Consumer goods : A high ROCE and sustainable growth avenue for UTI equity fund
UTI Equity fund has a strong predilection towards investing into businesses that have strong and steady profile of free cashflow generation, high RoCEs through the cycle and a high visibility of long term growth. The investment philosophy of the fund is pivoted around buying wonderful high quality businesses that are expected to remain wonderful for a long time and equally avoiding weak businesses even if they hold a promise for a turnaround in the future. High quality companies defy reversion to mean. Let alone reversion, these companies can sustain and even improve their superior cash flows, margins, RoCEs and growth over long periods of time. It is in this context that we find that companies from the consumer sector tick most of the boxes in the narrative for wonderful businesses and therefore no surprises that the fund is always overweight on this sector.
Companies selling many items each day are better able to earn more consistent returns and exhibit stickiness in profitability over the years than a company whose business is cyclical, like a steel manufacturer or lumpy like a property developer. It is this consistency of growth and also consistency of cashflow generation that makes companies from the consumer sector so much more valuable per unit of earnings when compared to ones from the other sectors. Essentially the strong cashflow generation of these companies not only funds the capital expenditure requirements but also leaves a surplus for the equity shareholders in the form of free cashflow. Therefore despite a significantly higher PE compared to the overall markets in general, these companies have had a disproportionate share of wealth creators in the past few decades as shown in the chart below. The chart here shows the performance of BSE 200 Index versus BSE FMCG Index since 2005. Over this period the BSE 200 Index has given a CAGR return of 13.84% while the BSE FMCG Index has given a CAGR return of 17.81%
In addition to the strong cashflows and high ROCEs that help the consumer companies generate economic value and thereby enable wealth creation, there is another factor that is working in favour of these companies. This factor is GROWTH. We feel that the consumer sector has a long growth runway in front of itself and this shall lead to compounding of economic value generation for many decades to come. Lets us discuss some of the factors that render this long growth runway for the sector.
India provides ahuge opportunity for penetration led growth in various categories. Even in highly penetrated categories like soaps and detergents and moderately penetrated categories like toothpaste the volume growth is expected between 5-8%. Let’s take the example of a fairly staple category like toothpaste. As per various estimates, India's toothpaste penetration is about 70%. Infact the criteria used for working out this number is fairly liberal as it considers anyone who has purchased a toothpaste in the last three months as a user without figuring out whether the usage is regular or not. Be that as it may even this number of 70% penetration signifies growth opportunities as about 30% of the population is still either not taking care of their oral hygiene or are using some primitive methods. It however does not stop here as the per capita consumption of toothpaste in India as of 2015 is at 120 gms/ year compared to emerging markets like Philippines at 350 gm/ yr and developed markets like US at 600 gms/yr. This signifies that people in other emerging markets and certainly developed markets have started brushing their teeth twice a day and in countries like Japan even thrice a day. So the growth runway would not stop at a 100 % but would go beyond that as people would increase their brushing frequency. This can now be extrapolated to various categories within the consumer sector. Chart 1 below shows that India lags massively vis-a-vis emerging markets and developed markets in its per capita spend across categories.
The other growth driver for consumer companies is the up-trading opportunities that exist in various categories. Continuing with the same example of toothpastes, for the largest company in the category which is Colgate the highest selling brand is Colgate dental cream which is at a significant lower price point compared to better perceived brands like Colgate Active salt and Colgate Charcoal etc. However as per capita income improves in the country we will see consumers up-trading across various categories which will help consumer companies not only improve their realizations and as a result their revenues but also their margins and henceforth profits.
Last but not the least there is another potent driver of growth for consumer companies. This is the market share shift from the unorganized sector to the organized sector. As consumers become more aspirational they like to associate themselves with the best brands in each category. This shift has been happening for the last couple of decades and as is shown in Chart 2, there is enough room for a continuous market share gain from unorganized to the organized across categories. The good news here is that GST implementation is going to accelerate this shift in the coming years as the unorganized players are going to lose their most significant advantage that was tax evasion and therefore would lose out on their competitive pricing.
In summary we feel that the consumer sector operates at the intersection of high quality and sustainable growth and we feel it is a fertile growth for wealth creators notwithstanding the optically higher valuations and this is the reason behind our overweight stance.
RoCE = Return on Capital Employed; Earning before Interest and taxes/Total Capital Employed
Free Cash flow = Profit after tax+ Depreciation- Working capital requirements- Capex requirements