Here are some thoughts on stocks from the dirty sectors- construction equipment, contracting, capital goods etc….
Infrastructure, capital goods, metals, commodities. Sectors which investors divorce, separate and then re-marry. Stocks in this sector keep hitting new highs and lows periodically. Almost predictable to the point of being boring.
In the past, Indian companies in these sectors were used to protection by tariff and non-tariff barriers. This ensured that their bottomolines swung, but never enough to hurt the investor.
Today, global factors influence the commodity prices. Consequently, the commodity sector stocks (whether it be Tata Steel or ACC or Hindalco or Grasim etc) have lost their pre-emintent status in the stock market. We have just recently witnessed the knocking out of Hindalco from the Sensex. It is very unlikely that it will stage a comeback to the Sensex.
These stocks react to demand supply- There is a high degree of unpredictability in their margins. There is lumpiness in their cash flows and even the order book is not a true indicator of the future. For example, a L&T or BHEL may have a huge order book. It means nothing. Execution capability is what is relevant. And today, capital goods are also a global commodity. No protection to the bottomlines.
However, these sectors follow a boom, doom and gloom cycle. Holding them over prolonged periods do not give any returns that we can write home about. We will be lucky to get positive returns at all.
However, these stocks do provide great trading opportunities. They are high risk plays. Often the move from peak to trough or the other way round, is brutally swift. Moves are anticipatory in nature and not reaction to results. It is a game of expectations. PE ratios and other ratios do not help us much, as far as this group of stocks is concerned.
This sector is also united by a common thread of what I call as ‘approximate’ accounting policies. The value of work in progress, percentage of work completed etc are very subjective items and hence the profit or loss is only an estimate. However, the markets accept them at face value and react to them. The market players do not seem to be bothered about rising debt, poor operating cash flows or very poor Return on Capital Employed.
So how do we trade this?
I have mentioned in the past that these kind of companies are valued more on their ‘Balance Sheet’ rather than on their “P&L” Account. My view again. I will use the ‘replacement’ cost as a proxy. I will not use P/E etc. A good measure to use is the Price to Book Value number in trading these stocks.
What I would do is to see a ten year history of the Price to Book Value range. I will be happy to use this band as a trigger to trade in them. P/E Bands are less relevant here because in a bad year, the Earnings may be very weak, resulting in very high P/Es. The price to book value equation will be more relevant for stocks in this group.