Is it Time to Shun the Capital Goods Sector? 

Hi Guys, this is Aditya Vora here.

Hope all of you are doing well.

While I am recording this video, the mid cap index has reached an all time high again.

What a recovery it has been for small and mid-cap stocks over the past 2 months.

While the rally in midcaps has been broad based, certain economy facing sectors have done exceedingly well.

So friends, let me start with a small observation which I have made over the past many years about psychology in the stock market.

'People buy with emotions and then justify it with logic'

How much ever we fundamental analysts try to justify things in the short run, unfortunately emotions rule the stock markets in the short term and at times even for more.

People in the stock markets are always interested in 'hot stocks' or 'hot sectors'.

Let me put it the other way, it is after a sector or a stock has caught the attention of the retailers, it becomes a hot sector.

In my experience, it is post a 20-30% gain in the sector, the sector comes to the limelight of investors.

It is when business channels and youtubers start talking about a sector, the sector becomes a hot sector.

A quote from Sir John Templeton is apt in this case...

'If 10 engineers tell you to build a bridge a particular way, then that is how you should build the bridge.

If 10 doctors provide the same diagnosis, then you should follow the treatment.

However, if 10 analysts tell you that a stock is cheap, then you must avoid it'.

The best investments are made in companies which are out of flavour.

So here comes the important question...

As a retail investor, do you buy a sector which is the talk of the town, or do you avoid it as it doesn't make sense following the herd mentality.

The answer depends on two things in my view,

1. Valuations
2. Earnings visibility - Best case scenario.

Let's try to keep it simple by focusing on the above two factors as of now.

Th point is to marry both valuations as well as earnings visibility.

While valuations on a standalone basis have very little meaning, the consolidated picture is clear when future earnings are projected.

Let me illustrate this further by talking about two sectors which have been the talk of the town over the past 6 months.

While the indices have been flat to marginally positive over the past 1 year, these sectors have outperformed.

1. Capital Goods
2. Public Sector Banks

If you look at the slide, the S&P BSE Capital goods index has given a 37% return over the past 1 year while for the past 6 months, the sector has delivered a 10% return which is impressive as the broader indices didn't perform much.

However, on the other side, if you look at the Nifty PSU Bank Index, what a crazy run it has had over the past 1 year as well as the past 3 to 6 months' time frame.

67% returns in 1 year for the PSU bank index looks like some small cap stock performance.

While this was the price movement, it is pertinent to look at the valuations picture too.

So friends, while the run up in stock prices for the PSU Bank index might be steep, when it comes to valuations, the story is different as compared to the capital goods index.

Despite a 67% run up in valuations, the Bank PSU index is trading at a discount to its long term average.

While the 10 year average price to book ratio is 1.3 times, the PSU bank index despite a stellar run over the past 2 years is trading at a 8% discount to its long term average.

Ideally, if you look at earnings expected to come ahead and the strong credit cycle, this 8% discount should be much more.

Shows that the banking space is still not overvalued.

Now, lets talk about the capital goods sector space.

The capital goods index has a different story to tell...

The capital goods index is trading at a 43% premium to its 10 year average price to book of 3.5 times.

Apart from looking at the capital goods index what I also did is, to look at the top 2 companies to get a better sense of valuation.

If you look at Siemens, the stock in terms of valuations is trading at an all time high on market cap to sales basis.

The median market cap to sales ratio for Siemens has been 4 x while currently the stock is trading at double the multiple.

Another darling of the street is ABB limited. And the story in terms of valuations is the same.

The market capitalization to sales ratio of ABB Limited is roughly 8 times while the median has been 3x.

Looking at the capital goods sector and the companies mentioned above, the verdict would be to stay away from the capital goods sector.

I mean, the current valuations are double or more than double the 10-year historic mean numbers.

However, to look only from a historic valuation basis would be wrong.

In fact, we are missing the most important thing in the stock market, which is the importance of future earnings.

So let us look at future earnings expected from the capital goods sector.

To simply put it, the order book and earnings growth anticipated over the next 2 years, for the capital goods sectoris likely to be the best in the history of the sector.

Sub sectors like railways, which give a large part of their business to the capital goods sector, are firing full throttle with lifetime high orders and visibility.

I am sure much of it is going to translate into superior earnings for the capital goods sector.

So the question is, Where do the Capital Goods and PSU Banking Sectors Stand?

Should you get in to the bus or are you late?

Well, this is what I feel.

While valuations are sky high, looking at the way the order book is and infrastructure development happening in the country along with thrust on private and public capex, the earnings growth is expected to be strong. In fact, this cycle we are going to see the best earnings growth in the history of companies.

However, the problem is that all of this is factored in the price and the valuation of the stock.

The best-case scenario for the capital goods sector with earnings doubling also takes the valuations of some marquee companies to their mean valuations.

Lets assume that earnings of companies like Siemens and ABB double, but the problem is that over the past 2 years the stock price have already doubled which is in anticipation of good numbers.

So if strong earnings come, it will be on expected lines.

To create wealth, it is pertinent to buy stocks at a reasonable discount to their long term mean valuations.

On the contrary, the PSU bank index, is still available at a discount to its long-term averages with NPAs being the lowest in more than a decade.

If quarterly numbers are an indicator, most of the PSU banks are registering record profit growth with lowest NPAs.

I mean if you look at the quarterly numbers of these PSU banks, they are as strong as they can be with NPAs trending downwards.

In my opinion all tailwinds are there for the sector with valuations also fairly reasonable. While I wouldn't call it cheap but they definitely don't seem expensive.

So friends that was my take on the much hyped capital goods and banking space.

Do let me know what you feel about the capital goods and the banking space.

Do you agree with what I believe. Please do give me your inputs in the comments section.

Thanks.