Proceed with caution

The turnaround in fundamentals in the capital goods sector is some time away. So, be prudent
M K Roy has been wondering whether to invest in capital goods stocks. The 45% rise in the BSE Capital Goods Index has left this Ranchi-based lawyer agog with excitement at the prospect of more gains as a new investment cycle be gins. However, he is also apprehensive about the sector's fundamentals and valuations.
Drivers of the rally The biggest driver of the current rally in capital goods stocks is the high expectations from the new government.
"The market expects the new government to revive both GDP growth and the capex cycle," says Dhananjay Sinha, head of research and strategist, Emkay Global Financial Services. The downturn in the capital expenditure cycle was attributed to the policy paralysis that had hobbled the UPA-II government. The NDA government, both stable and reforms-friendly, is expected to be decisive and quick, especially in granting project approvals.
It is also expected to focus on infrastructure development. And, Prime Minister Narendra Modi's own track record in Gujarat inspires confidence among investors.
The economic cycle has also bottomed out. As it revives, investors expect the capex cycle to follow suit. "The belief is that here onward capex can only improve and not decline," says Sanjeev Zarbade, vice-president, PCG Research, Kotak Securities. Currently, the capital goods sector faces myriad problems. The last investment cycle between financial years 2005-08 was driven by investment in the power sector. But that sector is in deep trouble owing to lack of fuel supply.
Explains Zarbade: "Capacity addition in the power sector ran ahead of fuel supply . Many power plants are operating at sub-optimal capacity due to lack of coal supply. Gas-based power projects are languishing because the expected supply of gas from the KG Basin did not materialize." Thus, despite India being a power-deficit nation, players will be reluctant to add more capacity. The rupee's depreciation has made imported coal and gas more expensive, thereby foreclosing that option for fuel-starved projects.
Development of many steel plants has been halted due to inadequate coal and iron ore supply .
After 2009, industrial capex declined severely, which in turn had a negative impact on the capital goods sector. "Industrial capex is a function of economic growth. When economic growth was high between 2004 and 2009, manufacturers needed to increase capacity to cater to rising demand. But as growth slowed down, so did demand. The rationale for capacity expansion then vanished," says Zarbade. In fact, many manufacturers are currently operating at sub-optimal capacity, which means that they will not expand capacity for some time.
Private capex also fell because a lot of projects got stuck, either because they could not complete land acquisition or failed to obtain environment clearance, while some got stalled because their promoters are facing allegations of irregularities and misrepresentation while bidding for them.
Furthermore, many companies took on heavy debt to finance their expansion. "Till balance sheets are repaired, you will not see capex expansion," says Shetty. Many of these issues will not get remedied overnight. Hence, reviving the capex cycle, despite the govern ment's best intentions, may take at least a year or more. The current situation while valuations within the capital goods sector have turned expensive, demand hasn't increased significantly to make one bullish on the earnings prospects of these companies. "The political change at the centre has triggered expectations of improvement, but it will take some time for the picture to change at the ground level," says Nilesh Shetty, associate fund manager, equity, Quantum AMC.
What you should do Invest in companies that can offset the weakness in the domestic market by expanding abroad. Companies catering to consumption and urbanisation offer good scope. Stick to players with strong balance sheets and those having strong and ethical management. "The management should have demonstrated strong execution capability in the past," says Rahul Shah, vice-president, Equity Advisory Group, Motilal Oswal Securities. Go with companies having large order books. Look for players with an economic moat, say, by way of a technological advantage. Finally, avoid stocks with expensive valuations. For example, Engineers India and Havells have attractive valuations.
Instead of investing at one go, accumulate the stock whenever its price declines. And have an investment horizon of at least three years.