Capital goods stocks have enough steam left to power ahead

Foreign institutional investor inflows into the sector showed moderation, declining from $1,141 million in August 2023 to $456 million in March 2024, as per NSDL data. (Photo: Pixabay)
Foreign institutional investor inflows into the sector showed moderation, declining from $1,141 million in August 2023 to $456 million in March 2024, as per NSDL data. (Photo: Pixabay)

Summary

  • A multitude of stocks in this sector have experienced significant growth over the last couple of years

New Delhi: With an astounding 77% surge in the past one year, the S&P BSE Capital Goods index has ignited discussions regarding the sustainability of returns and potential corrections in the industrials sector.

What added fuel to the fire was that foreign institutional investor (FII) inflows into the sector showed moderation, declining from $1,141 million in August 2023 to $456 million in March 2024, as per National Securities Depository Ltd (NSDL) data. 

Even mutual fund holdings in several capital goods stocks have moderated, showed data compiled by Abhilash Pagaria, head at Nuvama Alternative & Quantitative Research. 

He highlighted that the value of buying by mutual funds in industrial stocks like Schaeffler India Ltd, Bharat Heavy Electricals Ltd, Cummins Ltd, Kalpataru Projects International Ltd, Praj Industries Ltd, Siemens Ltd, Thermax Ltd, Apar Industries Ltd and ABB India Ltd, has come down dramatically.

Having said that even as a multitude of stocks in the capital goods sector have experienced significant growth over the last couple of years, fund managers remain confident that there is still untapped growth potential in the space.

“Even as price-to-earnings multiples of companies have expanded in these sectors, there is scope for earnings to grow significantly further," said Charanjit Singh, a fund manager at DSP Mutual Fund.

He highlights the themes of capital goods and power as multi-year trends, and believes that sectors such as road, railway, and defence have massive growth opportunities. After the election results are announced and the new government assumes office, the second half would see a pickup in activity across roads, railways and water sectors.

For key verticals such as renewable energy, power transmission and distribution, defence, railways, metro and water, order inflows have largely been stable throughout FY24 thanks to the government’s continued thrust on capital expenditure (capex). Following the general election, reforms are expected in power distribution, mining, and manufacturing sectors.

On the private side, investment activity has been selective, predominantly in segments such as data centres, real estate, cement, metals and mining, industrial automation, and production linked incentive-led capex. Green shoots are visible and the ordering momentum is expected to gather steam after elections. This is expected to prompt a sector-wide re-rating of valuations.

Singh echoed a similar sentiment, stating, "The private sector will experience an upswing starting from FY26, which will bolster the earnings of capital goods companies." He expects this manufacturing-driven cycle to persist across various sectors for 5-8 years.

All said, policy continuity remains key for sustaining growth in the capital goods sector. The government aims to achieve 'Viksit Bharat' status by 2047, with a $30 trillion GDP, outlining short-term, medium-term, and long-term goals. This would also spur activity in the capital goods space.

According to Ihab Dalwai, fund manager, ICICI Prudential Mutual Fund, “Power generation and transmission are expected to see good investment going ahead. Power demand growth has been strong and secondly the push to renewables will require additional investment in transmission."

Though, “One will have to be selective as valuations are at elevated levels. Bottom-up approach should be adopted going ahead," Dalwai said.

As the March quarter earnings announcements draw near, capital goods companies may experience a moderation in order inflows during Q4FY24 due to the impending elections. Nonetheless, strong order books of the companies should provide healthy revenue visibility.

“We expect 15% year-on-year (YoY) growth in execution in 4QFY24," said a Motilal Oswal Financial Services report dated 3 April. For companies under its coverage, the brokerage estimates a revenue growth of 15% year-on-year, with Ebitda and profit after tax growth of 13% and 5% respectively in Q4. Ebitda is earnings before interest, tax, depreciation and amortization.

Although many players are currently operating at peak margin levels, it is crucial to monitor their ability to sustain or expand these margins moving forward.

Meanwhile, ongoing supply chain disruptions, which have persisted since the past few quarters, might continue to hamper execution in the coming quarters. The market will closely track the corporate commentary on the Red Sea crisis.

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