Allied industries stocks good bets in short, medium-term
One of Bharatiya Janata Party's (BJP's) biggest promises during the election campaign was improving the country's infrastructure to put economic growth on the fast track. The new government, led by the party, has reiterated this commitment by promising 100 new cities, highspeed trains, low-cost airports, new highways and a string of new ports.
Stock markets have been quick to react. Investors, after ignoring them for years, have been lapping up infrastructure stocks since the poll results were announced on May 16. As a result, the NSE CNX Infrastructure index has soared 23% since then (till June 10). This is in sharp contrast to the 0.09% rise in three years to 16 May 2014. The new government has surely given a boost to the infrastructure sector. But for any specific sector or stock to do well over the long term, one thing is must-the prospect of good earnings.
This is where the problem starts. Infrastructure projects, by their very nature, take years to become operational. So, it takes a lot of time for earnings to start flowing. Execution delays are common, land acquisition, too, is a big hassle. Besides, there are other problems that infrastructure companies are battling, including corporate governance issues and high debt.
As infrastructure spending picks up, those likely to gain early are allied companies such as infrastructure financers and metal, cement and capital goods makers. "Infrastructure projects have long gestation periods, and therefore, earnings realisation takes time. Besides, the companies are facing issues such as huge debt and delay in environment clearances. Therefore, we prefer allied players such as capital goods makers and infrastructure financing companies," says Dewang Mehta, senior vice president and head, equityretail research, Anand Rathi Financial Services.
We discuss sectors that are likely to gain immediately from the rise in spending on infrastructure. Banks and infra financing companies:
According to the Planning Commission, India needs to spend 9% (compared with 7% now) of its gross domestic product (GDP) on infrastructure to achieve a high growth rate. A large part of it has to come from banks and infra financing companies. Credit growth to the sector has fallen of late due to paucity of new projects; also, many existing projects are stuck at various stages. Now, credit disbursal to the sector is likely to go up. Besides, with economic growth picking up, the non-performing assets of banks and financing companies are likely to fall, improving their financial health.
"In the financial sector, private banks have led the rally. In the same way, we are witnessing some late rally in public sector financial and infrastructure companies. It is a process which will continue on a relative basis as there is a lot of room for improvement in these sectors," says Vinod Nair, head, fundamental research, Geojit BNP Paribas Financial Services.
Capital Goods: As work begins on large projects, the demand for heavy machinery, engineering goods, etc, will rise.
According to a Barclays Capital report published on May 16, if the new government decides to speed up infrastructure projects, it can do so easily, as there are several projects that have been waiting for ordering despite completion of land acquisition, largely due to procedural and tendering issues. It sees potential for ordering out of $25 billion worth of large infrastructure projects over the next 12-18 months.
"Capital goods companies have a good amount of operating leverage (slight increase in sales leads to a higher rise in profit margin), which will play out well once the capex cycle improves," says Rabindra Nath Nayak, lead analyst, power and capital goods, SBICAP Securities.
Some companies likely to gain immediately are already trading at high valuations but those which are likely to gain in the medium term are fairly valued and can be bought. Besides valuation, other factors for selecting stocks in the sector are balance-sheet strength and project execution experience.
Metals: Metals are a key raw material for the infrastructure industry. If the big projects get started, the impact on demand will be immediate. One of the biggest gainers of this push will be the steel industry. However, metal stocks have already risen quite a bit of late due to improved sentiment. The future performance will depend a lot on how this sentiment gets reflected in the earnings. Tata Steel had gained 22%, Steel Authority of India Limited 44% and NMDC 23% between May 16 and June 6.
"The stock prices have already factored in most of the sentiment of improved macroeconomic situation after the election results. Now, it is to be seen if earnings catch up with the sentiment," says Gautam Chakraborty, analyst, institutional research, Emkay Global Financial Services. So, while metal stocks look for gains, the disproportionate rise after the elections have made them slightly expensive.
Cement: With housing being the government's major focus (creation of 100 new cities and lowcost housing), the cement sector stands to gain in a big way. The housing sector accounts for 60% cement consumption.
Besides, there is scope for increase in demand for cement given that at present the per capita consumption in India is less than 200 kg compared to 500 kg in developed countries. However, the sector is facing problems of rising freight cost and overcapacity, which put pressure on margins.
"Cement companies can improve margins by raising prices in line with the increased cost and by reducing the cost of production. That way larger companies with pan-India presence have a better chance of improving margins," says Piyush Jain, equity research analyst, Mornigstar India. Despite these negatives, cement companies are likely to improve their performance.
According to a Morningstar India report, the Indian cement market is likely to see a recovery to normalised performance owing to planned government spending on infrastructure and housing. Valuations, though, can be an issue. According to Kotak Institutional Equities, valuations of cement stocks are very high even after factoring in the recovery in volumes and profitability in the next couple of years. However, it sees near-peak profitability in 2015-16.
