Home / Money / Personal Finance /  Quality cyclicals is no longer an oxymoron now

We typically associate ‘quality’ with specific sectors such as consumer discretionary, staples, IT and pharma. Deep-cyclicals such as industrials and materials are considered anti-quality. Quality is evaluated by analysing trends in a company’s balance sheet in terms of debt to equity, free cash flow, return on assets (ROA), return on equity (ROE), etc. This is to ensure that the company is managed for the benefit of all shareholders and not just the largest shareholder and if the management is trying to enrich itself at the cost of other stakeholders.

This notion of cyclical sectors being poor in quality came about as the sector overinvested in the last capex cycle—early part of the last decade—at the cost of increasing debt. This, in turn, had a macro impact at a country level and balance sheet impact at the company/sector level. As per Reserve Bank of India (RBI) data, capacity utilization, or the fraction of capacity that is not idle, reduced from a peak of 80% in early 2010 to 72% in late 2015. This impacted companies in these sectors given the sub-optimal operations and deteriorating debt to equity ratio. However, over the last 6-7 years, sectoral discipline in terms of capex, improving underlying commodity prices and a resilient economy have resulted in a much-improved position.

Debt to equity and ROE trends
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Debt to equity and ROE trends

For instance, MSCI India Materials that tracks major commodity related stocks experienced a deterioration in its total debt to equity ratio from 60% at the beginning of 2006 to 100% by 2013-end. Over the same period return on equity (ROE) fell from 28% to 7%. However, starting 2015, things started taking a turn for the better and as a result the debt to equity has now come down to approximately 65% from peak levels and ROE also has seen healthy recovery at around 17.50%. Further, we also see similar trends in the Industrials space. As a natural corollary, capacity utilization as per RBI records, has also picked up and there is now a widespread expectation of improvement in private sector capex.

As a result, a greater percentage of cyclical companies now stand out as quality stocks. For instance, if we were to look at the top 30% of stocks within Nifty 100 based on ROE, it presents an interesting picture. At the beginning of 2015, while materials stock only constituted 8% of this group, this has now risen to 23%

However, investors need to keep in mind that the underlying volatility of a cyclical business will always be much higher than most businesses in a defensive sector such as the consumer space. To put it simply, the earnings of a cyclical business can be akin to a roller-coaster ride with possible large losses in a non-conducive business environment while earnings in most consumer names is more likely to be in positive territory even in the most stressed macro-scenarios. As things stand today, the term quality cyclicals is no longer an oxymoron and if investors want to look at quality stocks, then it may be worth exploring cyclical sectors as well.

Karthik Kumar is portfolio manager, alternative listed equities, Axis AMC.

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