August 9, 2011

We will all run our TVs without power

The Indian middle class is on the cusp of a fantastic change. The economy is growing by leaps and bound and so is the per-capita income. With all this money in our hands, we are and will continue to buy fridges, TVs, pressure cookers and all other comforts of life.
The white good companies have not even scratched the surface ! We have one of the lowest penetration for all these white goods and consumer goods in the world. It is silly not to believe in a glorious future. Companies like Hawkins, nestle, marico and all other FMCG and consumer companies deserve even higher valuation, because they will all grow at phenomenal rates.
In contrast, the infrastructure companies deserve the kind of lousy valuations we are seeing in the market now. Power companies, power equipment producers and all kind of companies engaged in building the infrastructure deserve the sub par valuation because the environment is  hostile. The government will never fix the policy issues and we will continue to have poor quality roads, blackouts and lack of other amenties.
If the market and a lot of investors are correct, I can visualize a scene where I will be sitting in my house without power, gas and connecting roads but with the best plasma TV and all kinds of soaps, detergents and packaged goods.
 I think I need to figure out a way to run my 100 inch TV without power and use my fancy shampoo without water :)
Is it not obvious that this scenario is not consistent?  If consumer goods are to grow, then the rest of the economy has to grow and hence the valuations of all kinds of infrastructure  related companies have to be higher. If the power, water and infra companies are doomed, do you think any of the other consumer companies will do well ?
A personal story
I hear this logic often – India has 50 Cr middle class. The global average is around X per million of population. In india, even if we double the consumption levels from here, we are looking at a huge opportunity. In view of this logic , the consumer companies deserve a higher valuation
Where have we heard this logic before?  Remember the dotcoms  and IT stocks in 2000, infrastructure and real estate in 2007-2008?
Let me give a personal story.  I used to work in the consumer goods industry in the 90s in sales.  Among the many products, we used to sell soaps . The logic would go like this – A family of 4 can use around 2-3 soaps per month. In a town of 100000, there should be a consumption of around 2-3 lacs per month. We currently sell around 10000 bars per month. So even if I can increase the penetration levels by 1%, we can easily double the volumes.
The above argument is very plausible and so easy to follow.  Except reality does not work that way.
An armchair investor like me sitting comfortably in a chair at home and sipping masala chai can come up nice projections on a spreadsheet and justify any price for the stock. But if you have worked in sales, let me tell you that it takes a lot of effort and time to grow sales. The reasons can be varied - such as poor ROI at the micro level due to which production penetration cannot be increased, or high competition - but the end result is that growth is not an easy linear process.
Company specific growth depends on a lot of factors beyond the basic macro opportunity and it is rarely a simple, linear process. If you make simplistic assumptions and pay top valuations for it, then the experience can be bad if those expectations do not materialize.
I have been investing in consumer good companies for some time now and my preference is to look for companies which can tap into a large macro opportunity and have the management capability to do so. At the same time, I don’t want to pay too much for it. Although’ too much’ is a subjective term and any number would be arbitrary, I would rarely pay more than 15-18 times earnings
Survivorship bias
The worst counter argument against the above logic is to give an example of a titan or a nestle. For every titan or such high valuation company which subsequently did well, I can give 2 examples of companies with high valuations which disappointed investors as the business reality did not match  the expectations.
One should pay for quality, but not take the logic too far.  Even if it is arbitrary and one risks missing some good companies, I would still prefer to have some cutoff to avoid buying an over priced stock which disappoints me in the future.


Anonymous said...

rohit,i like the way u keep grounded :)

mkd said...

Well articulated rational always :-)

kaho pyare said...

note 1 - seeing the subject of your post in my reader, i thought you are going to discuss science or some scientific company.

note 2 - it is very difficult to figure out when you are being sarcastic or when you are talking real.

finally i figured out that you were just telling that in long term consumer companies can not do well as long as infrastructure (companies) do not do well.

how can car sales grow at +25% if there are no roads to drive them and no place to park them.

Anonymous said...

Jhunjhunwala's comments on why variation is there in FMCG/CD and infra-

variation is a product of two-three factors according to me. One is I did some analysis and I found that valuations are a product of three factors growth, return on equity and cash flows. Now the FMCG has got reasonable growth. They have got very good ROEs and very high valuations and very high payouts. Now on the other side in infrastructure there is a constant need for money. The government's are not paying in time, the letter days are going up, lot of companies are over committed. Lot of companies need capital which is three times if you see their expansion plans two to three times a market cap. So there is anticipation for the dilution, projects are delayed, margins are not good. Then promoters have done that which are not healthy. So that is the reason why the variation is there.


Anonymous said...

So true. While on one hand we have the Hawkins of the world commanding a premium, we have IDFCs and Cromptons available cheaply.

The most common argument I hear against infrastructure is, 'no one knows when the turnaround will come'. Well, what we dont understand is, if we keep waiting for the turnaround, we might never get to enter at proper valuations.


Rohit Chauhan said...

anon / mkd - thanks for the comment

kaho pyare - i am allowed some amount of creative freedom isnt it :) ...perks of running your own blog.

who buys cars to drive ...i think these days it is a status symbol to impress your nieghbours and inlaws


Rohit Chauhan said...

anon 2- i noticed the interview after the post. the divergence in valuations is quite stark ..lets see how it plays out

rahul - the current scenario reminds me of 2008 ..everyone was waiting for the first sign of turnaround and then when it was obvious there was panic buying. lets see how it plays out this time


Lucky said...

Growth cannot be the only determiner of valuation. One must also look at profitability. If the debt levels are very high and the debt also gets costlier, the current valuations may not prove too off the mark.

So it might as well be the case that we do have power for our TVs but the power companies do not make more than meagre profits.

Ankit said...

Hi Rohit,

My 2 bits to the discussion

I blv that the key difference between consumers and non-consumers products is that consumers' come with a stickiness factor (soaps/ toothpaste/ cigarattes have existed for a long time with slightest variation) and more-over within each segment there is more stickiness for one brand over other...and all this without much of rationality from consumers (hence difficult to change the pattern)...on the other hand the non-consumer products are driven by cost/benefit analysis by consumers....Key reason why FMCG commands higher PE to infra....continuing with similar logic consumer durables/ discretionary cannot with stand the test of time due to changing technology ...hence a mediocre PE....In essence I believe that the PE of FMCG>Discretionary>Infra because PE is more a function of price elasticity (staples being inelastic) rather than income elasticity (your point that more affluence will demand more infra)...Pls suggest

Rohit Chauhan said...

Hi lucky
thats true the same time is the quality differential so high

also has something changed so dramatically in the last 2 yrs for almost all fmcg/ pharma companies to get such high valuations. dont get me wrong - i like these companies and have invested in them for the last 10 yrs ...but cant figure why the market is so infatuated with these factors regarding fmcg/ and consumer companies

nothing new in these companies which was not know ..only the market likes it now


Rohit Chauhan said...

hi ankit
you are right ...consumer companies have pricing power and competitive advantage

power and infra companies have a different set of competitive advantage ..though it is weaker than consumer companies.

infra or power companies deserve lower valuations but a PE of 6-7 for infra/ power companies v/s a PE of 40 for consumer good ..thats too wide a gap

and this nothing new ..IT companies enjoyed premium valuations for a long time when they were the market's fancy


rajesh sankar said...

Hi Rohit

Good Post. my thoughts

Power / infra companies:

1. Capital intensive
2. Long gestation period to yield profit.
3. High working capital.
4. More dependency on borrowed capital
5. High interest cost
6. Low margin
7. govt regulations and pricing cap.
8. High cash conversion cycle.

FMCG companies:

>>> Contrast to power / infra companies.


Lucky said...

I kind of understand your point now. You are not advocating same or similar valuations for the two sets of companies and are ready to accept a rationalized preferential treatment to the Pharma/FMCG ones.

The problem is that we keep going through fads. And interestingly, partially due to focus on stable and enduring competitive advantage (thanks to the value investors like Buffet and you) and partially due to turbulent times we live in, these companies enjoy kinder valuations than they deserve.

So the lesson for us could be the same: don't lose money by overpaying even for quality :-)

valueinvestor2010 said...

what is your view on FDC limited and VST Industries
The first makes Electrol Powder and the second Charmis cigarette. Do you believe they are undervalued relatively??
This is because all other FMCG firms trade at a P/E of 30+ i.e. an earnings yield of 3%. These are cheaper relatively. However, would really appreciate your views on the same.

Rohit Chauhan said...

Hi rajesh
fully agree to your point ...but not all infra, power companies are created the same. they are asset heavy but can still earn high return on capital

in the end return on capital and competitive advantage is what matter. so well run infra/power companies can compound capital very well.

agreed such companies do not deserve valuations as high as consumer companies but then they dont deserve single digit pe also


Rohit Chauhan said...

you hit the nail on the head.

there is no good or bad company ..price make all the difference

Rohit Chauhan said...

i really dont look at relative valuation much. exited VST industries before the growth happened i missed the upside.

FDC is showing dissapointing growth and hence the market is giving it low valuations ...which will not change till the biz resumes growth