Profit From The Past: Lessons from history for investing in cyclical stocks

Investors who are in for the long haul would require patience to play the waiting game.

Amid the recent market meltdown, the BSE capital goods index is down 13 percent from its 52- week and its all-time high levels. The index represents companies from sectors which are directly linked to economic growth, and are cyclical in nature.

Over the past decade, especially post-Covid, the government’s thrust on capital spending has augured well for the capital goods  and ancillary industries involved in the creation of infrastructure — such as power, roads, railways, ports, airports, industrial plants, oil rigs, logistics, mass transport, etc. The effect of this was reflected in the financials and stock market performance of capital goods companies.

Valuations gained momentum, especially over the last one year, and skyrocketed amid the market rally. The froth is finally clearing now with the market undergoing a course correction.

This reminds one of 2007-08, when capital goods and related companies commanded very rich valuations. They later corrected and remained low for a prolonged period of time when the capex tide turned in 2011.

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Let's see their market performance through this drawdown table of the BSE capital goods index. Drawdown refers to how much the index has declined from its peak during a specific period of investment, and how long it has taken to recover to its peak levels. The index includes companies from industries like power and transport equipment, infrastructure, construction, and engineering.

As you can see, from Nov 2007, the capital goods index fell 74 percent in over a year, hitting its lowest level in March 2009. The fall was  exacerbated due to the global liquidity crisis in 2008 and high interest rates. From there, it took the index over eight long years to recover. So, imagine if  someone had invested at the peak. Later, the index went through intermittent highs and lows, like peaking in November 2010 and falling 60 percent by August 2013.

Thereafter, from the lows of 2013, it took 4.6 years to recover.

The last two peak and low phases have been of shorter duration. One may argue that there has been a fundamental shift in the capex cycle over the past decade. But if we observe the present valuations, all the companies comprising the index are trading at record high price-earning (PE) multiples, or the levels seen in 2008. Please refer to the table below of the top 10 companies of the capital goods index by weight.

Sustaining such high valuations would require an exponential growth in their earnings. If the government’s infra push continues to support the growth cycle, the capital goods sector is likely to continue its earnings momentum and command the existing high valuations. The upside from here, though, appears limited.

Also, it is to be remembered that infrastructure cycles are marred with project delays, cost overruns, environmental compliance issues, political uncertainties, etc., which could affect the performance of the companies.

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Further, the industry is capital intensive and orders in the pipeline convert to revenues with a lag, as the gestation periods of the projects are long.

Investors who have direct exposure to such capital goods companies, or through investments in sectoral / thematic mutual funds should be aware of the cyclical nature of the sector. Investors in for the long haul would require patience to play the waiting game. One alternative is to exit such high-risk concentrated bets and take exposure to these companies through diversified mutual funds. A fund manager can do a better job of sector rotation in a broad-based fund and is better placed to take tactical bets on entering and exiting investments in cyclical sectors at the opportune time.

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Investors who missed the rally and ended up investing at the peak should not make the mistake of averaging out the cost by committing more money to cyclical stocks (in a falling market). It would be prudent to accept periodic losses and not let them get out of hand.

Roshni Nayak is the founder of GoalBridge, a SEBI-registered investment adviser.

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.