, given its defensive characteristics," said Nayyar.

Kotak Securities, however, sees limited upside in many stocks, as they seem to have factored in economic recovery already.

"Most consumer names are priced to perfection and offer limited upside in the near term. Our preferred picks are Hindustan Unilever, Tata Consumer, Godrej Consumer, Jubilant FoodWorks, Titan and Varun Beverages," Kotak said.

Nair also said that on the valuation front, the Nifty FMCG index is trading above 5 to 10-year averages, which may limit the upside in the short term.

The current valuation trend, he said, is abnormal due to low earnings in the pandemic. "On a medium-term basis, the sector real earnings outlook will improve, and in such a premium valued market, the FMCG sector will be a stable performer as inflation eases and discretionary demand pick-up," said Nair.

Chepa suggests buying Jyothy Labs and Bajaj Consumer Care. "Jyothy Labs has a favourable and lower P/E of 33.55 as compared to its peers. The stock has been showing consistent growth in sales revenue and operating profit. The company has also been able to maintain a ROCE of above 15 percent (approximately) from FY16 onwards," Chepa said.

Bajaj Consumer Care has a favourable and lower P/E of 17.60 as compared to its peers. Moreover, the company has been able to maintain an operating margin of above 25 percent and the RoCE from FY13 has been above 35 percent.

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