Take a fresh look at defensive stocks

Defensive sectors such as FMCG and healthcare have actually proved good bets in a rising market too.

---

Rajalakshmi Sivam

Investors usually look to defensive stocks to protect their portfolios from damage during market falls. However, defensive sectors such as FMCG and healthcare have actually proved good bets in a rising market as well. Had you picked some of the pharma stocks or consumer goods stocks in March last year, your portfolio returns would have skyrocketed by now.

Lupin, Dr Reddy's Laboratories, GlaxoSmithKline Consumer Healthcare, ITC, Colgate-Palmolive, and Dabur India have all touched their life-time highs this month. Marico hit its new high in April. The BSE Healthcare index has delivered 100 per cent return since March last year, against the Sensex's 83 per cent. The BSE FMCG index has returned close to 60 per cent in the period; the returns would have been even higher reckoning without Hindustan Unilever, which has been an underperformer (up just 8 per cent).

In the previous bull market rally, the FMCG and Healthcare indices underperformed the Sensex by a vast margin (between 2006 and 2007 Sensex return was up 116 per cent; the BSE FMCG index recorded a return of 35 per cent and the BSE Healthcare index delivered 42 per cent). What is different this time? Have the earnings outlook improved? Do the stocks remain defensive bets?

The high returns from stocks in these ‘defensive' sectors have resulted from robust earnings growth as well as a re-rating of valuations, a sign of improving investor confidence. However, for some of the ‘defensive' stocks, this has been accompanied by a rising Beta and investors may need to exercise caution from here on.

Part of the reason why ‘defensive' sectors such as consumer goods or pharma have outperformed in a rising market stems from their fundamentals.

Earnings picture

Consumer goods and pharma companies have fared much better than the BSE-500 companies in sales and profit growth in FY10. While the BSE-500 companies reported an average 5 per cent growth in sales, the BSE FMCG companies saw sales rising 7 per cent.

Sans Hindustan Unilever, the growth stands at an even higher 16 per cent. The consumer goods companies have been growing on robust demand growth in the hair-care, skin-care, foods and detergents segments, following an expansion in urban and rural spends. Lower commodity prices too aided margins in some segments. Net profit has grown by 19 per cent (sans HUL it was 33 per cent) for the BSE FMCG index constituents, far higher than the growth of the last two years.

For the pharma companies, improved domestic demand, new product launches and increasing preference for generics in the US helped good sales growth. The companies of the BSE Healthcare index reported 11 per cent growth in sales (consolidated) while profits more than doubled, thanks to a fall in crude oil prices and the favourable rupee-dollar exchange rate.

Re-rating of valuations

Pharma players have seen a good year pass by. With a substantial amount of outstanding FCCBs being bought back (by players such as Aurobindo Pharmaceuticals, Lupin, Orchid Chemicals, Jubilant Organosys) during the year, the mark-to-market losses arising from exchange rate fluctuations, declined for many. Also, as the rupee continued to be weak against the dollar for most of the year, some pharma companies even made forex gains on their overseas trade.

The above developments apart, a revival in the merger and acquisition deals within the sector also helped valuations in many cases. The interest evinced by foreign drug majors in Indian pharma companies (Pfizer-Aurobindo Pharmaceuticals; Pfizer-Strides Arcolab; Hospira Inc-Orchid Chemicals), the attractive valuation at which the injectibles business of Orchid Chemicals and Pharmaceuticals was sold to Hospira Inc. (at $400 million for a business that turned revenue of $90 million), a host of new product launches and the robust growth in profits, saw the domestic pharma stocks getting re-rated.

From a PE band of 15-20 times last year, pharma stocks are now valued at around 25-35 times. Cadila Healthcare, Divi's Laboratories, GlaxoSmithKline Pharmaceuticals and Lupin have all moved to the PE band of 25-30 times. The re-rating in valuations has inflated stock returns.

FMCG companies saw PE multiples expand as their profit growth trajectory picked up. Godrej Consumer Products, Dabur India, Nestle India, Marico and Emami have moved to a PE multiple of 35-40 times from around a band of 25-28 times last year.

Who has bought them?

Were rising multiples and stock price returns for the ‘defensive' sectors backed by institutional interest in these stocks? Comparing data on shareholding pattern of the BSE FMCG and BSE Healthcare index constituents shows that while domestic institutions did not significantly hike their stakes in these stocks, foreign institutional investors have been active in doing so.

Aurobindo Pharmaceuticals, Mcleod Russel, Opto Circuits, Lupin, Dabur India and Colgate-Palmolive have all seen an over five percentage point increase in FII holding between March-09 and March-10.

FII holding in United Spirits has increased to 46.3 per cent from 30.6 per cent in March last year. Domestic mutual funds and retail investors have mostly been exiting these sectors and selling to FIIs in this period.

Rising Beta?

If FMCG and pharma stocks have traditionally enjoyed a ‘defensive' stock status in the markets, has there been a role reversal now? Having outperformed the market and with significant increase in purchases by FIIs, are consumer goods and healthcare stocks prone to higher volatility now? This may not hold good for all stocks.

Beta, the measure which indicates the sensitivity of the stock price to index changes, has risen significantly only for a few of them. For example, Glaxo SmithKline Consumer Healthcare's beta has risen to 0.6 now from 0.2 in the period between 2008 and March-2009 (the stock fell 5 per cent as Nifty corrected 50 per cent).

The other stock whose beta rose sharply is United Spirits. The stock's beta is 0.9. In the healthcare space, Sun Pharma, Biocon, Ranbaxy Laboratories, Orchid Chemicals and Pharmaceuticals, Aurobindo Pharma and Strides Arcolab are in the 0.6-0.9 beta band now.

Despite the uptrend for some stocks, ‘beta' remains below the crucial level of 1 for most companies in the two sectors. Stocks of Dabur India, Colgate-Palmolive, Hindustan Unilever, Marico, Godrej Consumer Products, Britannia, Cipla, Dr Reddy's Laboratories and Lupin are still below a beta of 0.6 despite their sharp stock price increases. Though it cannot be said with certainty that high-beta stocks will suffer when the broader market suffers a setback, it may be better for conservative investors to have a limited exposure in high beta stocks.