Playing capital goods theme: A stock-specific approach is the right tactic

The S&P BSE Capital Goods Index hit a 52-week high of 18,252 on Monday

The capital goods or industrial sector has bounced back into the limelight on hopes of a swift economic recovery and reasonable stock valuations.

The S&P BSE Capital Goods Index hit a fresh 52-week high of 18,530.46 on Wednesday after rallying more than 30 per cent since November. As a result, the index now trades at 12-month forward price-to-earnings (P/E) multiple of 31 times – the highest since March 2018.

And there is reason to cheer. The October IIP data released last Friday post market hours showed factory output expanded the most since February. The healthy recovery in manufacturing was reflected in strong improvement in capital goods which recorded positive growth for the first time in 21 months during that period, indicating signs of an economic rebound.

The capital goods sector has also been one of the most beaten down sectors in recent years. “There are a combination of factors responsible for this such as excess industry capacity/low capacity utilisation levels, slow/uneven government spending, weak domestic economy and threat of cheaper imports,” explains Deepak Jasani, Head – Retail Research, HDFC Securities.

As shares fell to multi-year lows on account of the pandemic fuelled sell off in March-April, valuations which were already at a discount to their long term averages turned more attractive leading to renewed investor interest.

However, now, even though the outlook for the sector is improving, the recent rally suggests that the low-hanging fruits are no longer available. Hence, investors are advised to follow a stock-specific approach, say market experts.

Among important factors, investors should look at companies with good revenue visibility, strong execution track record, less leverage and favourable long-term growth prospects. Three such companies whose names appear repeatedly in brokerage reports are Larsen & Toubro (L&T), Cummins India and KEC International.

“For L&T, given the improved visibility and restart of ordering activity on large multilateral projects such as high-speed rail, we believe demand will improve and aid ordering from similar projects in metro, water segment, etc,” said Renjith Sivaram, research analyst, ICICI Direct.

Cummins India is seen gaining market share following the implementation of stricter emission norms across its product range in next 4 to 6 quarters. Margins are seen expanding aided by an improving product mix and stringent cost control measures. Analysts also like the company’s strong cash generating profile and dividend yield.

In case of KEC International, the company has a robust bid pipeline and strong order backlog and lowest bidder position for contracts worth over Rs 23,000 crore providing revenue visibility for the next two years. As operations gradually gather steam, analysts remain upbeat about the company’s execution for the rest of the ongoing financial year.

As economic prospects and order flows improve, possibility of upward revision in growth estimates of brokerages isn't ruled out.

Among other companies in the sector, analyst are positive on ABB India, Kalpataru Power and Engineers India while they have a Sell/Hold rating on Siemens, Thermax and BHEL mainly as they see limited upside after a sharp surge in their share price.

While there is optimism over positive macro data, experts await further clarity on its sustainability. “It needs to be seen if this positive growth (in IIP) can be sustained for another two months before we can conclude that there is a turnaround,” said CARE Ratings chief economist Madan Sabnavis. Another concern for the sector is the over-dependence on government spending. “As private capex is expected to be weak in the near term, the onus continues to be on the government to keep pump-priming the demand and this is subject to how fiscal deficit can be managed,” said Sivaram.

The other worry is the surge in prices of inputs such as steel, base metals, cement, oil, etc. So, unless there are clear signs of a pick-up in investments and orders, further share price gains for the sector may be limited.