India's capital goods (CG) companies were amongst the best performers of the previous bull-run that ended in 2008. Most CG stocks were among the investors' favourites. In fact, two of them - BHEL and L&T - are among the best-performing blue-chip stocks of this decade. However, when it comes to 2010, the performance the sector has been mixed to say the least.
As we see from the chart below, the BSE-CG Index has underperformed the BSE-Sensex during 2010. This is however notwithstanding the fact that a large part of the underperformance came in during the final months of the year. Overall, the CG index rose by 8.4% during 2010, as compared to 15.6% gains for the Sensex.
|Data source: CMIE, Prowess
Now if we were to take a look at individual companies from the CG index, there arises a mixed picture. Of the 19 companies from the index, 9 delivered returns in excess of the 15.6% return of the Sensex during 2010. The remaining 10 companies underperformed the Sensex, with 9 of them actually yielding negative returns.
This defies the popular market notion that companies from underperforming sectors underperform the broader indices as well. In the case of CG stocks, investors have rewarded companies with strong growth and reasonable valuations irrespective of the sector's overall performance.
Let's now look at the best and the worst from the CG space during 2010.
Best performers: Here is the list of best performing stocks from the CG index during 2010. The list is topped by Havell's India. This is a mid-size electrical equipments company and has largely benefited from the business restructuring it did to improve its balance sheet in 2010. The stock was trading at attractive valuations at the start of the year, chiefly because the markets perceived its problems to continue for long. But the company restructured itself, paid off large part of its debt, returned to high growth part, and its investors were subsequently rewarded for their patience.
Data source: CMIE, Prowess
As for the other good performers from the sector, it was largely a case of improved financial performance combined with low valuations at the start of the year.
Worst Performers: Now take a look at this list that shows the worst five performers from the CG space during 2010. Punj Lloyd and Suzlon top the list, and for very obvious reasons. The former remains shrouded under one legal suit after another on some of its international projects. And this has taken a heavy toll on its overall performance. The company still boasts of a big enough order backlog, but investors are seemingly cautious about the execution of the same. We believe these concerns are very valid.
Data source: CMIE, Prowess
Let's now understand the case of Suzlon, The company was growing fast, raising capital for future growth, and making large scale acquisitions. This was until it hit upon a speed breaker in 2008. Its wind-power equipments started breaking down. Customer complaints piled on. Some of them even cancelled ongoing contracts. Its balance sheet started showing stretch marks. Its cash flows dwindled. Overall, its financial position went from bad to worse. The stock took a severe beating, and has still not recovered its losses. Instead, investors continue to bleed as the company's performance is getting worse by the day.
The performance of CG stocks during 2010 make two things very clear. First, it is very important to study business performance instead of just buying any stock expecting it to go up over time. And second, valuations play a key role in a stock buying decision. So even if you expect the sector to do well and the companies to grow strongly in the future, your buy price will determine your returns over the long term. As Warren Buffett has often said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Now as far as our 2011 outlook for CG stocks is concerned, we believe that these two aspects - business performance and valuations - will continue to play important roles. The overall basket of stocks from the sector does not look cheap at this point of time. However it is still advisable to study companies individually, understand their growth prospects and see if the valuations are fair or cheap.
Most companies from the CG sector have good growth prospects considering India's plans for large-scale infrastructure spending. But then, even the execution issues are high as we have seen in cases like Punj Lloyd, Suzlon, or for that matter BHEL.