Earn great returns from capital goods

Capital goods stocks are again in the limelight, backed by strong growth and greater earnings visibility for the next few years. 

Not too far back in history, it was the results of software stocks, which were avidly watched by shareholders. If software did well, there was a good chance that the markets went up too. And when software companies went down, so would the markets. 

Today, that role seems to be shifting to the capital goods sector. After oil and gas, and banking indices, the capital goods index stands third in BSE's sector indices and in the sector composition of the Sensex as well. 

The sector has smartly outperformed the Sensex - it has gained 124 per cent since the beginning of 2007, compared with the Sensex's 45 per cent. Since the end of September 2007 quarter, it has gone up 39 per cent, more than twice the gains in the Sensex of 15.5 per cent. Thus, the contribution of capital goods in the recent rally is evident. 

Driven by better-than-expected Q2 results and strong order books of capital goods companies, the BSE Capital Goods index has scaled higher levels. 

Today, whether it is an institutional or a retail investor, it is not possible to have beaten the benchmark without an exposure to this sector. The average equity mutual fund has an exposure of around 20 per cent to the sector. 

We questioned some fund managers and industry analysts to understand what makes them so bullish about capital goods. And, of course, should one buy these stocks at current levels or are the upsides priced in? 

"One can expect most of these companies to grow at about 30-40 per cent a year over the next two to three years. So, in this context if you compare the current valuations with growth in earnings or the price-earnings growth ratio (the ratio of price-earnings multiple and earnings growth), they may not look expensive," says, Ajay Bodke, senior fund manager-equity, Standard Chartered Mutual Fund. 

"Capital goods stocks are commanding a premium in anticipation of positive events in the future, which could be a huge order coming their way," added Sanjay Sinha, head equity, SBI Mutual Fund. 

And companies are getting huge orders - Larsen & Toubro has announced several projects of over Rs 500 crore (Rs 5 billion) ast. 

As highlighted by Bodke and Sinha, most fund managers believe the current rally is a reflection of the strong earnings growth over the next few years. They also believe that the earnings are sustainable. 

This is also reflected in growing order book of these companies and there is no sign of any slowdown in the flow of projects. In most cases, these companies have been able to grow their order book faster then the sales turnover. 

"I think one should take a longer term view on this sector, if these companies are growing at higher rate, they are bound to command high multiples, which seems justified from a perspective of two to three years. Moreover, these companies offer greater earning visibility," explains Raamdeo Agrawal, joint managing director, Motilal Oswal Securities.

Is this sustainable?

In stock markets, when investors value a stock or a sector at a premium, it is because they find comfort while investing in it or find it exceptionally attractive. Capital goods stocks are considered to be in the former camp. This is because of the long-term sustainable growth that these companies can deliver. 

Most of these companies have an order book to sales ratio in the range of 2.5-4 times FY07 revenue. This implies that for the next two-to-three years, even if the companies do not get fresh orders, they can still maintain revenue growth of 30-40 per cent. 

However, in a growing economy like India, it is almost impossible to think if there would be no work left for these companies. "We believe there will be strong inflow of projects in the long run, and more importantly, there will be significantly larger projects coming in their way," adds Agrawal. 

"A large part of the GDP growth is contributed by the asset formation that is why we see the capital goods index outperforming the consumption-led sectors such as FMCG," says Amar Ambani, vice-president of research, India Infoline. 

Capital formation, which was about 25 per cent of GDP in year 2000, has now gone to over 30 per cent. And if the economy keeps this pace, capital formation has to grow faster to support the growth. In the case of China, capital formation was just 23 per cent to the GDP in 1990, and is over 45 per cent, at present. 

In the pipeline

This growth in capital goods sector is closely linked to the growth in the economy. Today, when the Indian economy is growing at over 8 per cent, the capital goods sector is growing at double-digit rates. Between April and August 2007, capital goods production increased to 21.3 per cent against 19.5 per cent in the same period last year. 

The government has set a target of 9 per cent GDP growth in the Eleventh Five Year Plan during 2007-12. However, there are supply constraints within the economy, as most of the industries or related infrastructure such as ports, airports, roads, urban infrastructure, power and so on are functioning at nearly full capacity utilisation. To support the 9 per cent growth, India will require huge investment to improve the infrastructure. 

The Planning Commission estimated gross capital formation in infrastructure to rise from Rs 2,58,580 crore (Rs 2585.80 billion) in 2007-08 to step up to Rs 5,71,315 crore (Rs 5713.15 billion) in 2011-12. Considering this investment outlay, which is significantly higher, compared to the previous plan, the Indian capex cycle has a long way to go and may last for a decade.  

CAPITAL FORMATION
	Earnings CAGR* 07-09	EPS (Rs)			PE (x)		PEG (x)		CMP
		FY07	FY08E	FY09E	FY08E	FY09E	FY09E	ROE (%)
L&T	29.4	63.9	84	107	50.5	39.7	1.35	26.1	4244
The company is a diversified engineering and construction company
BHEL	39.91	42.4	63	83	43.1	32.7	0.82	28.8	2715
The company supplies electric equipment to core sectors of the Indian economy such as power generation & transmission, industry and transportation
Crompton	40.35	6.6	9	13	45.6	31.5	0.78	32.6	410
The company offers products and services related to power generation, distribution, transmission and industrial electric products
ABB	47.44	16.1	25	35	64	45.7	0.96	36.7	1600
The company provides automation products, switchgears and industrial lighting solutions to manufacturing companies
Thermax	40.98	16.1	23	32	38.7	27.8	0.68	39.7	891
The company is into cooling and heating solutions and supplies plant equipments
Siemens	34.4	31	42	56	45.3	34	0.99	36	1904
The company produces electric products and services used by different industries
Voltas	41.42	4	5.5	8	37.1	25.5	0.62	38	204
The company is present in mining, machine tools, and construction equipment

This will not only require a huge amount of investment by the public sector and the government and even private players will need to make large investments to shore up their existing capacities and their stakes in public-private projects. 

According to a report by Assocham, "India is set to become a potential goldmine as investment announcements surged to Rs 1,75,629 crore (Rs 1756.29 billion) in the months of August and September 2007." The companies across the industries like, oil and gas, power, cement, steel, telecom and real estate are all in expansion mode. 

Beneficiaries

Most of these investments are of a long-term nature and projects will be executed over the next four to five years. The ongoing capex will open up a plethora of opportunities for companies in the capital goods. 

Analysts also emphasise on capital goods companies which have exposure to the growing power sector. The government has set aggressive targets to take current power generation capacity of 1,32,329 MW to 2,20,000 MW by 2011-12 and further to 3,05,623 MW by 2016-17. This will also require a huge investment in power generation and other related equipment. 

Players like L&T, Siemens and Crompton Greaves will benefit from the booming industrial capex in the country. Even smaller players like Voltas and Thermax will stand to gain, Within power generation equipment, Bhel will be the key beneficiary. Bhel is the largest power equipment manufacturer. 

Besides, companies like L&T, ABB, Siemens and Crompton Greaves will benefit as suppliers of transformers, switchgears and EPC contracts. 

HIGH VISIBILITY
Rs crore	Order book	order book/sales
L&T	44,000	2.50
BHEL	62,400	3.62
Crompton	2,140	0.64
ABB	4,640	1.09
Thermax	3,500	1.64
Siemens	10,820	2.38
Voltas	2,000	0.79

What to do?

The investment in capital goods is a no-brainer, but the price is surely not cheap. Most of the capital goods stocks are trading at their historical highs, which often scares a potential investor. But at the same time, one cannot afford to miss the bus. 

India Infoline's Ambani suggests, "One can start investing systematically in selected companies for the long term." Buying a few shares every month is better than trying to time the market. This way, you will be consistently investing in a strong sector and enjoy the ride. 

Others suggest that retail investors should take the help of professionals. "Investors can also choose funds having higher exposure to the capital goods sector or the infrastructure funds to take the advantage of this investment boom in the country," says Agrawal. 

DSP Merrill Lynch Tiger (one-year return of 76 per cent), Reliance Diversified Power Sector (125 per cent) and JM Basic (89 per cent) are some funds worth looking at. 

There is no perfect time to invest. Not buying in the hope that the markets will correct or there will be better opportunities to invest later may lead to more surprises like it has in the past.