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Valuations Not Scary

Saurabh Pant of SBI Mutual Funds is cautious of the current valuations of FMCG sector.

What is your outlook on FMCG stocks now?
We are witnessing some slowdown in the sector. Over the last few quarters, there has been deceleration in growth rates. Different categories have slowed at different points in time. Few discretionary categories started slowing down last year and staples is seeing some deceleration now. So, in this context, the current valuation of the sector seems expensive. The current valuations can sustain only if; a) there's no further growth deceleration in the consumer sector and b) there's no improvement in the macro situation. Other sectors are much more leveraged to the economy. If the economic situation stays grim then there may still be a case for FMCG to outperform the markets in the short-term. It is pertinent to note that while we are positive on consumption from a long-term perspective, as a fund house, we are underweight on consumer staples from a tactical perspective.

Did you expect the market's preference for these stocks would prevail?
No, in fact, we never expected the valuation premium of the sector to go up so much. In fact, during the last calendar year, we believed that many FMCG stocks were rich in valuations. So, not only has the premium sustained, it has increased and we have been proved wrong. I believe this has a lot to do with other sectors.
Look at the GDP, the IIP and the currency; nobody had expected such kind of setbacks. There were expectations that interest rates might start coming down, but on the contrary, the short-term rates have gone up. I believe the valuation premium of consumers is largely a function of the weakness in other sectors and to a smaller extent, the resilience of consumption demand.

How much does the current valuation of FMCG stocks scare you?
Over the past two decades, the FMCG sector has traded at almost 1.8 times the market valuations. Today, that is 2.7. But again, the extent of this premium has to be seen in the context of earnings estimates for the broader market. I believe the Street is factoring in a 12 per cent earnings CAGR for the Sensex over the next two years. But if earnings growth for Sensex is 5 per cent CAGR then the valuation premium of the FMCG sector is close to its historical median. From this context, the valuations don't look scary. Probably like a bubble that has room to grow! Having said that, if you take a view of say, 2-3 years and believe in some sort of a revival in the economy, earnings for the market may surprise on the upside. Hence, we are cautious of the current valuation of the sector.

How much of your investment universe of stocks for FMCG fund has shrunk because of rich valuations?
We are relative return investors hence, this doesn't bother us. From an absolute return perspective, yes, I believe the universe has definitely shrunk. We believe risk reward is not favourable in many FMCG stocks. There may still be opportunities down the market capitalisation curve albeit with a higher risk. In the SBI FMCG fund, we have an overweight of around 30 per cent in mid- and small-caps. The strategy hasn't worked till now as large-caps have outperformed mid- and small-caps. But we remain optimistic and continue to have that positioning. If we believe that the risk is more than adequately factored in the valuations, we will not hesitate to increase the exposure to mid- and small-caps.

Stocks you will keep away from...
Fortunately, in the FMCG sector there are fewer business risks vis-à-vis other sectors. For instance, leverage has been a significant concern in other sectors. Whereas most of consumer companies have net cash on their balance sheets. Having said that, even in the FMCG space (especially mid- and small-caps), few stocks have high leverage and we are staying away from them. In the context of deceleration in growth for the sector we are also avoiding stocks which have marginal market shares. In periods of slowdown, companies with economies of scale have significant advantages. So we try and keep away from stocks where we think market share is at risk.

In your view, how risky is buying an FMCG fund today for any investor?
Sector funds are at the top end of the risk spectrum because of exposure to a single sector which results in lower diversification. But having a sector fund in a broader portfolio of multiple funds might provide an opportunity for risk reduction. The sector exhibits a low correlation to other equity funds and differs in sensitivity to macroeconomic factors and hence, can be more effective than other sector funds. Investors should have an investment horizon of at least 5-7 years so that they can experience the entire cycle because returns in sector funds are likely to be cyclical.