Stock prices of FMCG and pharma cos are believed to be overheated.

However, the majority of these defensive stocks are still fairly valued and quite a few of them look cheaper than their historic valuations. An

 WHEN a stock becomes too hot to handle, stay away. This is the advice of most analysts and fund managers. And right now, it's considered that stocks of fast moving consumer goods (FMCG) companies and drug makers are overheated. But we differ. An analysis by ET Intelligence Group shows that despite the recent rally in their stock prices, majority of defensive stocks are still fairly valued and quite a few of them look cheaper than their historic valuations. A handful of the 29-odd stocks in our sample do look expensive based on their long-term ratios, but the premium is reasonable and nowhere near the bubble zone visible, in case of growth stocks in late-2007 and early-2008.
    For over three years in a row, the FMCG companies and pharma manufacturers have been outperforming the broader market. The rally in these two defensive sectors have been especially sharp in the past six months with the ET FMCG and the ET Pharma Index appreciating by 15% each since the beginning of this year — much higher than 3.5% rise in the Sensex during the period. A majority of leading companies in these two sectors now rank among some of the most expensive stocks in the market as measured by their price-to-earning multiple. But investment in these stocks can still fetch you handsome returns as their premium valuation is more than justified. The earning growth in most of the companies in our sample has kept pace with the rise in their market capitalisation. Besides the broader market continues to be volatile, FMCG and pharma stocks offer the most stable earnings growth in the forthcoming quarters.
    There's nothing novel about the premium valuation of defensive stocks. Our analysis shows that historically, FMCG and pharma stocks have always traded at a premium to the market, except for two brief occasions in 2003 and 2007, respectively. (See Always Been Expensive). If anything, the valuation gap between the defensive sectors and the broader market has only narrowed in favour of the latter in recent years. While the Nifty is currently 10% lower than its all-time valuation touched in December 2007, ETIG's defensive index is still over 25% below it's all-time high reached in March 2006. This opens up the possibility of another rally in the stock price of defensive stocks.
    Our analysis is based on the financial and the market performance of a mix of top 29 companies from FMCG and pharma sectors for the past 11 years. Some of the leading stocks in our sample include ITC, Hindustan Unilever, Dabur, Nestle, Marico, GSK Pharma, GSK Consumer, Cipla, Tata Tea, Sun Pharma, Asian Paints, Britannia, Colgate Palmolive, Castrol, Novartis, Pfizer, P&G Hygiene, Piramal Healthcare, Lupin and Gillette India among others. We dropped companies such as Dr Reddy's Lab and Ranbaxy Lab from our sample as their earnings are highly volatile and may have skewed the results.
    On an average, these stocks are currently trading at around 24.5 times their net profit during the year ended March 2010. The current valuations are not much higher than their 11-year average P/E multiple of 23.2x. The trend doesn't change much, if we consider the sample's valuation in the past five years (22.6x).
    In the past 11 years, the combined market capitalisation of the 29 stocks in our sample has jumped by 3.35 times from Rs 1.21 lakh crore in June 1999 to around Rs 4.4 lakh crore in June 2010. This compares favourably with the 337% growth in their net profit and a 330% growth in net sales during the period. So despite being expensive, the rally in their stock price is fully justified. (See Getting better with time )
FMCG SECTOR
In the past 11 years, the earning growth of top 16 FMCG companies in our sample has outpaced the rise in their market capitalisation except for the three paint companies — Asian Paints, Berger Paints and Kansai Nerolac. The combined earnings of these companies have grown by 375%, but the market capitalisation of these stocks has only increased by 185% during the period.
    The most surprising thing is that the FMCG giants that form 85% of the FMCG market capitalisation have not been given a valuation they should get, despite their earning growth and risk premium that they deserve. Major players — ITC, Hindustan Unilever (HUL), Nestle and Colgate-Palmolive — have shown double-digit growth in their earning growth as against the increase in their market cap.
    Among these, HUL and Colgate Palmolive are trading at a discount to their previous five-year median price-to-earning (P/E) multiples. For instance, HUL is trading at a P/E of around 24 while it previous five years median P/E is 28.2. All the above mentioned paint companies, besides ITC and Marico, have maintained their valuations and not seen much volatility in their valuation ratios in the past five years.
    However, other companies that include Nestle, Dabur, P&G, GSK Consumer Healthcare and Castrol, which are trading at multiples higher than their trailing five years median ratios, will have to show higher earning growth in subsequent quarters to sustain the premium that they are receiving at this point of time. Any slippage in earning growth may mean a sharp correction in their stock price.
    Tata Global Beverages (formerly Tata Tea) is currently trading at a P/E of 15x, which is much higher than its five years median P/E of 12. The company however deserves the premium and may in fact witness a further rise in its valuation, if it could sustain its growth momentum. TGB's market cap has gone up only by 2.6 times in last 11 years compared to 31 times jump in its earnings during the period.
PHARMA
As in FMCG, even in the pharma sector, the earnings have outpaced the growth in the market cap. The earnings of the top 13 companies have jumped by 11 times while the market cap has increased only by six times. But the pharma space has been very active and varied in terms of the way each company has performed and rewarded by the market. INVESTORS have been more careful than before and the market capitalisation have increased with the same pace as that of their earnings, though there have been some outliers, such as Aurbindo, Glenmark, Lupin and Torrent Pharma that have seen their earnings increasing much faster than their valuations.
    These companies have shown a very high growth in earning in the past five years, which also is due to the small earnings base back then.
    As far the valuations of these pharma companies are concerned, Aurbindo, Glennmark, and Pfizer are trading at a lower P/E multiples than their past five years median and average multiples.
    Aventis pharmaceutical, IPCA and Sun Pharmaceutical are trading at much higher valuations than their previous five-year median and average valuations.
FUTURE OUTLOOK
When the street goes short on these stocks, we take a contrarian view and say that these stocks are still the best bet for retail investors given the macroeconomic uncertainty arising from sovereign debt crisis in Europe and doubtful recovery in the US economy. Most of the defensive stocks in our sample rely on domestic consumption growth and are mostly self funded. This makes them impervious to the gyrations in the global economy or the volatility in the financial markets. While their domestic focus and strong balance sheet protect them from turbulence of the global economy, their earning growth is ensured given the continued buoyancy in consumer demand. In the past 12 years ended March 2010, the private final consumption expenditure (PFCE) at current prices has grown at compounded annual rate of 10.8% and has kept pace with the increase in GDP.
    In recent years, consumption demand has marginally lagged behind GDP growth, but that is because of rapid expansion in fixed capital formation, which is natural in a fast-growing and capital hungry economy like India.
    krishna.kant@timesgroup.com