#4 Growth in the Balance, FMCG stocks, and Progress vs. Caution

All dressed up…

Primed for Growth?

The balance sheets of corporate India are in fine fettle. Over the last few years, their assets have grown more than their liabilities. This is especially true of companies in the manufacturing sector: since 2018, the ratio of corporate liabilities (borrowings) to net-worth has improved from 1.1 to 0.9 times, by roughly 18%. 

Another way of expressing the health of companies is to look at the ratio of their profits to the interest they pay on borrowings. This ratio is called the interest coverage ratio, or ICR; obviously, when this ratio is higher, a business is better placed to invest in the future. To quote the Reserve Bank of India (RBI), “With reduction in interest outgo and rise in profits, interest coverage ratio (ICR) of manufacturing companies increased to 8.7 in Q1:2021-22”. In 2018, this number was at 4.86. The 80% improvement on this key metric is truly dramatic, and lays a solid base for investment and capacity growth.

The ability to invest, however, needs to be met by the need to invest, and this trigger has to come from demand. Companies set up new factories only when they see their existing plants running close to full capacity. Today, this looks like a distant horizon. The RBI puts out a quarterly estimate of capacity utilisation, in its OBICUS*.  In 2018 and early 2019, Indian manufacturers were running at a capacity utilisation of 74-75%. By the quarter of June to September 2019, well before COVID, this number sunk to 69%. Since then, it has not recovered, and during the last survey, for April to June of this year, manufacturing firms were only using 60% of their capacity. Till companies see a sustained surge beyond 75%, new investment is unlikely.

What is the financial health of their major consumer, the Indian household? RBI data on the balance sheet of Indian households is a little conflicted, because financial savings are up, but borrowings are also up. My own reading is that this speaks of two Indias - one which has saved money during the pandemic, and the other, which is taking loans to fund expenditure.  I looked then, at another quarterly RBI survey,  which tracks the attitude of the Indian consumer every two months. From 2017, through to mid- 2019, the Consumer Confidence Index ran at about 100. By the end of 2019, it had dropped to 85, and during the pandemic, hit a low below 50. The latest round, for November, shows a recovery, to 62, but there is still a great deal of pessimism around incomes, employment, and the overall economic sentiment. Spending on essential goods is looking up, but when it comes to non-essential expenditure, the Indian consumer is still hunkering down.

I turned, then, to the balance sheet of the other Indian consumer, the Indian government. Through the pandemic, the government has accelerated its borrowings. The indebtedness of a government is measured by its Debt/GDP ratio, and the number for India will hit an all-time high of 90% by the end of this financial year. If you measured the health of govt finances by interest coverage, you would get a number deep in the red, as governments rarely make a surplus; every year, they spend more than they borrow, so the interest coverage is hugely negative. With interest rates at all-time lows, this debt burden may be manageable today. But if global interest rates harden next year, which looks increasingly likely, the Indian government will be hunkering down, like the consumer, fiscally unable to boost demand in the Indian economy. 

The time to boost demand was two years ago, in 2019, when the economy showed distinct signs of slowing. Instead, the government cut corporate taxes, and boosted the health of the corporate sector. Of course they cheered then. They always do. But now, they’re “All dressed up, with nowhere to go”.

*Order Books, Inventories and Capacity Utilisation Survey

Fast Moving Consumer Goods?

Indian investors and analysts regard shares of our consumer goods companies as ‘defensive’ investments. Meaning that, when nothing else is looking very attractive, you can ‘safely’ buy shares of companies with trusted brands. Consumers keep flocking to these products, and they have ‘moats’ around them, meaning that it's difficult for others to attack their place on top of the hill. As a result, they have high and stable profit margins, and since the Indian economy is growing, so does their turnover, hence their share price, hence the value of your portfolio. Fast Moving Consumer Goods, FMCG, they’re often called.

Between 2010 and 2015, the turnover of the top seven* FMCG companies grew by just over 100%. This pace of growth makes up for any pricing mis-judgement. Even if you bought them at prices which were 50, or 70 times earnings, and this multiple dropped a little, the profit growth made up. When Nestle’s star brand, Maggi noodles, bounced back from a food adulteration charge, the prevalent wisdom around FMCG shares was underlined - “Don’t worry about the price-earnings multiple being too high - the number will always be high.”

This logic is underpinned by high growth, and makes perfect sense. When interest rates are 4 or 5%, and a business is growing at 15% per annum, as this sector did between 2010 and 2015, it’s worth paying a rich multiple for such stocks – if you are pretty sure it will continue to grow at that pace over the next several years.

That assumption may be fading now. After doubling in size between 2010 and 2015, turnover for these top consumer goods companies slowed to just under 30% over the next 5 years. Once you factor in inflation – which was 24.63% – the real growth of the companies was  just over 5%, or 1% a year. Unless we see a remarkable rebound of demand over the next few years, it may be difficult to associate the term ‘fast’ with them. 

In which case, those price-earnings multiples of 50, 60, or even 70, will make no sense.

*Hindustan Unilever, Nestle, Britannia, ITC (consumer goods only), Dabur, Marico, and Godrej. 

Technology vs. Limits to Growth

In a provocative phrase, Simon Kuper writes in the Financial Times of  “the most disastrous peaceable human who ever lived”, a GM engineer called Thomas Midgley Jr. He discovered that when tetraethyl lead was added to petrol, it reduced the ‘knocking’ sound that I often heard from the engine of my Ambassador car. Leaded petrol became the default car fuel around the world, extending engine life and reducing driving costs, before the world realised that lead in the atmosphere had gone up more than a thousand-fold, causing premature infant deaths and reduced IQs.

It’s easy to make the case that the world would have been a better place without lead in petrol. Less so for Midgely’s other significant invention, CFC gases, which powered refrigeration for decades, till we discovered that these CFCs were causing holes in the earth’s ozone layer. By then, we had created less harmful refrigerants to take their place. Most significantly, we had also eliminated small-pox from the globe (and polio is all but gone), thanks to vaccines, which could never have been deployed without refrigeration.

Discussing the Midgley article with my son, I brought up the Green Revolution. Today, it’s imperative to question the resource-intensive nature of cereal farming in Haryana and Punjab: it has depleted ground water, leached pesticide into the soil, and consumes vast quantities of subsidised fertiliser. And, our exchequer is groaning under the burden of storing all that excess grain. But India of the 1960s was starved of food, and we observed one grain- free day a week. In one infamous phrase, India lived from “ship-to-mouth”, as its wheat supply chain depended on concessional US grain, shipped to us under the PL480 program enacted by the US Congress. This was a politically awkward arrangement in the Cold War era, as India was nominally non-aligned, but part Soviet client, and it was often alleged that the White House was using wheat as a political lever. Ironically, it was an American agricultural scientist, Norman Borlaug, who introduced dwarf strains of wheat into India, and forged our independence from US largesse.

Without the Green Revolution, there is a fair chance that India would have met the fate predicted by the authors of the ‘Limits To Growth’. This 1972 publication, based on computer modelling at MIT,  predicted that food availability per capita would tail off rapidly in the 21st century. But human ingenuity is vast and unpredictable, and it would have been well-nigh impossible to predict the magnitude of either the Green Revolution, or of its fiscal and environmental burden. The reality is that the starvation of a sub-continent was averted, and we must now apply science to restore agronomic health to the Indian north-west. 

The march of technology traces the arc of human progress, and while it must be subject to questioning and scepticism at every stage, it must not be impeded by those comfortable with the status quo, or by excessive application of the Precautionary Principle.