Is it Time to Shun Capital Goods Stocks?

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

We fundamental analysts try to justify things in the short run. Unfortunately, emotions rule the stock markets in the short term and at times, longer.

In economics, this can be related to the demonstration effect. Here our buying decision is influenced by others or the herd mentality effect.

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

Let me put it the other way. It's after a sector or a stock has caught the attention of retail investors, it becomes 'hot'.

In my experience, it is post a 20-30% gain in the sector, the sector comes to the limelight of investors. It's when business channels and youtubers start talking about a sector, the sector becomes 'hot'.

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 is 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 in the best case scenario.

The 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 one year, these sectors have outperformed.

1. Capital Goods
2. Public Sector Banks

Are These Stocks Expensive After a Sharp Run Up?

Returns	3 Months Return	6 Months Return	1 Year
S&P BSE Capital Goods Index	10%	10%	37%
Nifty PSU Bank Index	43%	63%	67%

Data source: Equitymaster

The run up in the PSU Bank index might be steep, but when it comes to valuations, the story is different as compared to the capital goods index.

PSU Bank Index at a Discount to its Long Term Average

Valuations	Current P/B	10-year Average P/B	Discount to 10-year average
Banks- PSU	1.2	1.3	-8%

Data source: BSE

The Capital Goods Index has a Different Story to Tell

Valuations	Current P/B	10-year Average P/B	Premium to 10-year average
Capital Goods	5	3.5	43%

Data Source: BSE

Another way to look at the capital goods sector is to capture the valuations of the top 2-3 companies and discount them two years ahead based on best-case earnings growth.

Siemens at an All Time High Marketcap to Sales

 

The median marketcap to sales ratio for Siemens has been 4x. Currently the stock of Siemens is trading at double this multiple.

The Story is the Same for ABB

 

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

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

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

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

To simply put it, the order book and earnings growth for the capital goods sector anticipated over the next two years is by far 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 on 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.

Where do the Capital Goods and PSU Banking Sectors Stand?

While valuations are sky high, the point is, if earnings double over the next two years, the capital goods sector looks fairly valued from a 2-year forward earnings perspective.

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

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

In my opinion it's time to hold your horses and not be hasty.

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.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure