Since the global economic crisis in 2008, cyclical segments such as materials, energy and utilities have been underperforming their benchmark equity indices. The reasons for this are many. Although the outlook for particular sectors remains weak, a few stocks may show reasonable divergence in their price performance.

Slowdown in spending

The materials segment has witnessed difficulties related to excess cement production capacity as demand has fallen following a slowdown in infrastructure spending. Mines and mineral companies have come under environmental pressure and new restrictions from local Government and the Supreme Court related to iron ore mining. Gas and power utilities face supply challenges and rising fuel prices. They also lack the ability to pass through the rise in costs to buyers as demand has dropped.

The difficulties for the energy sector are largely chronic in nature, given the drop in earnings and the heavy debt burden seen in downstream oil marketing companies. Upstream oil producers are constrained by lower realisations and the subsidy burden of downstream companies.

The telecommunications sector has been a victim of regulatory overhang. It has also faced allegations of graft among senior management, with excessive competition restricting pricing power.

Need for stock selection

This, however, does not mean that investors should ignore the sectors completely as there are stocks that have delivered robust returns in the last three to five years. This underscores the need for stock selection. In the cyclical segments, investors should look at the strength of the franchise, how the company adds value and its general consumer presence. We would suggest taking a closer look at companies that produce finished goods and have a widely known brand identity.

Niche business models led by stronger technological advantage combined with end-to-end integration help companies manage costs as well as give them strong pricing power. Balance sheet quality is vital, as it implies a lighter debt burden and interest costs to mitigate pressure points during weak growth environment. Investors should also look at companies that do not have to meet extremely strict regulatory requirements. Still, investors should bear in mind that they will not be able to entirely avoid general sector dynamics, although they may be mitigated and minimised by stock selection. If and when sentiment recovers for the sector, such stocks are likely to recover before the others.

The writer is Chief Investment Officer, RBS Private Banking, India.

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