The Indian economy is on the cusp of an upturn in its capex cycle and early signs of a pronounced capex upswing have begun to emerge. Given that Capital Goods outperform the broader market in a capex cycle upswing, it is advisable that investors to focus on this space despite the supposed weakness in the June IIP numbers.
Clear signs of an upturn in the capex cycle
Rising economic growth momentum, improving domestic demand prospects and growing capacity utilization since FY09 have translated into a recent uptick in capacity expansion plans as well as in actual project implementation. Moreover, project cancellations are trending downwards as the economy’s execution ratio trends upwards.
The rise in the capex cycle is a catalyst for higher profitability for the Capital Goods sector
An upturn in the capex cycle of the economy (FY11 onwards) bodes well for the capital goods sector. The last upturn in India’s capex cycle (FY04-06) saw companies constituting the BSE Capital Goods index experience a like-for-like expansion in their profit margins. Simultaneously, the ROCE as well as RONW cycle for this sector received a boost from this capex expansion phase.
Historically, the BSE Capital Goods index consistently outperforms the Sensex during an upswing in capex spending.
Drivers of the capex cycle : Domestic macro and 11th Five Year Plan (FYP).
In an economic upturn, higher GDP growth fuels higher capex to augment production capacity. This higher production capacity then augments the economy’s ability to grow faster. This feedback cycle will power the performance of capital goods producers through FY11. This capex upswing is likely to receive another boost over FY11 and FY12 due to a disproportionate rise in public spending as the government tries to achieve its 11th FYP (FY08-12) targets.
For instance, of the Rs. 13 tn (at FY07 prices) public investment in infrastructure planned for the 11th FYP, the annual average spending in the first three years amounted to Rs. 2 tn and the subsequent two years are projected to see an annual average spend of Rs. 3 tn.
The inadequacies of the capital goods gauge of the IIP
It is important to clarify at this juncture the inadequacies of the YoY IIP metric in measuringcapital goods production. The slowdown in June 2010 was wholly a result of the base effect switching from low negative in May to high positive in June. In fact on a MoM basis, capital goods output expanded at 6% in June 2010, significantly ahead of the ten year average
Secondly, the capital goods segment of the IIP index is most volatile (and not symmetrical annually) and hence monthly YoY observations need to be interpreted with caution. merge as the safest bets in this regard.
The Indian economy is at the cusp of another gross capital formation (GCF) expansion cycle. Its onset will boost the earnings of Capital Goods producers and their stock prices.The last capex jamboree lasted more than three years starting FY04. Between Q1 FY04 and Q4 FY06, quarterly GCF expansion averaged 16% YoY while the capital goods index delivered a return of 840% (as opposed to the Sensex return of 230%) during the same period.