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

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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.