Market mispricing consumption sector, needs new valuation approach: Kotak analysts

Kotak calls for a fresh look at consumption stocks

Analysts at Kotak Institutional Equities said they are still hopeful that the market will eventually reassess its view on consumption stocks. According to them, investors continue to be overly influenced by the past and are failing to account for the fundamental changes that have taken place in the sector, changes that call for a new way of valuing these companies and justify meaningfully lower valuation multiples.

Over the past two to three years, valuations in the consumption sector have been driven by a variety of narratives. These included recurring expectations of a revival in rural and urban demand, as well as constant optimism around higher margins, largely based on what were still favourable market structures that benefited existing players.

At present, the dominant narrative is centred around expectations of better margins due to declining raw material prices, such as falling palm oil prices, anticipated drops in tea prices, and relatively low crude oil prices.

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However, analysts cautioned that if companies are unable to deliver a decent improvement in margins, the sector may face notable downward revisions in both earnings and valuation multiples.

"The market’s last hopes could be tested against the twin realities of weaker market structure across sectors and different strategies of companies (volumes or profitability)," they said.

Looking back, analysts described the 2010s as a "magical era" for consumption stocks. During that period, companies saw strong earnings growth and consistent re-rating of valuation multiples.

This success was largely due to supportive market conditions, which enabled steady volume growth, strong revenue increases through inflation and premiumisation, and stable margin expansion as companies either passed on raw material cost inflation or retained the benefits of cost deflation.

In contrast, the 2020s have so far delivered more moderate operating and financial performance for most consumption companies. Notably, even three years after the peak of the Covid-19 pandemic, performance remains subdued, which analysts believe points to deeper, structural problems within the sector.

"These include growing competition across categories, ongoing erosion of distribution moat with
the emergence of new channels eroding the solid advantage of the incumbents in the general trade channel and companies’ margin-focused strategy, which could possibly handicap them versus more aggressive competition," analysts added.

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