Where upside lies: Fund managers still see growth pockets in industrials

Most capital goods stocks, or industrials, have rallied recently and are hovering near their 52-week highs. Still, they witnessed the greatest traction among all sectors in May. Mutual funds flocked to the industrials, investing the most in the sector during the month. Foreign institutional investors (FIIs), too, made their highest sectoral investment in capital goods stocks.

In May, mutual funds ploughed the highest in industrials sector, according to a report by PhillipCapital (India) dated 11 June. The industrials sector saw the highest buying activity in May, with its weight rising to 9.3% in MF holdings (up 66 basis points month-on-month), followed by auto & ancillary at 9.1% (up 44 bps), metals & mining at 3.7% (up 11bps), staples at 4.7% (up 7 bps), and building materials at 3.9% (up 5 bps), the report said.

Meanwhile, FIIs made the highest net equity investment in the industrials sector at $723 million in May, followed by $240 million in consumer durables and $162 million in realty, according to NSDL data.

More room for upside?

The BSE Capital Goods index currently trades at a price to earnings (P/E) multiple of 58.5 times, significantly above its five-year average P/E of 37.92 times, Bloomberg data showed. In fact, several index constituents are tad shy of hitting fresh 52-week highs. All index constituents are trading 2-14% below their 52-week highs.

Much of the optimism arises from investors' confidence in the capex outlook, as the key infrastructure ministries continue to be led by the same ministers, ensuring policy continuity in sectors such as roads, rail, and defence. Additionally, there is a robust pipeline of projects in the power sector, including thermal and renewable energy, transmission and distribution, as well as data centers.

So, as long as order inflow visibility remains strong, there will be sustained earnings delivery and hence relatively strong valuations, said Priyankar Biswas, analyst at BNP Paribas. “Given the multiple sector growth outlook, we may not expect near-term moderation of investor appetite for the space despite the valuations,” he said, adding that considering the visibility of order inflows till FY30, there is still headroom to be constructive on the space.

Read more: MDF imports spike in April, likely to remain elevated in FY25

Even Saion Mukherjee, managing director & head of equity research, India, Nomura, is of the view that the capital goods sector offers strong growth prospects over the medium term. Investments in power, data centers, railways and facility upgradation by corporates present significant growth opportunities, he explained.

He pointed out that there is high demand for high-value products, and this is reflected in strong order flows and improvement in earnings before interest, tax, depreciation and amortization (Ebitda) margin. “We think the sector valuation may adjust overtime and there may be some time correction,” said Mukherjee. Given the strong narrative, he believes a deep correction is unlikely.

That said, Mukherjee is overweight on the sector, but is more selective given the run-up in valuations. He prefers companies with diversified presence and strong earnings visibility.

Time to buy or sell?

“The sector's rapid re-rating has outpaced earnings upgrades, with valuations soaring,” said Nitin Arora, fund manager at Axis Mutual Fund. If the earnings growth continues, one might look at increasing exposure to the capital goods sector, he added.

Strong earnings and order books, a robust capex outlook, and continued government focus have driven sharp rallies, and consequently slightly higher valuations in the industrials space.

According to Arora, the capital goods sector has a structural narrative, with power emerging as a multi-decadal theme, alongside the scaling up of electronic manufacturing services companies.

Read more: After Piramal's big bets disappointed, a course correction is rekindling hopes

Meanwhile, from a positioning perspective, Sorbh Gupta, senior fund manager – equities, Bajaj Finserv Asset Management, believes one should remain invested in the sector regardless of the run-up. The only indicators that might prompt a reduction in exposure to this sector would be risks to revenue and earnings growth for the companies within it, he highlighted.

Though, according to Gupta, what possibly could change due to election outcome is that the government’s budgetary support towards capex might see some moderation and support towards consumption might increase. “This can possibly impact some companies in capital goods space which are majorly dependent on government support for capital and orders.”

Deepak Shenoy, founder and CEO of Capitalmind, remains fully invested in the capital goods sector, despite some segments being highly valued, as he believes the scope of growth is tremendous. He mentioned that they have not significantly reduced their exposure, and in fact, Capitalmind were net buyers in this sector in May and June, retaining their strong focus and selling very little.

Sub-sectors you can’t afford to miss?

Many believe that revenue growth of capital goods players will be driven by PLI schemes and opportunities in emerging sectors like electric vehicles and data centers, offering automation, digitalization, and charging network services.

“These sectors (PLI driven schemes and emerging sectors) which accounted for ~10% of investments in fiscal 2024 is expected to rise to ~25% by fiscal 2028,” said a CRISIL Ratings report dated 24 June.

Several fund managers favour data centers, railways, power transmission and distribution, defence, and water and wastewater treatment as emerging sectors for the coming years. Transformer players that are expanding capacities to meet surging domestic and export demand, are also seen as a growth pocket for the future. Solar modules, chip and battery manufacturing, and electronics manufacturing services are also on the radar.

Read more: Developed economies lead the global race to ease monetary policy, for now

Shenoy of Capitalmind finds industrial companies in the manufacturing space particularly attractive. He prefers firms with strong momentum, low debt, and significant expansion potential. With that in mind, he likes sectors such as defence, railways, shipbuilding, transformers, and power transmission lines and equipment.

The government will continue its capex push to transform India into a global manufacturing and export hub, with over 35 industries now participating compared to just 5-6 during the 2003–08 cycle, said a report dated 21 June by Nuvama Institutional Equities.