Switch from Defence to Railway Stocks? 

"Does management think the tooth fairy pays for capital expenditures?"

This was Warren Buffett's response to a query on utility of operating margin-based valuations. He aimed to criticise the short sightedness of investors.

In accounting terms, operating margin is often referred to as EBIDTA. The acronym stands for earnings before interest, depreciation and taxes.

So, investors who value stocks based on EBIDTA literally ignore the cost of capex (interest and depreciation) and tax obligations. In doing so they undertake a big risk. They end up ignoring the business' vulnerability due to incremental capex.

However, when it comes to the government announcing big ticket capital expenditure through PSUs, Indian investors seem to be throwing caution to the wind these days.

Indian public sector enterprises have been at the centre of stock market attention for few years now. But there is a big twist.

In the past, the largest public sector banks were known to accumulate huge non-performing loans at peak of every capex cycle. The PSU corporate customers somehow never managed to honour the loans as the cycle turned.

But this time things are different.

It started with the defence sector winning big orders since 2018. The entities did not just win the orders but also executed well. Prompt payments from government put all their working capital issues to rest.

The bulging order books of defence PSUs also trickled down to the metal, mining, engineering and power PSUs.

The PSU banks, meanwhile, have cleansed their books and are geared to lend for capex.

So, the sentiment towards PSUs has shifted from pessimism to extreme optimism.

Railway stocks are the latest beneficiaries of the euphoria.

The managements of the railway companies and their investors seem to be more keen on EBIDTA, completely ignoring the risk of capex.

Railways is one of the key drivers of the PM GatiShakti scheme and the National Logistics Policy. This master plan for multi-modal connectivity has an estimated budget of Rs 100 bn. It aims to decongest India's rail infrastructure significantly in the next few years.

There are several parts to this mega capex trend.

The railways has finalised the largest acquisition of 75,000 wagons over the next three years. In addition, the government is considering introducing nearly new Vande Bharat trains. To add to that there is a plan to revamp almost 200 major stations around the country.

So, needless to say that a bunch of railway companies, most of which are now listed, are winning orders at a pace never seen before.

The news headlines on the railway capex plans are keeping investors hooked to the stocks.

Now, most railway stocks other than IRCTC were very reasonably valued until few months back. Hence, some early investors grabbed the opportunity to buy into them. And since then, there has been no looking back.

There is a buying frenzy in railway stocks over past few weeks, notwithstanding frothy valuations. It has even overshadowed even the gradual rise in defence stocks.

No doubt the sector deserves a re-rating thanks to the bulging order books. But I believe the markets are likening Railways to the Defence sector too much, too soon.

Despite the government's increasing focus on capex, Indian Railway has been losing its share to road and air transportation for decades.

The railways' share in total freight traffic has come down from around 89% in the 1950s to around 28% currently. In comparison, 40% of long-distance freight volumes are carried by trains in the USA.

The railways have attempted to claw back passenger traffic from air travel by introducing high-speed trains. However, so far, the execution rate offers no comfort.

So, relying on capex announcements alone can be the biggest undoing for investors in the sector.

Rather investors should notice the technology led changes in few railway stocks.

For instance, IRCTC is not just in the businesses of online railway ticketing, catering services, and packaged drinking water. Rather with the help of AI the company is generating smart algorithms for predicting trends in ticket reservation.

Moreover, IRCTC is also using AI to upkeeep the hygiene and safety conditions of its catering units.

IRCON is not just a company executing BOT projects for railways. Rather the company is now a significant player in renewable power (solar energy).

RITES has leveraged technology to offer third-party inspection, quality assurance, construction supervision to clients other than Indian Railways.

RAILTEL Corp, a leading PSU telecommunications infrastructure provider that focuses on offering high-speed broadband and networking services to the railway sector. The company now offers comprehensive data centre solutions.

But here is the interesting fact. While IRCTC continue to fetch consistently high margins and return ratios, its other technology led peers in the railway ecosystem do not impress as much yet with their bottomline growth or return ratios.

Check out the companies historical and current return ratios and valuations here.

Even then the stocks have seen a massive rerating since listing and investors are falling head over heels these days to grab a share of the railway stocks pie.

Then comes IRFC, which is a lender to the companies in the EV ecosystem. Now a lender, say a bank or NBFC has to typically prove its lending capability and quality of lending right? But IRFC does not need to do that.

Thanks to recent massive capex plans on Vande Bharat trains, IRFC is expected to see its loan book swell. But the quality of such loans is already guaranteed by the government of India.

Plus, the company is exempted from taxes. Therefore, the NIL NPA and profitability of IRFC are vulnerable to any policy change on the part of IRFC's only client... the government. Yet the stock continues to hit new highs every few trading sessions.

So, investors need to be careful about going overboard to ride the railway capex opportunity.

Also keep this in mind before replacing defence stocks with railways.

High execution rate is a given for defence stocks, due to national security concerns. But the valuations of railway stocks can get derailed with even minor delays in execution.