Investors start shifting to cyclicals from defensives

Defensives like HUL, ITC, Dr Reddy?s and Cipla either fall or remain flat in recent rally

After being stuck with defensive stocks for a long time, investors are beginning to see opportunity in cyclical stocks. Since September 5, the BSE sensitive index, or Sensex, has risen 6.83 per cent. However, defensive stocks like Hindustan Unilever Ltd (HUL), ITC, Cipla and Dr Reddy’s Labs have either been flat or fallen.

For instance, ITC is down 5.19 per cent and Cipla has fallen 2.33 per cent. HUL and Dr Reddy’s are marginally up 0.06 and 0.02 per cent, respectively. On the other hand, Jindal Power and Steel and Tata Motors are up 20 per cent. Even ICICI Bank, State Bank of India, Larsen and Toubro, Tata Steel, Hindalco and Reliance Industries are up 10-18 per cent.

The defensive sector indices such as, fast-moving consumer goods (FMCG), information technology and pharma remained under-performers in the recent rally. FMCG has been the only index which has fallen – by 3.47 per cent – in the recent rally.
 

RISK-ON MODE BSE Sectoral indices
Sector	Sept 5, ‘12	Sept 18, ‘12	%chg
Realty	1,507.03	1,742.96	15.66
Cap Goods	9,326.18	10,512.08	12.72
Bankex	11,292.73	12,670.22	12.20
Metal	9,453.72	10,500.73	11.08
Auto	9,239.76	10,135.90	9.70
Oil & Gas	8,193.78	8,786.13	7.23
PSU	6,901.10	7,360.95	6.66
Cons Durable	6,290.87	6,668.15	6.00
Midcap	6,023.53	6,371.71	5.78
Smallcap	6,391.36	6,746.66	5.56
IT Sector	5,726.24	5,973.59	4.32
Power	1,865.02	1,938.70	3.95
Healthcare	7,399.68	7,370.00	-0.40
FMCG	5,399.42	5,212.33	-3.47
Sensex	17,313.34	18,496.01	6.83
Data compiled by BS Research Bureau

Investors are asking two key questions: Is this rally sustainable and whether it’s time to switch the portfolio to cyclicals? Going by the recommendations of the top brokerages, the answer to both these questions is affirmative.

Leading brokerages believe attractive valuations along with improving macro environment makes for a strong case to invest in cyclical sectors and exit from defensives.

Bulls are here to stay
Most brokerages have revised their Sensex targets since the reforms were announced and now expect the Sensex to achieve the 20,000-mark by December 2012, a return of eight per cent from current levels. The Sensex is expected to trade at 14-15 times FY14 estimated price/earnings ratio — a shade below its historical average of 15-16 times one year forward P/E range.

“Conditions for a new bull market are getting slowly satisfied. The yield curve has stopped flattening, liquidity is improving, valuations appear supportive and profit margin expansion is a growing possibility in the coming months. The market is likely to form a new base with positive developments on domestic policy,” believe Ridham Desai and Sheela Rathi of Morgan Stanley Research.

Further, the government is likely to announce more favourable measures in the coming months and falling interest rates will provide the much-needed impetus to India Inc's growth. On the flipside, rising commodity prices, worsening asset quality of banks and risk of populist measures before the elections remain key downside risks.

Moving away from the ‘slowdown kings’
In the past year, Indian investors favored defensive sectors such as FMCG, auto, IT and healthcare. Given the fact that most of these companies have higher earnings visibility and are cash rich, they tend to trade at premium valuations to the benchmark BSE Sensex index historically. However, currently, the current price/earnings ratio of defensives are at extreme high levels (see chart) – driven by increased risk aversion amongst investors.

Sakthi Siva of Credit Suisse says: “We suggest investors to switch from defensives into cyclicals as the price-to-book gap between cyclicals and defensives in India was even bigger than 2008 and that rising US bond yields could act as a catalyst for the switch. We continue to favour Tata Motors, Tata Steel and Reliance Industries (price to- book below 2008-09 lows).”

Notably, the trailing 12 months price/earnings ratio of FMCG index has expanded from 21-22 levels to around 30 times in the last two-three years. Factors like strong volume and earnings growth have fuelled this expansion. Also, the premium it enjoys over the Sensex has expanded significantly to 153 per cent against historic average of 117 per cent. Analysts believe volume growth across this sector is likely to tone down further. While a stronger rupee will hurt both Pharma and IT sectors, the risk to volume growth would add to the woes of technology companies.

“Investors looking to play the beta rally should increase exposure in banks, metals (although we confess that after initial momentum China slowdown concerns may temper rally), real estate and select infrastructure names and trim positions in IT services and pharma (on recent strong performance and expected rupee appreciation)”, believe Abhay Laijawala and Abhishek Saraf of Deutsche Bank.

Echoing this sentiment, Ridham Desai and Sheela Rathi of Morgan Stanley write: “Cyclicals look ultra cheap relative to defensives. We go underweight consumer staples and raise energy and materials to overweight, as well as taking industrials to neutral. We are also trimming technology by 100 basis points. Consequently, our average sector position has expanded, and we see this as our emerging strategy, as the average correlations of stocks to the market appear to be falling and no longer merits extreme focus on stock picking.”