After a rather extended downtrend, the capital goods sector is showing some signs of moving into an upcycle, albeit slowly.

The BSE Capital Goods index has been moving up since the September quarter.

What’s driving this conviction?

To start with, unlike the last couple of years when there was investment in a few areas such as food processing and services sectors, this time the recovery is broad based. Sectors such as auto and auto components, cement, steel, chemicals, engineering and consumer goods are investing in additional capacity. Of course, the magnitude is still small in core sectors such as steel.

According to a Credit Suisse report, the index of short cycle industrial products is up in double-digits in financial year 2018. The 24% year-on-year (y-o-y) sales growth in the September quarter, without any low base-effect support, is better. “Capacity utilization has also trended up by 150-200 basis points on a four quarter moving average basis and is closer to 74% now versus 72% earlier," said the report.

One basis point is one hundredth of a percentage point.

Sustained capacity utilization implies prospects of rising order flows. The September quarter order flow growth was about 30-35% year-on-year.

Private sector and multinational firms such as ABB Ltd, Siemens Ltd, and Voltas Ltd bagged robust order books. Little wonder then that most of these stocks have rallied in the last few months.

Further, industrial goods imports are also rising steadily, which is a harbinger of a strengthening in the business cycle. Here again, the Credit Suisse report highlights that the 20%+ (y-o-y) growth in capital goods during FY18 gained momentum in the six months of FY19 to 26%.

According to analysts, if this trend sustains, it may gradually move into a strong upcycle.

That said, there are challenges as well. “Going ahead, we believe orders to gradually slow as we approach elections. Working capital continues to remain at elevated levels for most of the companies given liquidity tightening," explained an Edelweiss Securities Ltd report.

Meanwhile, export growth outlook has turned hazy, with the slowdown in the global economy.

Valuations of the firms in this sector have come off over the last three to five years. Stocks are trading at about a third of the price-to-earnings multiples hit during the peak, which could be one of the reasons some investors are accumulating.

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