While consumption stocks dominated the stock market in the last decade, now it's the industrial stocks that are making a comeback. In the past year, industrial stocks like L&T, Siemens, ABB, Thermax, Polycab and KEI have delivered exceptional returns to investors. Moreover, all these stocks are trading close to their 52-week high and are getting re-rated by most of the brokerage firms.
Investors preferred to pick consumption stocks over Industrial stocks in the last decade as private consumption in the economy increased while investment in the economy lagged. This trend has taken a reversal in the last two years where private consumption is showing a sign of peaking out while private investment has picked up handsomely.
Of late, the industrial sector is being re-rated due to higher capital expenditure by the central government and renewed interest of the private sector in capex.
However, one of the worrisome aspects of the Indian market is its lack of depth when it comes to industrial stocks. Thus, with a renewed focus on the industrial sector, a basket of just a few stocks in the sector are likely to enjoy the upcycle and become very expensive in the future.
Catalyst for Industrial Sector
Are the industrial stocks now ripe enough to repeat their glory days of 2004-08, when they gave multifold returns to stock pickers?
As per a recent report by Jefferies, all leading indicators like new projects, credit growth, capacity utilization and order inflows to industrial companies are reflecting buoyancy in the Industrial sector. Also, banks' capital adequacy ratio at 15.7% is close to all time high and their tier-I capital to risk-weighted assets are at all time high. Thus, Indian banks are well capitalised to fund private capex.
The capital adequacy ratio is calculated by dividing a bank's capital by its risk-weighted assets. The minimum ratio of capital to risk-weighted assets is 10.5% under basel III norms.
In the last fiscal (FY23) around ₹25 lakh crore of new private projects were announced. This is up 150% from pre-pandemic levels. Also, credit growth at around 16% is close to pre-pandemic highs. But the most promising sign is higher order inflows to the industrial companies with over 15% year-on- year (YoY) growth from the pre-pandemic lows of 5%. Order flows of industrial companies have shown over 15% YoY rise for the last 2 years.
Also, capacity utilisation at 73% is above the historical average, which gives optimism that India is entering into a new phase of the capex cycle. Also, the gross debt to equity ratio of large 600 companies in India indicates that corporate leverage is at 15 years low. Jefferies noted that corporate sector leverage is at a cyclical low, and corporate spending is likely to rise in 2023.
Consumption Plateaued While Industrial Picked Up
Private final consumption expenditure (PFCE) as a share of Indian GDP rose from 54.7% (FY11) to 61.3% (FY21) as the private consumption cycle strengthened while investment cycle weakened in the last decade. But PFCE as a percentage of GDP is showing a sign of topping out as it has consistently declined in the last two years. From 61.3% in FY 21, PFCE fell to 61.1% in FY22 and it is estimated to touch 60.5% in FY 23. The important consumption indicator reversed in the last 2 years as GFCF (Gross Fixed Capital Formation) as a share of GDP has started rising.
Highlighting how last decade belonged to consumption stocks, the Jefferies report noted that rising consumption share in GDP over the last 10 years drove PE multiples. Over the last decade, as Private Final Consumption Expenditure i.e. consumption share in GDP was rising and consumer stocks saw consistent re-ratings. The one-year forward PE of FMCG stocks, which was 20x in 2011, is now 50x whereas consumer discretionary names (ex-autos) went up from 20x to 70x over the same period. The re-rating was also a function of investors preferring to play the consumption theme rather than the weakening investment theme.
Applying a similar trend as seen in the consumption cycle to capex cycle, Jefferies noted that capex revival will lead to re-rating of industrial stocks, especially as the choices are limited. There is a dearth of large liquid stock ideas to play the story, especially as a few large names, like L&T, Adani Group stocks, cement sector, suffer from ESG issues as well.