It's still early to bet on cyclical stocks

Experts prefer domestic consumption-driven plays and defensives such as information technology and pharmaceuticals

Cyclical indices such as S&P BSE Bankex, S&P BSE Capital Goods, and S&P BSE Metals have under-performed the S&P BSE Sensex in the past year (see table). Against a seven per cent fall in the Sensex, these indices have fallen anywhere between 7.6 per cent and 32 per cent. Slow economic growth, weak demand environment, drying up of private sector capex and higher leverage are among the reasons behind this under-performance.

Typically, these sectors also carry higher beta and hence react more (in either direction) than the benchmark index. For example, if the Sensex falls by X per cent in a given time frame, these indices might fall more than X per cent, and vice-versa when the Sensex gives positive returns.

However, the trend has changed over the past three months. In this period, the Sensex has corrected by a mere 1.7 per cent and some of these indices have given a return of -1.3 per cent to eight per cent. Bankex and Capital Goods are the exceptions and have fallen 4.4 per cent and 9.9 per cent, respectively, in the past three months.

This rally is led by the utilities index, which includes companies such as Power Grid Corporation, Adani Power, GAIL, CESC, Indraprastha Gas, among others. Notably, most of the stocks in this index are direct/indirect beneficiaries of recent reforms such as UDAY, improving terms of RasGas availability and ordering of new compressed natural gas buses in Delhi.

That is a key reason for the surge in these indices. Not surprisingly, the power index is up nearly one per cent in the past three months. The auto sector, too, has gained four per cent in the past three months as it is among the key beneficiaries of the seventh pay commission hike effective January 2016, besides reporting decent volume growth in recent months.

In contrast, defensive indices such as S&P BSE FMCG, S&P BSE IT and S&P BSE Healthcare have outperformed the Sensex in the past year with returns of up to 13 per cent. Except healthcare, most are ahead in three-month period, too.

Given the lack of any meaningful improvement in the financial performance of the cyclical companies, the defensive sectors were considered safe heavens and most investors held on to these to preserve their capital.

In the past three months, although the IT and Healthcare indices have fallen on the back of revenue warnings by key companies in case of the former and a host of adverse actions/notices by the US Food and Drug Administration and slowing global growth (Venezuela) in case of the latter.

In this backdrop, the key question is whether 2016 will see a reversal of fortunes for cyclicals? The Street continues to be cautious on these sectors. Nitin Bhasin, head of research at Ambit Capital, says: “It is difficult to believe things are becoming better for cyclicals in the next year.

We might see a marginal improvement in macro indicators such as GDP growth, interest rates, and inflation, but it is unlikely to move the needle meaningfully for any of the key cyclical sectors such as banking, capital goods or cement.” He believes investors need to focus on bottom-up approach and adopt the stock-specific strategy for 2016. He remains a seller of Larsen & Toubro (L&T), cement stocks, among others.

Gautam Trivedi, managing director and CEO of Religare Capital Markets, echoes this view. “We believe the time has not come yet for cyclicals as they are linked to global commodity prices. Outlook has not turned positive on commodities.” Notably, analysts at Credit Suisse as well as Deutsche Bank, too, say metals and industrials sectors will continue to be laggards in 2016.

Most analysts remain bearish on L&T citing the latter’s high legacy order book, which may or may not materialise, diversification into unrelated domains as well as a higher order book from crude-linked geographies. There’s more proof.

The domestic steel sector is battling dumping from China and has got a relief from anti-dumping and safeguard duties on imports and free-trade agreement countries. Demand environment, however, remains weak. Cement companies, too, are facing pricing and demand pressures.

The Street, though, has mixed views on the banking sector. On the one hand, the sector is witnessing tighter regulations (non-performing asset provisions, base rate calculations, etc), higher competition from new banks/payments banks/small finance banks, delayed pick-up in capex cycle and so on.

On the other, any meaningful uptick in credit growth due to lower rates and seventh pay commission, could offset some pressures arising from higher provisioning towards NPAs. Well-capitalised banks in both private and public sectors will be in a position to tap into and benefit from any uptick in credit demand.

In the longer run, improvement in real estate demand, rural wages and capex could act as key catalysts for cyclical stocks. However, these improvements are likely to be gradual in nature and the positive impact might also come in with a lag. Over-leveraged cyclicals might not benefit much from these catalysts unless they monetise their non-core assets to de-leverage their balance sheets.

While most experts are bearish on cyclicals, there are some having a contrarian view. Pankaj Tibrewal, fund manager at Kotak Mahindra AMC, says, “Investors’ growth expectations on PE stocks are much higher and so are the risks of disappointments. Our belief is that investors should ride the recovery in macro through financials and early cyclicals such as cement, capital goods, bearings, etc.

Late cyclicals such as commodities-linked sectors still have a long way to go.” He believes cement companies stand to gain as and when the government and the private sector spends pick up and the housing sector starts to improve.

The market is divided and the consensus is far from a favourable view on cyclicals.