Must Have Sectors For 2013

The markets are well on their way to touching new highs in 2013. DSIJ tells you about the sectors that will see significant movement and will prove to be wealth multipliers for investors.

2012 has been a rather tumultuous year from the economic point of view. This is true not just for India, but also from a global perspective. We are sure most of you who actively look at stocks as an ideal wealth creating asset class have faced a lot of dilemmas through the whole of last year. Whether it was about the point at which to enter the markets or deciding on profit booking, investors have found themselves in a fix due to the largely volatile market conditions.

But we are sure that readers of Dalal Street Investment Journal have been saved that pain, and in fact, have benefited from the timely actions we suggested. Remember, we were the ones to have called the bottom of the market precisely, and that would have helped you take up positions to ride the next bull run of Indian equities. While the ride so far in the New Year has been pretty smooth, we are sure the going will be good ahead in the year too.

Of course, taking a call on the markets’ behaviour is just one part of the success story. What really matters is to put your money in the right pockets, where it is likely to grow well. In our Cover Story in the preceding issue of the magazine (‘Funds Tsunami’, DSIJ Vol. 27, Issue No. 2), we had categorically mentioned that funds will continue flowing into the Indian markets.

Picking up from where we left last time, here is a set of sectors that have healthy prospects in the year to come. The Sensex is likely to provide strong returns and there are sectors that may well outperform it. In 2012 too, sectors like Realty, Consumer Durables, FMCG and Banking had significantly outperformed the Sensex. So, which are the ones that will move up and stay there in 2013? Our research and edit team has rounded up four sectors that are worth investing in to make good returns over the next one year.

The methodology we adopted to select these four sectors include the following steps: 

• We considered the valuations based on the PE of the sectoral indices and the relative (Discount)/Premium to the broader index (the BSE 200 in this case).
• We further reinforced our view by considering the valuations based on the P/BV (Price to Book Value) of the sectoral indices and the relative (Discount)/Premium to the broader index. 
• We then considered the performance of the sector (based on the returns provided by the sectoral indices) in CY11 and CY12 and their relative outperformance vis-à-vis the broader index. 
• The weightage of each sector in the broader indices was considered so as to arrive at the relative importance of the sector in the overall scheme of things. 
• Last, but most important, we considered the future growth potential of the sector based on very obvious and some not-so obvious factors at play.

Based on the results of this sifting process, Banking finds a place among the top sectors to invest in for 2013. With the many developments that have happened in the overall economic scenario, particularly those related with this sector, it is bound to do well going forward too. The flip side is that the stocks have already seen a sizeable run- up. The BSE Bankex was up 56 per cent in CY12. Will it be able to repeat this kind of a performance yet again? There are enough reasons to believe it will.

Next in line is the Capital Goods sector. Early indications are coming from the change in the level of depreciation, which is suggesting a change in the capex cycle. The order books of capital goods companies too are swelling, and a reduction in interest rates will further speed up the capex cycle. Fund managers who had drastically cut exposure in this counter have begun scaling up their overall investment in the Capital Goods segment. Importantly, it has been severely beaten down in CY11 and saw only marginal improvement in CY12. This leaves immense scope for a bounceback to happen there.

Metals, as a sector, is also trailing in terms of valuations vis-à-vis the broad- er indices. On the returns parameter, having underperformed the broader index in both CY11 and CY12, it has a good chance of catching up now. What will primarily drive the sector’s growth in CY13 is a pick-up in manufacturing, particularly in China.

The last of our picks is the Auto sector. Many of our readers would be surprised as to why we are looking at Auto as an investment-worthy sector for 2013, when it seems to be going through a bad phase with dwindling volumes, particularly in the medium and heavy commercial vehicles (MHCV) segment. We take a contrarian view and hence, a contra bet on this sector. The most important factor that will probably change the fortunes of the Auto sector is the reversal of interest rates, which is on the cards now. The moment this happens, cheaper financing will once again be available in a big way to drive volumes. Sounds too good to be true? Have you looked at the new vehicle launches on the cards in the Indian market of late? Big international names including luxury car makers have lined up the entry of a host of models here. What does that signify, an expected demand or a slump?

We’ll leave you with that thought and proceed to give you a more detailed analysis of why these sectors will help you build good wealth over 2013.
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Banking

After a dismal performance in 2011, when the BSE Bankex declined by a huge 32 per cent, the index backed up stealthily in 2012 to go up by a humongous 57 per cent. It remained one of the most favoured sectors in 2012. Cynics may argue that last year’s outperformance might limit the performance of the index this year. However, there are strong factors that support the fact that Bankex will remain an outperformer this year too.

The primary factor is the valuation. Comparing the median Price-to- Book value (P/BV) of 2.34x for the last five years ending December 2012, the current P/BV of the BSE Bankex stands at 2.14x. Even the Price-to- Earnings (PE) ratio is currently at 13.3x compared to an average 14.3x over the last five years. But this is not the only reason that makes the banking sector look like an attractive investment option. There are various other macro-economic developments expected over the year that will help the sector to outperform the broader index in CY13 as well.

Moderation on the monetary policy front will be a key factor that will propel the growth of the sector this year. After a single rate cut it effected in the beginning of FY13, the RBI has not obliged the markets and has maintained the key policy rates as they were for the better part of the last eight months. This was primarily due to higher inflation, which just did not seem to ebb.

This situation is showing some signs of improvement and economists are expecting a minimum 75 basis points cut in interest rates in CY13. The Wholesale Price Index (WPI), which measures inflation in India, is witnessing early signs of softening and has decreased from 7.81 per cent for the month of September 2012 to 7.45 per cent for October and 7.24 per cent for November. This is also below the RBI’s projections of 7.5 per cent for FY2013. If this trend continues for the month of December 2012 as well, we may expect some rate softening as early as January 29, 2013 (the date of the RBI’s next monetary policy review meet). Moreover, in the last policy meeting, the central banker had clearly indicated a shift in stance and its concerns on addressing growth.

The impact of such a rate cut will have a big impact on the performance of the BSE Bankex. The last time we saw the rates coming down (between November 2008 and March 2010, when the RBI cut the repo rate from 7.5 per cent to 5 per cent), the Bankex doubled over the same period. (See figure: Cut In Interest Rate Boosts Bankex Returns). The most important point to note is that not all of these gains are due to an expansion in PE. (PE expanded by 50 per cent in the same period). It essentially implies that rate cuts boost the performance of banks (in terms of credit growth as well as treasury profits), and in turn, help in improving their valuations.

Nonetheless, there are some concerns regarding the deteriorating asset quality of banks, which may drag their performance going ahead. This concern will go away with an improvement in the Index of Industrial Production (IIP) figure, which, over the past, has shown a negative correlation with the non-performing asset (NPA) provisions. It may seem like jumping the gun to say that there is an uptick in the IIP by just looking at the figure for October 2012 (up by 8.2 per cent on yearly basis), yet, it can scarcely be argued that things are improving.

Therefore, we believe that although the BSE Bankex has moved up by 57 per cent last year, the index still has a lot of steam. As and when the rate cut actually kicks in and industrial activity picks up, we may see a catch-up in valuations and further upward movement in banking stocks. You can surely bank on them, so, stock on.
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Capital Goods

The Capital Goods sector has been lying low for almost two years now. The sector faced a host of maladies, including higher interest rates, which resulted in a slower (rather halted) capex cycle, ultimately leading to lower order inflows for the capital goods companies. What added to its woes were the increasing raw material prices, which saw an erosion of operating margins. As expected, the sector, which was once witnessing strong growth on account of rapid GDP expansion, ground to a halt after 2009 as India entered a slower growth period. The slower growth resulted in a significant decline in order flows for these companies and diminished margins. The declining capex was also evident from the sharp fall in depreciation for the past few quarters. The overall result of this was that the sector remained off the investors’ radar.

Things are changing for the better now. The capex cycle is on a revival path, which is indicated by the increased depreciation for the September quarter of 2012. The quarter also brought in some other good news, as the order inflows of most of the companies witnessed good growth.

While the early indicators are in place, there are many growth drivers for the future too. Moves towards diversification made by capital goods companies is a noteworthy point here. With a sharp slowdown in the domestic investment cycle over the past two years, we expect the companies to increasingly diversify on two fronts - geographically and vertically. To qualify this with examples, players like KEC International, Thermax and L&T have successfully won orders and seen growth from outside India too. We see this trend gathering pace as Indian players are aggressively expanding into the Middle East, Latin America and Africa. So, while leading economies are not growing, Indian companies are looking for opportunities in other countries. A company like L&T has also been extremely successful in compensating for the lack of power orders with road and urban infra contracts. K Venkataramanan, CEO, Larsen & Toubro, elaborated on this saying, “Uncertainty prevailing around revival of growth in the global economies have led to deceleration of growth across the sector. However, our company has been sustaining its growth momentum on the back of its strong and diversified business portfolio and increasing international presence.”

Another growth factor will be the increased demand from the captive power segment. Higher industrial production, as indicated by the improving PMI numbers, coupled with power deficits across the country, especially in highly industrialised states such as Tamil Nadu, Karnataka, Andhra Pradesh and Maharashtra, will lead to increased demand for captive power as it is cheaper. Statistics have it that the cost of captive power would be around INR 4.20 per unit as against INR 56 per cent unit paid for grid power. Further, captive power is a much more reliable source. We expect the captive power market to revive to around 2 GW per annum as against just 1 GW seen in FY12. The government’s 12th Five Year Plan also suggests that there will be 13 GW of captive power capacities being added in India as against 10 GW that were added in the 11th Plan, and this will make for a huge order book.

Apart from the power sector, order inflows are also improving from other sectors like roadways, irrigation, railways and construction equipments. After a dull H1FY13, the tendering activity has increased significantly. While the number of tenders in the month of November 2012 has almost doubled on a YoY basis, there has been a 57-60 per cent growth in value terms (See table: Tendering Activity).

With the orders flowing in, the operational performance of companies is also expected to be very strong. Commodity prices are expected to rationalise, helping companies to perform better on the margins front. Apart from this, margins improvement is also expected as the interest cost is likely to come down. While this is expected to drive the capex cycle, the interest cost on working capital too will come down. This will be a double booster for capital goods companies.

The moot question is why will FII funds flow into this sector? The most important factor is that a majority of capital goods companies are MNCs with a strong management bandwidth. Secondly, in the past two years, these companies have gone through a difficult time, and hence, are available at cheaper valuations. Though the average P/E of capital goods companies stands at 19.50x, which is marginally higher than that of the BSE 200 Index and even the Sensex, we feel that the sector has historically enjoyed a good premium over the broader market. Additionally, it enjoys a marginal premium over the BSE 200 Index in P/BV terms. Hence, the sector seems to be placed well on the valuations front. All said, it looks good to add value to your portfolio.
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Metals 

The performance of the Metals sector is closely linked to the international market, especially to the economic performance of China and the US. Over the last two years, due to the deteriorating global economic conditions especially in China, US and Europe, stocks of companies in the metals sector have been the most beaten down ones. This is evident from the under-performance of the Metal index in the last two years. In CY11, the BSE Metal Index was down by 48 per cent and in the following year, although it was up by 19 per cent, it largely under-performed the broader market index, the Sensex, which was up by 25 per cent.

Nevertheless, as the global economy gathers momentum, metals as a sector will be looking attractive for the first time in the last two years in terms of both valuations as well as relative performance. The early signs of a revival in the economy are reflected in the pick-up in the global manufacturing PMI. For December 2012, it expanded for the first time in the last seven months, which argurs well for the metals sector. With the US having partially resolved its fiscal cliff issues, relative calmness on the European economic front and acceleration in Chinese growth, we may see the start of a rotation into cyclical sectors like metals.

Even on the domestic front, things are improving. The Finance Minister P Chidambaram has unleashed a spate of reforms that will help investments to grow going forward. The setting up of a Cabinet Committee on Investment (CCI), in particular, will help expedite big ticket infrastructure projects and will thereby, fuel the demand for metals.

What will also help the stocks in this sector along with a growth in volumes is the likely improvement in financials along with a firming up of metal prices. In the first week of January 2013 alone, steel companies like JSW Steel, Essar Steel and RINL have increased the prices of steel thanks to the improvement in the demand situation and a rise in input prices. Other key metals like aluminum, copper, etc. are likely to see their prices firming up once the economy picks up. With a lot of debt sitting on the books of these metal companies, an interest rate reversal will surely help these companies to significantly improve their margins.

Besides this, the cheap valuations at which metals stocks are trading will attract a lot of investors. For example, Tata Steel and SAIL are currently trading at a PBV of less than one, which is below the levels seen in 2008 and 2009. That was a period when we saw a crash in commodity prices. Moreover, companies in this space (like Hindalco, Tata Steel, SAIL, etc.) are among the best in terms of management bandwidth, and also have clear records on the corporate governance front. Hence, once money starts pouring into equities, we may see this sector shoot up. The last quarter of CY12 hints at this, as the BSE Metal Index was up 4.5 per cent then.

In sum, improving global as well as domestic macros along with an improvement in the companies’ financials will definitely help the metals sector as a whole to outperform the broader market in 2013.
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Auto

The Auto sector may not be firing on all cylinders in last couple of quarters, and therefore, seeing this sector in our preferred list may surprise some. Like many other cyclical sectors, auto is plagued by weak demand due to higher interest rates and lower economic activity. Nevertheless, scratch the surface of the segment-wise numbers of auto sales, and the situation does not seem to be as bad as is being made out to be. In truth, it is the medium and heavy commercial vehicles (MHCV) segment that is pulling down the performance of the entire sector. All the major players like Tata Motors, Ashok Leyland and M&M have witnessed de-growth in the MHCV segment and the sales of these three companies are down by 26.2 per cent, 11.7 per cent and 10.2 per cent respectively on a year-to-date basis.

However, the growth drivers of this segment are expected to show signs of revival in 2013. According to a report by Fitch Ratings, the volumes in the commercial vehicles segment have traditionally displayed a strong correlation of as much as 86 per cent with the Index of Industrial Production (IIP) between January 2007 and October 2012. As industrial activity picks up, it is reflected in the improving IIP numbers, as has happened for the month of October (8.2 per cent). If the same trend is followed, we may see the demand for commercial vehicles go up following this performance on the IIP front. A reduction in interest rates will further benefit this sector. In fact, that is the biggest bet that goes in favour of this sector. More than 90 per cent of MHCV vehicles are financed, and a reduction in interest rates will definitely help this segment to play the catch-up game.

The Passenger Vehicles segment, which accounts for 15 per cent of total sales of the auto sector in term of volumes, has maintained its momentum. Major players like Maruti Suzuki have shown a growth of four per cent in this segment in CY12. Even the two-wheelers segment, which forms 77 per cent of total auto sales by volume, is maintaining its momentum and is far from being down and out. All this points towards a marked improvement in the fortunes of this sector, which would only get better from here on.

Here, we would sound a note of caution. We have included this sector as a purely contrarian bet. We do not foresee anything much worse happening here from what has been seen so far, but you never know. So be cautious in playing out the auto sector.

We would like to say that while we have tried to analyse the sectors well in detail, we would certainly keep track of the developments on all fronts. If need be, a course correction is always a viable solution rather than wealth erosion.