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Stockmarkets: The ''infrastructure'' theme

Jun 8, 2006

The stock markets are seemingly in the midst of a correction, with the benchmark BSE Sensex having lost nearly 25% from its all-time high levels of 12,671 hit in May. Global concerns over rising interest rates, in the US as well as Japan, and a resultant drying up of liquidity, particularly in emerging markets, have led to a global meltdown, and the Indian stock markets have also not been spared. The remarks by the US Fed about slowing economic growth and inflation have further triggered fears. Nonetheless, the BSE-Sensex, at current levels of 9,757, trades at a price-to-earnings multiple of 17.2 times its trailing 12-month earnings. This is a considerable climb-down from the heady levels of over 22 times trailing earnings that the markets saw just one month ago! The correction is something that many 'market experts' have been concerned about for quite a while now, and we believe that from these levels, growth expectations should be moderate. To their credit, the 'Big Wigs' of India Inc have met and, in some cases, outperformed expectations so far in announcing their FY06 numbers.In this write-up, we give a perspective on the 'infrastructure' theme. As is well-known, the UPA government's focus on developing the infrastructure of the country has led to a phenomenal jump in interest for stocks that are even remotely related to this sector. In order to sustain a high rate of GDP growth, India undoubtedly needs to improve its infrastructure drastically. Better roads, ports, airports and power, all of which are in a fairly dismal state, are urgent - if the country is to maintain an over-8% GDP growth rate over the long-term. Thus, companies that are related to these activities have seen ever-increasing interest from market participants, leading to substantial jumps in and a re-rating of their share prices.

Engineering
The engineering sector, having reputed companies such as BHEL, Larsen and Toubro (L&T), ABB and Siemens, has witnessed heightened interest ever since the government announced its urgent need to develop the infrastructure in the country. Virtually all the engineering companies have bulging order books, amounting to a multiple of their sales. BHEL, for example, at the end of FY06, had an order book of as much as Rs 376 bn, which is nearly 3 times its FY06 sales. Even other engineering companies, such as ABB and L&T, have order books that are equal to or higher than their annual sales, giving them strong revenue visibility into the future.

As can be seen in the above chart, despite the recent correction, the BSE Capital Goods index has comfortably outperformed the benchmark BSE Sensex by a wide margin, almost doubling compared to the Sensex over the three-year period since the current bull run began. The entire sector has seen a re-rating, with many companies now getting astronomical price-to-earnings ratios in the region of as much as 70 times! Going forward, the major factor to look out for will undoubtedly be the execution abilities of these companies.

As in the software sector, engineering companies are also people-driven, where complex skill sets come at a premium. The sector is already losing out in some way to its more glamorous software cousin. As an investor, this is the key factor that one should look out for - the growth sustainability rather than just the order book size. Undoubtedly, while the sector's potential is immense, it also faces numerous challenges.

Real estate
Another sector where a tremendous amount of interest has been generated is real estate. Companies such as Mahindra Gesco and Ansal Housing, which are property developers, have seen their stocks surge significantly, even taking into account the recent market correction. Due to factors such as a shortage of housing and the SEZ plans of numerous companies on the anvil, these stocks have surged into the limelight. The upcoming DLF public issue has been another reason for the 're-rating' of these stocks.

While there is undoubted potential for such companies, given the strong infrastructure focus of the government, one must be wary and avoid companies that do not have established track records. We have seen stocks of companies that have merely announced plans to foray into the real estate sector hitting their respective upper circuit limits for 3 or 4 days in succession! In fact, to give an example, when a telecom company announced poor results for FY06, but also announced plans to get into real estate, the stock soared by 7% that day! Thus, one needs to carefully evaluate this sector and the companies in it before taking an investment decision, given that it is a relatively new sector in the Indian markets.

Other sectors, such as power and telecom, would also come under the infrastructure theme. Given the Ministry of Power's goal of adding 100,000 MW of power capacity during the 10th and 11th five year plans, the investments required in power generation, transmission and distribution (T&D) will be immense, and companies in this sector could surely benefit. Companies like BHEL and ABB, which supply equipments to the power generation and T&D markets respectively, are expected to benefit in a big way. As regards telecom, this is one area where India seems to have got it right, given the phenomenal increase in monthly subscriber additions being reported by mobile service companies, and the ever-increasing affordability of mobile services.

Conclusion
While there is significant growth to be had in the Indian infrastructure sector, one must ensure that as an investor, one does one's homework properly, so as not to invest in companies that do not have a good track record. The sector is fairly diverse, and the segment in which to invest (engineering, real estate, power, etc) also needs to be carefully decided. Please note, this is not a recommendation to invest in any stock or stocks. Our major focus has been to give a broader, macro perspective about the major growth drivers for these industries over the long-term. As an investor, one should always look at individual companies in these sectors that are most likely to benefit from the growth story. A bottom-up approach would surely be an appropriate strategy to use in these markets. And, needless to add, a look at the valuations - buying the business at lower than its fair value.


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