Mutual Funds

FMCG Funds: Quit while the going’s good

Aarati Krishnan | Updated on October 20, 2012

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The two sector funds dedicated to FMCG stocks — ICICI Pru FMCG Fund and SBI FMCG Fund — have been chart-toppers in the equity category for five years now.

Today, they sport an average one-year returns of 41 per cent, three-year returns of 32 per cent and five-year returns of 21 per cent, on an annualised basis. Both funds have also comfortably trounced the market, earning returns that were a whopping 20 percentage points over the Nifty over the five-year period.

But with valuations for FMCG stocks now at a huge premium to the market, delivering better-than-market returns over the next three to five years may prove a tall order for the sector.

Investors should thus sell their holdings in FMCG sector funds and switch the proceeds into diversified funds such as ICICI Pru Discovery, Quantum Long Term Equity or others with a good track record. We recommend switching out of FMCG funds for three key reasons.

Too much premium

FMCG stocks have been steadily bid up in the choppy markets of the past five years, based mainly on healthy fundamentals. Leading companies in the sector have displayed pricing power and delivered predictable sales and profit growth, at a time when much of corporate India was struggling with both. With low leverage, the sector also managed to stay immune to interest-rate increases that trimmed profit margins for most companies. As a result, FMCG companies have held on to high returns on equity (ROE), in contrast to shrinking ROEs for the rest of India Inc.

However, these positives already seem to be built into FMCG stock valuations. They are now at a hefty premium to the broader market. In October 2007, the average price-earnings ratio for seven leading FMCG stocks stood at about 26 times their trailing earnings, same as that for the BSE 500 index. Five years later, the average PE multiple for the same stocks hovers at an expensive 41 times, while the broader marker trades at about 21 times.

This suggests that, for FMCG stocks to even keep pace with the market, they may have to deliver over twice the earnings growth that BSE 500 companies manage over the next few years. Given that they have a high base to contend with, this appears quite difficult.

Concentrated portfolios

What heightens the risk is that FMCG sector funds have fairly concentrated portfolios, betting heavily on just two stocks. To illustrate, in its latest September portfolio, SBI FMCG Fund, the better performer, had 38 per cent of its assets invested in ITC and another 8 per cent in Hindustan Unilever.

The top stock choices were similar for ICICI Pru FMCG Fund, with 55 per cent of its portfolio in ITC (36 per cent) and Hindustan Unilever (19 per cent). Holdings in these two stocks in fact have been consistently high for both funds.

The heavy bets on ITC and Hindustan Unilever have paid off for both funds in the last year or so, with both stocks outperforming the markets by high margins. But with their price gains driven by mainly re-rating of valuations, the outperformance appears unsustainable over the next three to five years.

The concentrated portfolios of the above funds also reflect the limited choice of FMCG stocks available for institutional investors. The FMCG sector offers not more than a dozen listed stocks. While there are quality names, low liquidity often prompts fund managers to steer clear of large positions in companies such as Nestle, Britannia or GSK Consumer. ITC and Hindustan Unilever are in fact the most liquid ones in the space.

Better consumer plays

Even for investors looking to stay defensive after the recent market rally, there are consumer-themed stocks outside FMCGs that are available at more reasonable valuations. For instance, stocks of consumer-durable companies and some textile retail names are more attractive than FMCGs. Even within FMCGs, holding select stocks may prove a better bet than holding the entire basket through the diversified fund route. Diversified equity funds may have greater flexibility to benefit from these opportunities than narrow sector funds playing on the FMCG theme.

Franklin FMCG Fund, also launched at about the same time, has already been merged into Franklin India Prima Plus in September 2011.

Published on October 20, 2012

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