Any disappointment in earnings or a turnaround in other sectors could pose a risk to the high valuations of consumer stocks. Buy a stock with low or moderate valuations and high earnings growth prospects. However, in the opposite situation, investors should be cautious, as with consumer goods stocks right now.

Slowing volume growth

Fast moving consumer goods (FMCG) companies are experiencing low volume growth due to a slowdown in rural demand. Unseasonal rains early in the year; lowered or delayed food procurement and delayed payment by the government; no increase in money flow to the rural economy through government schemes and risk of a monsoon failure are all responsible factors. The correction in real estate and gold prices also created a negative wealth effect and led to cautious spending.

Over the last 5-7 years, rural consumption has outpaced urban spending by 1.5 times. Rural growth of FMCG companies is now converging with urban growth rate,. A pick up in rural demand will depend on progress of the monsoon and government spending. A meaningful recovery in urban demand is still some time away. It will depend on a pick-up in economic growth and improvement in consumer sentiment. With demand remaining weak, companies are finding it difficult to hike prices.

Margins protected for now

The steep correction in prices of commodities is expected to protect, or even expand, the margins of consumer goods players in the first quarter of 2015-16. However, any expansion in operating profit margin could be limited by higher publicity and advertising spends in anticipation of urban demand revival, says a note from HDFC Securities. Any pullback in commodity prices from the current low levels could also pose a risk to margins.

Valuation risk

The biggest risk of investing in FMCG stocks arises from their high valuations. While recovery in the economy and in corporate earnings has been sluggish, inflows into the equity market have been high. Investors have sought shelter in stocks with high earnings visibility, chiefly consumer goods. Consequently, valuations of these stocks have touched high levels compared to historical averages (see table).

While firms with high earnings visibility have done well in the past four years, they may not do so in future. Cross-cycle evidence suggests that while a strategy of investing in stocks with high earnings visibility works well in periods of slow economic growth, these stocks tend to underperform when the economy recovers.

These high valuations leave little room for further upside. What if these companies are unable to replicate past growth? At such high valuations, even one quarter's disappointment in earnings growth could lead to de-rating of these stocks. Prices could now remain range-bound due to which valuations may moderate over time. If other sectors recover and investment flows into them, then a compression in valuation of this sector can't be ruled out over the medium to long term. The following are stocks facing issues and which you should be cautious about.

ITC: ITC's cigarette business is under pressure due to sharp excise duty hikes. Its hotel business is capital intensive and the paper business lacks pricing power.The stock's fortunes could turn if the government moderates excise duty hikes and more of rural youth shift from bidis to cigarettes.

Titan: The depressed performance of gold is affecting Titan. If the rule regarding revealing PAN number for large gold purchases is introduced, it will affect the more compliant players. Competition from online retailers has intensified in the watch segment.

Nestle: Nestle's business performance has been affected by the ban on Maggi. Margins have been affected by lower operating leverage. The stock is also not cheap