Why The Much-Loved FMCG Stocks Are Underperforming

Over the last few years, the focus on quality and high return ratios led investors to jump into fast-moving consumer goods (FMCG) stocks, often at arguably high valuations. However, with commodity costs spiking due to various macroeconomic and geopolitical issues, these companies are likely to face margin pressure over the next few quarters.

The underperformance of these stocks relative to the broader markets is visible from the large differential in the performance of the Nifty FMCG index and the broader Nifty 50 Index. FMCG behemoth Hindustan Unilever has witnessed a 10 per cent decline in its stock during the same period. Year-to-date, the Nifty 50 has risen by 17.04 per cent, compared to 9.75 per cent for the Nifty FMCG index.

Volatility in commodity prices and fears of hurting demand haven’t allowed these companies to pass on the entire cost increase, which is visible in the companies’ lower gross margins.

According to data supplied by screener, Hindustan Unilever saw raw materials costs rise up to 47.72 per cent of revenue in the third quarter of the financial year 2022, compared to 45.96 per cent in the same quarter of the previous fiscal.

Similarly, Marico saw materials costs rise to 56 per cent as a percentage of revenue in December 2021 as opposed to 53 per cent in December 2020. Procter and Gamble saw a steeper fall as material costs made up 34.8 per cent of the revenues in December 2021, as opposed to 30.7 per cent in the third quarter of FY21.

Clearly, the volatility in commodity prices does not bode too well for the FMCG pack.

Prices of crucial commodities such as crude oil, palm oil, speciality chemicals, and packaging materials have been on the rise since the last year. The announcement of a ban on palm oil has already caused the prices of these companies to fall significantly as higher prices and sourcing could become an issue for these players.

Over the last few years, brokers and finance professionals have marketed FMCG companies as evergreen companies that will perform regardless of the valuation one buys these companies at.

Further, these companies today face competition from several online-first brands that have quickly scaled to mid-sized companies within a few years of inception. These direct-to-consumer (D2C) brands have managed to take advantage of the technological revolution and sell to customers directly.

Distribution, which has been one of the biggest strengths of FMCG companies, is becoming relatively weaker as internet penetration rises and a larger number of areas can be reached by D2C companies. D2C companies have also been quite aggressive in building new brands by partnering with popular influencers across social media channels.

Incumbents, in contrast, have been relatively slower in building their digital presence. While D2C is unlikely to dislodge FMCG giants from their perch anytime soon, some D2C players have grown to sizes comparable to several traditional FMCG companies.

The growth of larger distributors such as Metro Cash and Carry, Reliance Retail, and Jiomart has resulted in FMCG firms having to offer lower prices due to the high volumes of goods sold to these players. It is expected that these players would take away their share from traditional distributors in several segments, helping them increase their bargaining power.

Similarly, the rise of modern trade channels and the shift away from fragmented general trade channels could mean relatively lower margins and longer credit periods as modern trade outlets get better credit terms from FMCG manufacturers.

While some players have managed to maintain their operating margins by cutting other costs, there are limits to cost-cutting, and continuing to maintain margins could be a tough task going forward. The underperformance in FMCG could last for a relatively long time period if commodity prices continue to remain volatile and capital moves into other sectors that are witnessing improved fundamentals.

However, the brief period of pain has probably demonstrated to investors the problems with buying into storied stocks that are priced to perfection, without regard for the potential headwinds the sector faces.

This article was first published here.