Is it the time to shift from defensives to cyclical stocks?

For the last couple of years, it is the defensive stocks that have outperformed the market. Be it IT, pharma or even FMCG; they have vastly bettered the markets. On the one hand, these companies enjoyed sustained growth and high levels of ROI. A sellers market ensured that margins were also quite exciting. A lot of that seems to be changing gradually. The question that arises is whether investment strategy must shift from pure defensive plays to a more aggressive play on cyclical sectors. While the shift may not be immediate, the first signs are there for the shift. Let us understand the reasons…

Defensives are under multiple pressures…

For long, defensive sectors like IT, pharma and FMCG managed to grow without disrupting their margins and ROI. Now, the problem of sustaining that growth seems to be visible. Take the case of IT sector. On the one hand, we have cross currency headwinds that are wiping away profit margins from these companies. Then there is the issue of the end-user industries. BFSI has largely saturated and in the post-Lehman period, clients have managed to get finer pricing putting pressure on margins. Telecom and energy have their own problems and are not in a position to substantially increase their IT investments. Telecom is plagued by overcapacity and energy is plagued by low oil prices. Neither seems likely to change in the immediate future. With a chunk of future IT investments happening on the digital front, Indian IT companies will have some time-gap before they can capture their old growth rates.

Pharma and FMCG are a slightly different ball game. Pharma has already seen the pressure on margins in the last quarter. Non-US businesses are likely to suffer due to weak demand and cross currency headwinds. Also the regulatory risk of stringent US FDA regulation imposes a cost on pharma companies. FMCG is again facing a double whammy. On the one hand, rural demand is weak due to low rural incomes and that has badly hit growth in FMCG companies. Margins are also hit due to competition and lower input costs are being passed on to the end-consumer in the form of lower prices. At least in the short to medium term, these defensive stocks seem to have hit a roadblock in terms of growth and margins.

Cyclicals are showing signs of turnaround…

The second quarter may give the first whiff of a turnaround in cyclical stocks. Of course, metals will continue to get hit by low global prices and that is unlikely to change in the near future. But capital goods could be the space to watch out for. While margin and bottom-line pressures will stay, the top line growth now seems to be visible. At least if the order book starts growing and the top-line starts showing positive growth, the first signs of a turnaround will be confirmed.

Auto could be another space to watch apart from banking. Banking stocks have seen their NPA cycle peaking out and the positives should be visible in the next few quarters. Auto demand on the heavy vehicles space has shown a smart turnaround and that is a good lead indicator of a pickup in economic activity. But the most important factor favouring the cyclical is that India is operating on a capacity slack almost akin to that of 2003. Rapid production increases can be implemented without the worry of additional investment. This was exactly the situation in 2003 when the base of the multi-year bull market in cyclical stocks was set up.

Start cherry picking on cyclical stocks…

It may be too early to make an all-out shift from defensives to cyclical at this point of time. Even with the margin and ROI pressures, the defensive sectors are likely to enjoy premium valuations for quite some time. But the time to start the shift is now. To begin with, investors must look at cherry picking leaders within the cyclical sectors. Automobiles, capital goods and energy have specific stocks that are poised to outperform the sectors overall. The current focus should be on those stocks.

The markets may have finally reached a situation where the performance advantage of defensives may be starting to wane. The first signs are visible in this quarter and it may just get more pronounced in the quarters ahead. The cyclical stocks, on the other hand, are showing green-shoots of recovery in terms of top-line, although the margins are still a concern. But investing is all about buying on hope not on hype. From that perspective, the time may be ripe to start shifting gradually towards cyclical stocks!

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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