Beware, 'defensive' shares come at a heavy price

The sell-off across Asian markets intensified on Monday after the government data on industrial production disappointed the Street. Poor industrial production is an indicator of things slowing down sharply due to the tightening of interest rates. The BSE Sensex has already shed close to 3% of value in the first four hours of trading.

Market pundits are advising an investment into defensive sectors like consumer and pharmaceuticals. However, how defensive are these?

[caption id=“attachment_81733” align=“alignleft” width=“380” caption=“There is a clear robust showing from consumer companies. Reuters”]  [/caption]

Scrips like Hindustan Unilever, ITC, Cipla are holding firm while broader indices shed 2% in value. Since the beginning of calender year 2011, BSE FMCG index rose 7.8% while the BSE Sensex is down 20%.

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There is a clear robust showing from consumer companies. While you may want to protect your capital by parking your money into these companies, it must be understood that shares of these companies are already expensive in terms of valuation and would not give you high returns when the market finds its bottom or starts to rally. Hence, an investor could be better-off being in cash.

Price earnings multiple (PE multiple) is an indicator of relative value of these companies. If you look at the BSE Sensex, it currently trades at 13.5 times forward earnings for year ended March 2012. Shares of ITC, HUL, Cipla, P&G Health & Hygiene, Nestle, Colgate, Marico, Godrej Consumer are all trading at twice or 25 times expected earnings for March 2012.

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According to securities firm Espirito Santo, shares of Colgate Palmolive, Hindustan Unilever, ITC, Castrol and Hero Moto Corp are trading higher than the 5-year average forward price-earnings multiple. This means the current forward PE is higher than the 5-year average.

HUL shares gained 3% on Monday when the Sensex fell 2.6%. HUL trades at a forward earnings multiple of 27 against the 5-year average of 24. Market analysts expect companies like HUL to grow at 13-15% earnings per share growth. However, the current price has taken into account these factors.

Similarly, Colgate Palmolive is currently trading at a forward PE of 28 against the 5-year average of 23. See chart below:

A fund manager at a foreign mutual fund pointed out that retail investors could hold cash instead of putting the money into defensive equities. However, institutional investors have to invest in equities and have a limit on how much they hold on in cash.

“Defensive sectors like consumer and pharma would stay at current levels as they have already outperformed the market already,” the fund manager said.

“During times of uncertainty and high volatility, companies with high dividend yield and high earnings certainty should represent better investment opportunities,” says Brazilian securities firm Espirito Santo’s India research note.

According to the note, stocks listed in the chart could be looked at by investors. However, these also include companies like Colgate Palmolive, HUL, ITC that are already rich in valuation at current prices.