Ride India's growth engine

Many countries would kill to be in China's place in the early 2000s. It was a time of an economic boom like no other. Rapid, large-scale infrastructure development and massive fiscal firepower for manufacturing helped the dragon nation become 'the world's factory'. Home to nearly one-third of global manufacturing today, it is still decisively holding the title. India, although a little late to the party, hopes to change that. And meaningful policy action is beginning to show results. Public money is being ploughed in infrastructure more than ever, making capital goods the largest beneficiaries. It explains the colossal gains investors have made in them lately and the party is far from over. The sector, whose machinery and equipment runs everything from roads, power grids, telecom towers, transport to housing, is now a stand-in for economic strength. And investors have got time on their side to gain from the yearlong structural story set to play out from here. We tell you how to profit from the boom. Regaining lost ground Government's capital expenditure (capex) spending has grown strength to strength in recent years, helping capital goods companies roar back to life after over a decade-long underperformance. The BSE Capital Goods Index topped its previous peak of 2007 after a gap of 14 years in 2021, becoming the second-best sectoral performer in the last three years. With a 35 per cent annual return in this period, it handily beats the Sensex at 9.5 per cent. The heady performance follows a resounding uptick in financial performance. Capital goods companies' five-year annual growth in profit before tax (excluding exceptional items) has touched 22 per cent, among the highest across sectors, primarily driven by government's fiscal largess that's been spurring industrial demand. But there were other factors, too. For one, increased efficiency helped companies reap substantial additional profits. This was achieved as the sector deployed its available capacity that was lying unused to meet the sudden pep in industrial demand, saving on new capex. Additional capex was only initiated once demand showed signs of sustainment, consequently helping earnings grow. See graph 'How capital goods sector gears up for demand'. This underscores why assessing efficiency is a crucial parameter, in addition to growth, to assess the overall health of capital goods players. While return on capital employed (ROCE) is most commonly used for this purpose, we used an often overlooked metric—incremental return on capital employed (I-ROCE)— to check how the sector scores. But first, what is I-ROCE? A touchstone for assessing capital-intensive businesses, I-ROCE reflects returns from recent or additional investments. Unlike traditional ROCE that measures the overall return on the entire capital base, I-ROCE focuses on how well new capital investments (new projects, expansion) generate profits. I-ROCE should ideally be higher than existing ROCE. This would suggest that new investments are yielding higher returns than those generated on the base investments in the past. Why it should be your gauge A higher I-ROCE than the current ROCE suggests that the management is finding better growth opportunities and higher-return projects, adding value for shareholders. A consistently high I-ROCE demonstrates the company's adeptness in selecting profitable long-tenured projects. It provides regular insights into the company's capital deployment strategy, making it a credible yardstick to predict management's future decision-making. It suggests the business is scalable and capable of adding value through expansion. How does the sector fare? Pretty well. The sector's overall ROCE has improved from 12 per cent in FY20 to 22 per cent in FY24. The reason? This was due to the additional capital invested during this period, which generated a massive 69 per cent return (I-ROCE). Check the graphic on the top right. Not just that. Over the last three years, 109 capital goods companies generated I-ROCE of over 15 per cent that also exceeded their average ROCE, the most among all sectors. The industry is provenly more efficient today than in the past, suggesting that company managements' capital allocation decision-making is on the right track. Solid I-ROCE across the board means higher efficiency will likely sustain for the sector. Combine this with the broad tailwinds and the growth story looks unstoppable. The growth levers? 'It's the economy, stupid'. Betting on capital goods means betting on the economy. And both are on track for solid expansion. The government's ploughing in large sums of investment in the local story. It has paid off in chemicals and pharmaceuticals. Heavy machinery and engineering are the obvious successors as the world's pharmacy fancies becoming the world's factory, too. The country's fixed assets (excluding depreciation) and net capex have grown 10 and 9 per cent annually in the last five years, respectively. The latest budget allocated 3.4 per cent of the GDP to capital expenditure, up 11 per cent in FY24-25. The 'Make in India' push and Production-Linked Incentive or PLI schemes are further acting as catalysts. Secondly, the world more than ever is looking beyond China for its needs. The risks of a concentrated supply chain and the spry neighbour finally catching up to age while struggling with a slowdown is helping. This is why global players are looking at India to pick up the slack as evident from the surge in order volumes across capital goods segments. According to an industry report, the total order book for capital goods companies stands at a record Rs 10 lakh crore—double their revenue in FY24. In effect, improving capital efficiency and macro tailwinds offer a promising outlook for the long run. Now, to the not-so-fun part: addressing the risks. Cyclicality and valuations The sector no doubt comes with a sturdy runway for growth that will last over many years. But every now and then, as the economy changes rhythm, the industry succumbs to cyclicality. The industry's earnings alternate between expansion (during government stimulus, economic expansion) and contraction phases (stagnant or slow growth). The rotational pull changes the tides of valuation, too. When responding to an uptick in demand from government infrastructure spending, valuations often reach the high-water mark, like they have now. Although the BSE Capital Goods Index has corrected over 7 per cent from

This article was originally published on December 01, 2024.