Capital goods boom continues

Sagely wisdom has it that excessive optimism about anything is unhealthy, but this view does not seem to be applicable for stocks in the domestic capital goods sector.

These stocks have dominated the bull market in the past year and may continue to do so, given the immodest expectations from investors about the sector’s ability to deliver steady earnings growth over the next 3-4 years.

Going by the huge amount of investments lined up for India’s infrastructure and order books of these companies, such expectations may be justified. But the question remains “do the existing premium valuations in these shares vis-a-vis the market and the regional peers leave any room for error”?

The answer is probably a “no”. ING Asset Management’s CIO (equities) Paras Adenwala says, “There is too much optimism to the extent that even a small setback could have exaggerated consequences on stocks, given that the sector is over-owned.”

According to analysts, L&T is trading at over 45 times 2008-09 estimated earnings, BHEL at over 30 times 2008-09 estimated earnings and ABB at roughly 34 times 2008-09 estimated earnings. The 30-share Sensex trades at 20-21 times 2008-09 estimated earnings.

Though not strictly comparable, the mania in capital goods stocks is eerily reminiscent of the dotcom era at the start of this century when investors were willing to pay unreasonable valuations for IT companies. Analysts cite there could be possible delays in expansion plans and order execution as most of these companies are functioning at full capacity.

Also, a higher-than-expected decline in margins, arising out of foreign competition, may be a dampener. It is known that the government is trying to rope in Chinese and Korean companies to accelerate India’s infrastructure growth.

Their entry may not be positive for domestic players such as BHEL, L&T and ABB, given their better operational efficiencies. A few months ago, power minister Sushilkumar Shinde said Bhel’s current capacity was not enough to meet the country’s power needs even if it doubles its capacity. Bhel is raising its capacity 2.5 times in the next three years.

Fund managers feel that there will be a gestation period of at least 2-3 years before foreign competitors start catering to the domestic infrastructure story. Despite concerns, Mr Adenwala remains bullish on the sector. “This is probably the only sector with visibility in earnings for at least 3-4 years.”

This is one of the reasons why most fund managers feel premium valuations in these shares are sustainable. Also, no fund manager can afford not to have these stocks in their portfolio, which have risen 125-250% in the past year.

While sceptics may argue that the stocks have become overvalued, cheerleaders point out that earnings of these companies for the latest quarter have matched high expectations that the market had from them.

Analysts estimate that total investments needed over the next 5 years to build India’s creaky infrastructure would be roughly Rs 15,000 crore. Optimists argue that there is no need to be apprehensive about the prospects of these companies, given their plans to expand to other areas of infrastructure development beyond their core strengths.