We can classify sectors in to broadly two categories: Cyclicals and Defensives. Cyclicals are those that are directly impacted by economic growth and include capital intensive industries. Cyclicals would include Metals, Cement, Construction, Corporate lending banks, Capital Goods/Engineering, Hotels, Textiles, Telecom, Oil & Gas, etc. . Defensives sector would include FMCG, Auto, Consumer durables, Retailing, retail lending financials, IT & Pharma sector.

There have been prolonged phases where when the economic growth has been subdued the defensive sectors have done well.  There have been prolong phases when the economic growth has been good the cyclicals sectors have done well. 1992 to 2001 was the phase where defensive sectors did well. From 2001 to 2008 Cyclicals out performed defensives by a mile and from 2009 till date defensive sectors have done well and Cyclicals have struggled big time. Between 1999-2001 cyclical stocks were going at dirt cheap valuations but money was chasing IT, Pharma & FMCG. In 2006-07, Pharma, FMCG & IT was going dirt cheap and money was chasing Cyclicals. Today large amount of money is chasing defensives.

There is a strong buzz in the air that this cycle is about to turn in favour of cyclicals sooner than later. This mail is my endorsement of that view.

The current phase has many similarities with 2001-2003 phase.

• For past 4-5 years PSU banks lending was slow/low due to NPA problem. PSU banks have provided for 12-13 lakhs Crs of NPA & this NPA cycle is coming to an end. In 2003 Bank NPAs were 13%, they came down to 5% by 2005. NPA peaked in Mar 2018 at 14% and now have come down t0 9.5%.  Govt has promised to infuse PSU banks with 5Lakh Crs capital in next 5 Yrs. That would lead to lending to the tune of 40-50 lakhs Cr by them.
• A lot of excess capacities were created in 2007-2012 phase. Many of these were done with debt. Corporates have deleveraged heavily in past 5 years and at aggregate level their balance sheets are the healthiest since 2002. Capacity utilization levels is hovering aroung 75%. New capacities will start to come up in next 1-3 years. Govt is trying to woo global players to setup manufacturing base in India. If they succeed we will have a new private sector capex cycle starting. Govt has plans to spend a huge amount in infrastructure.
• Between 1998 and 2002, interest rates had come down from 11% to 5%. Home loans were available for 7% in 2003. Real estate sector has a big slack from 1994. In 2003 the gap between rental yield and home loan rate was less than 4%. In 2013 this gap had reached 7%, right now it stands at about 5%. With govt’s focus on affordable housing and agenda to create 10 Cr homes in 5 yrs we are already witnessing green-shoots in real estate sector. Repo rates are at lowest level in a decade and can go down further.
• One of the biggest driver for growth in 2003/08 phase was exports growth as china was growing at break-neck pace. Today globally there is talk that since monetary policy is not able to propel economic growth and stoke inflation, there is a need for fiscal stimulus in form of infra spending. That can potentially propel the global economy forward and create tailwinds for our exports. It can also mean higher commodity prices.

I am not predicting a re-run of 2003-07. It could be smaller than that or larger than that but the point I want to make is that in the next 5-8 years cyclicals would make a lot more money for investors than defensive sectors excluding pharma which has corrected already.

In the tables below I have some data on which stocks entered and exited Nifty since 1996 to make my point. As you might be aware a few stocks get included in nifty every 6 months and a few get excluded. This is done on the basis of marketcap. Stocks with lowest marketcap get excluded and stocks outside Nifty with highest marketcap replace them. In these tables I have shaded stocks from defensive sectors in green and stocks from cyclical sector in orange. The first table is of those stocks which got included in Nifty and second table is that of stocks that got excluded from Nifty.

You can notice the following:

• In 1996 to 2002 phase most stocks that got included in Nifty were from Defensive sectors and most stocks that got excluded from Nifty were from cyclical sector. Hence in 2002 the index was heavily skewed in favour of IT, Pharma & FMCG.
• In 2002 to 2009 phase almost all stocks that got include in Nifty were from Cyclical sectors. Hence Nifty weightage became heavily skewed in favour of Cyclicals.
• In 2009 till date almost all stocks that 25 out of 29 stocks that were excluded from Nifty were from cyclical sector. Hence today’s index is heavily weighted in favour of defensives.

Polarisation:

Usually when market become too obsessed with one theme it tends to ignore everything else. Eg. In dotcom bubble all the money was chasing IT stocks and ignoring everything else, in 2007 most money was chasing power, construction and real estate developer stocks and ignoring FMCG, Pharma & IT. Similarly at the moment there are innumerable sectors and stocks which are at attractive valuations and hold good promise. I  don’t know when & what will trigger the rotation of money from defensives stocks to other undervalued stocks, but it will happen. Prashant Jain of HDFC MF who saw both the turns in 1999 and 2007 and positioned his portfolio accordingly has very low allocation to defensive and high allocation to Cyclicals at this moment. S Naren of ICICI pru who also foresaw 2007 bubble, 2013 real estate bubble and 2017 mid/smallcap bubble also holds a similar view. Many veteran investors like Ramesh Damani, Vijay Kedia and Manish Chokasi are also suggesting the same inspite of having almost 100% of their portfolio in defensive sectors.

Most of the fund managers will align their portfolios sooner or later to benefit from this turn, some already have done that. It’s imperative to have a well-diversified portfolio which includes value category funds along with midcap & smallcap category funds in the portfolio.

Just as we have seen in the past 2-3 years Nifty/Sensex go up without similar improvement in your mutual fund portfolio, in the next 2-3 years you will see your portfolio go up much more than Nifty/Sensex. The reason why Index will underperform is because the heavy weights in the index will underperform other stocks. It’s not like 2017 where we were worried about return of capital, here we are talking of opportunity cost which can be significant. When Cyclicals start to perform their performance is not measured in percentages its measured in multiple of capital. We will know the exact turning point but we have to build positions in cyclicals which are at dirt cheap valuations and have patience. Such opportunities come rarely.

Nifty Stock-by-Stock weights in Jan 2008 vs Dec 2010: Look at how dramatically the composition has changed.