The latest rally in leading cyclical stocks has led to an expansion in their respective price earning multiples. However, since some of these scrips still trade below their historical average multiples, a further expansion in valuations cannot be ruled out if the pre-election rally maintains momentum even after the results.
Since mid-February as the Street bets on rising probability of the BJP-led National Democratic Alliance (NDA) coming to power, stocks from banking, capital goods, metals, realty and cement sectors have led the market gains. During the period, when the BSE Sensex scaled multiple record highs on the back of a 12% rise, more than half of the top 50 companies that outdid these gains came from these cyclical sectors.
The banking space has predominantly steered the market with as many as eight public and private sector banks reporting a minimum return of 17% in the period. Public sector banks, which due to their decayed financials (higher provisioning and elevated NPL levels) were the most beaten down until two months, ago have benefited the most given the top three PSBs have on an average rallied 43% in the period. As a result, these stocks managed to reduce the discount on their historical valuation in terms of trailing price to book value. While in early February, PNB, State Bank of India
and BoB were each trading at about a third to half of their respective historical average book value, as of Friday, this discount came down to 20-40%.
Despite the latest run-up, the valuation discounts are likely to keep the investor interest intact in these stocks. In the brokerages like Goldman Sachs, Espirito Santo Securities and Barclays capital have raised their outlook on the sector citing likely decline in stressed assets and improvement in India’s macro conditions going ahead.
Amongst the bluechips, metal producers Hindalco Industries and Jindal Steel, which have rallied 40% and 20% respectively since mid-Feb, still continue to trade at 25-45% below their average PE multiples. These stocks may continue to maintain their momentum as the Street may also acknowledge the cost realisation and deleveraging efforts taken by metal companies in general. Citi recently turned bullish on the space and upgraded Hindalco and Sesa Sterlite.
While Capital good majors, Larsen & Toubro Ltd and Bharat Heavy Electricals Ltd (BHEL) are also among the top gainers in the recent rally, BHEL continues to trade at a huge discount of about 60% to its past valuation due to a striking slowdown in its order-book. Last week, BHEL announced over 50% discount in provisional net earnings for 2013-14.
According to Jefferies analysed cyclical stocks using EV (enterprise value) to sales barometer for manufacturing companies. It noted that the implied three-year growth rate to justify current stock price for Cement stocks, L&T, Hero, M&M, BHEL and Crompton are lower than 15-year median growth expectations.
While some bleuchips are still maintaining a gap to their historical averages, the surge in cement stocks (ACC Ambuja), private sector banks (IndusInd and Kotak Mahindra bank) and realty major DLF appears overdone as each of these stocks have more than converged with their past averages.