Guess which of the BSE's sectoral indices recorded the maximum gains over the last one year? If you answered banks, petroleum, IT or pharma, think again.

The answer is the BSE Capital Goods Index (BSE CG Index) which outperformed all the other sectoral indices by a mile over a one-year period.

While the BSE CG Index appreciated by nearly 152 per cent (2109.72) to reach an all-time high, the next best was the BSE PSU Index (3313.68), lagging way behind with 115 per cent. Ditto for other big indices like the BSE Healthcare Index (2398.04) and the BSE IT Index (1884.70) which posted gains of 99.81 per cent and 14.97 per cent respectively.

For the record, the Sensex itself appreciated by only 60.67 per cent over the last year.

The secular bull run has seen gains across sectors for the better part of this year, but none more than the capital goods sector.

While it can be argued that the CG Index's market capitalisation at Rs 35,564.85 crore (Rs 355.648 billion) -- which includes 38 scrips -- is still well below that of other indices such as IT and PSU, analysts say that the sector is poised to play a more significant role in market dynamics going forward.

Most of the scrips that constitute the CG Index have - not surprisingly - also been among the biggest gainers at the bourses over the last one year.

While Bhel, which has a weightage of more than 31 per cent in the index, gained 168.63 per cent over a one-year period (Rs 454.65 on December 10, 2003), other biggies like Bharat Electronics (up 222.34 per cent at Rs 557), Siemens (up 207.03 per cent at Rs 860) and ABB (up 144.52 per cent at Rs 611.80) have also caught investors' fancy. And the story is not limited to the frontliners alone.

B1 group scrips like KEC International (up 370.67 per cent at Rs 70.60), Gammon India (Rs 420.25, up 281.35 per cent) and Greaves (Rs 47.30, up 382.65 per cent) have also proved to be hot this year.

"Stock prices of capital goods companies have moved up mainly because of two factors - the reforms in the power sector and the growth witnessed in industrial production," says Sanjeev Zarbade, research analyst at Mumbai-based Fortis Securities.

While a hike in stock prices does point to improving fundamentals of these companies, analysts view the upsurge more as a result of positive changes in the country's infrastructure development and reforms in core sectors.

The government's focus on infrastructure development, especially in the road sector, has given a boost to major engineering and construction (E&C) companies, which have seen a surge in orders.

Industry watchers also point out the policy changes in the power sector as another positive factor.

"If India has to achieve a GDP growth of 7-8 per cent, infrastructure has to do well. Opportunities in the future and the bulging order-book positions of companies have triggered the upsurge in prices," notes Amod Gore, equity analyst with domestic securities firm Sushil Finance Consultants.

Increasing opportunities in the export markets and value-added services markets like equipment management and engineering solutions have also contributed to the improved outlook on the sector, note industry watchers.

The good news is also a function of the overall improvement in the economic environment. The country's industrial sector is showing signs of an upturn which is reflected in the improved performance of companies in this sector in fiscal 2002-03 and the first half of fiscal 2003-04.

"The Index of Industrial Production turned positive in the last fiscal after recording a negative growth in FY02. The growth rate is expected to sustain for this fiscal, too. The country's manufacturing sector is also expected to do well for the next four to five years, which bodes well for firms in the capital goods sector," notes Zarbade.

Capital goods production has recorded a healthy growth of 8.6 per cent y-o-y in the first half of FY04, driven by an increase in demand and capacity utilisation.

Industrial production has also registered a rise of 5.8 per cent during April-September 2003 compared to a 5.4 per cent increase in the corresponding period of 2002.

Recovering from the lows of 1997-98, the capital goods sector managed to take small steps forward during the subsequent years.

However, things took a turn for the worse in 2001-02 as shrinking industrial investments pushed growth rates down to a negative 6 per cent.

The outlook for the sector brightened up significantly beginning FYO3, as investments in the roads and construction sector picked up and reforms in the power sector gathered momentum. According to analysts, new road projects provided a lifeline to the struggling sector.

The 2003-04 Budget added further fuel to the growth story by announcing 48 new road projects, spanning 10,000 km with an estimated outlay of Rs 40,000 crore (Rs 400 billion).

According to estimates, close to Rs 55,000 crore (Rs 550 billion) are likely to be spent on roads in the next few years.

Power sector reforms were the other big catalysts behind the revival in the capital goods industry.

The Electricity Act 2003, the securitisation of state electricity board receivables and the Accelerated Power Development and Reform Programme were mostly responsible for the upturn in fortunes of companies like Bhel, ABB and Alstom Projects.

According to Zarbade, the power sector has been the traditional demand driver for capital goods companies.

"The reforms that have taken place in the power sector, especially the introduction of the Electricity Act, are expected to contribute significantly to revenue generation."

"Moreover, companies like the National Thermal Power Corporation have made significant investment plans for the future which will yield a windfall for many companies in the power equipment sector.  Another driver is the connected investment in transmission and distribution facilities, which will also have a positive impact for the sector," he adds.

The resurgence of the auto industry and investments in oil and gas sectors has provided further stimulus for sectors like industrial machinery, drilling equipment and auto ancillaries.

"Another factor that has contributed to the interest in the sector is that big oil companies like ONGC and several steel companies have announced major capex plans for the coming years. The capital goods industry reaps the benefits," adds Zarbade.

As an intermediate industry, capital goods derive their impetus from the expected growth in end-user sectors like cement, steel and auto.

Even more so when you consider the fact that most of these end-user sectors already have high capacity utilisation levels.

Capacity utilisation levels in the cement industry is close to 90 per cent already, and this could mean even more demand for the capital goods sector as cement companies build up capacities.

Same is the case with autos and auto components which have utilisation levels of more than 80 per cent currently.

Domestic demand and growth are only part of the story. More and more Indian companies are now looking at emerging markets such as Latin America and Africa.

While the upsides from exporting are a real opportunity, these companies are also aiming to derisk their business from the volatility of local demand.

Traditionally, low labour costs and skill sets have made Indian capital goods competitive in the export market, say analysts.

Low manpower costs are estimated to give Indian companies a cost advantage of more than 7-8 per cent over big international competitors. They have also recorded improved financials with exports starting to play an ever increasing role.

"Most companies are cost competitive at the moment and are looking at export markets in a big way. The export potential is also anticipated to improve by leaps and bounds," says Zarbade.

Gore agrees that there is a huge opportunity in exports. "Currently, the percentage share of exports in total sales is very low. However, the export boom has just begun as far as the sector is concerned. Going forward I expect a tremendous increase in exports," explains Gore.

The dynamics of the export scenario is undergoing a change, too. Till now, technological constraints had made Indian companies confine themselves to low-end machinery.

However, technology tie-ups with leading international companies and the contract manufacturing window have opened up new vistas for these players.

It is estimated that the industry's combined export revenues may touch the $10-billion mark by 2006 from the current level of $6 billion.

But it's not roses all the way. Delays in capital inflows in infrastructure development and ever increasing raw material prices in items like steel and the pressure on margins have many analysts raising their eyebrows.

"The risk factor is that even if reforms are happening in the power sector, capital investments are not (yet) taking place in a big way. The big question is how soon will investments take place in the power sector - as it is happening in the roads and construction sectors," says Gore.

Even though the order books of many companies are swelling, there are definite pressures on margins.

"The pressures are mainly due to overcapacities and increasing competition for the available business," says one analyst with a prominent research firm.

The industry has been coping with the problem of overcapacity in the past, too.

"If you look at companies like Siemens and ABB, they already had capacities. Capacities have been in existence for more than five years now but there were no orders coming through. It was more a case of waiting for the right opportunities," notes Gore.

With the situation improving now, capacity utilisation is also expected to improve. Most analysts expressed optimism that companies in the sector will be able to meet the big surge in order flows going forward.

"I don't expect any significant capacity additions for the next two to three years, even with the surge in order flows," affirms Zarbade.

The companies have also undertaken restructuring measures to improve operating efficiencies.

"Fundamentals of companies in the sector are very strong. Most of them are debt-free and have managed to reduce their working capital and operating costs. Companies like Bhel and ABB are expected to post a 15 per cent topline growth in the coming year, while Siemens and Crompton Greaves are likely to grow by 10 per cent per annum," says Zarbade.

According to market watchers, valuations are quite attractive even after the current run-up in prices.

"As far as valuations are concerned, Bhel (18.94x) and ABB (28.42x) are undervalued at current levels. Siemens (20.45x) and Crompton Greaves (23.77x) also look to be undervalued. Ingersoll Rand and Alfa Laval are also good picks in the sector," claims Zarbade.

Gore agrees. "Valuations of most of the firms in the sector are still cheap. Scrips like Siemens and ABB are still lying low and have further scope for appreciation. Other picks in the sector are Gammon India, Lakshmi Machine Works and Dredging Corp. Bhel also has good potential, considering the kind of growth envisaged in the sector," he adds.

With the sector is all set to improve growth figures, marketmen  are optimistic.

"The climb in stock prices is expected to sustain, considering that the sector is likely to grow by around 6 per cent for the next three to four years. The outlook is very positive for the next two years at least," says Zarbade.