The long and impressive outperformance of defensive stocks in the Indian market may finally be over, as they will likely give way to cyclicals in 2013.
Defensive stocks found favour for most of 2011 and 2012 as a faltering economy and declining earnings drove investors away from riskier bets such as banks and autos to safer havens such as consumer goods and pharmaceuticals. As the macroenvironment brightens, cyclicals once again appear to be on the upswing.
Defensive sectors such as consumer goods have already underperformed the Sensex in December. Cyclical stocks such as banks and real estate have been among the top outperformers in the past month, rising by at least 7% even as the Sensex climbed roughly 3%.
There are three key reasons why this trend is likely to persist in the new year: the still-stretched valuations of defensives compared with cyclicals, improving sentiment on the Indian economy, and an expected surge in global liquidity, which is likely to push up prices of undervalued cyclicals much more than overbought defensives.
Even after the recent rise in December, cyclicals such as banks and automobiles appear more attractively priced compared with defensives. The BSE Bankex, for instance, is trading at 12 times its estimated forward earnings for the next 12 months. Compared with the historical price-earnings (P-E) of the index in the past five years, the Bankex’s current P-E is 16% lower. In contrast, the BSE FMCG index is trading at an estimated PE of roughly 34, which is 36% higher than its five-year average P-E.
The ratio of price-to-book value of defensives to that for cyclicals rose to a 10-year high in September and has corrected since then, as seen in a study by Gaurav Mehta, analyst at Ambit Capital Pvt. Ltd. The pendulum had clearly swung too far in favour of defensives and is swinging back towards the cyclicals now.
With central banks in the US, the European Union and Japan indicating an unfettered appetite for monetary easing, emerging markets are likely to be flooded with liquidity in 2013. Also, the Indian economy is expected to recover next year and interest rates are expected to drop, boosting earnings and risk appetite for Indian equities.
While an overall improvement in the economy tends to raise all boats, it tends to benefit the cyclical sectors disproportionately. This is likely to be truer next year because of the extraordinary gap between the valuations of defensives and cyclicals in the Indian market.
Unless a black swan event pulls back risk appetite dramatically, 2013 should see a rise of the cyclicals.