Sankaran Naren believes that over the next three years, the infrastructure theme should outperform the market and the consumption theme. Just as there were drivers put in place in 2008 that powered the consumption theme over 2009 and 2010, Naren sees the drivers for the infra theme falling in place now - which should result in 2011 to 2014 being the infra years……
WF: The infrastructure theme has relatively underperformed the consumption theme. Why do you believe that this trend is now going to change, in favour of infrastructure?
Naren: Lets go back a couple of years. What happened in 2008 was that, once the financial crisis happened, our government came up with a strong stimulus package to boost demand. One is they cut interest, second is they cut excise duties and other taxes and third is the pay commission which put a lot of money in the hands of government employees and fourth is the big farm loan waiver program. Now, the combination of these four actions resulted in a consumption boom from 2008 until now.
As a result of this consumption boom, stocks and sectors that played this theme have benefited very well - especially the discretionary spending oriented sectors - auto, white goods, media, entertainment, airlines etc.
The other impact of the consumption boom is that we have high food inflation, high manufacturing inflation and high trade and current account deficits. Inflation has to be tacked. You need additional manufacturing capacity, which means that you have to encourage investment.
We can see that the Government is gradually shifting gears from promoting consumption to promoting investments. We saw in June that the Government raised fuel prices - at a time when inflationary worries were already there. Our belief is that higher interest rates and higher inflation can start impacting consumption growth, going forward. There will be a tax on consumption - whether by way of a move to market determined prices of fuels or impact of GST etc - as the Government's focus will move now from accelerating consumption to accelerating investments - now that the recovery is well and truly underway. This year, the Government had a windfall in terms of license fees from 3G. This may not happen every year - and revenue considerations will become more important.
We believe we will see a significant shift in Government's thrust towards infrastructure and away from consumption around the time of the next budget - Feb 2011. We believe earnings of infrastructure companies will show significant increases in the 2011 to 2014 period. And therefore, in our view, the time between now and the next Budget should be used by investors to buy into infrastructure funds, with a view to participate in the potential upside over the next 3 years. We should see infra stocks deliver over 2011-14, the kind of performance we've seen in consumption stocks over the last 18 months.
Lets look at the different sectors within the infra theme. Capital goods at a sector level should do very well. Telecom - which is infra - but where demand is consumption led - is coming off a bad phase and has begun rallying from its recent lows. We took a call to buy into the telecom weakness - and that's paying off well now. Likewise, we believe the next 12-18 months will see weakness in cement due to oversupply. We will look at an opportune time to buy into cement weakness sometime in the next 12 months - as we believe the long term prospects are undoubtedly bright. Banks will also benefit from rising infrastructure spending. Then, if you take metals - ferrous metals have done very well. Non ferrous metals have struggled - but that's due to specific issues rather than the sector being in trouble.
Coming to construction - the sector tends to bottom out when interest rates peak. We believe interest rates will peak out over the next 6 months - and that may be a good time to go overweight in construction sector.
The final piece is oil & gas - this sector has underperformed, but we believe it offers among the best value in the market from a future prospects point of view.
WF: In the engineering and capital goods space, some analysts worry about diminishing capital efficiency and falling ROCEs - even as order books continue to rise. Is profitability a key issue in your view? Naren: In my opinion the bulk of these kinds of mistakes were made by the companies in the boom year of 2007. Unfortunately, what happened in this sector is that what you bid in 2007, you executed in 2009. Today, companies are a lot more conscious about how they bid. In the construction space for example, companies are a lot more cautious about the traffic assumptions they are now building into their models.
The aspect I would worry about in this context is the power utilities space. With so many large corporate houses keen to enter this space, there are bound to be some mis-allocations of capital in this space. As a fund house, we are cautious on the unregulated power utilities space. We are staying invested in the regulated power utilities space - although there has been recent underperformance - as we believe in the value story there.
WF: The other area of debate within the infra space is whether to own infrastructure owners or infrastructure builders. The former has the attraction of annuity cash flows kicking in over the long term, while the latter has the attraction of reporting sharper earnings growth in the near term. What do you prefer ? Naren: My belief is that as an equity fund manager in a mutual fund, I don't have a sufficiently long mandate in terms of time to get value out of an infrastructure owner. The private equity segment is perhaps better suited to take those kind of long term calls. As an equity fund manager, I am happier looking at infrastructure builders, where we are betting on project execution - and not the annuity cashflows from the project over then next 10-20 years.
WF: What are the key risks that you would be watchful about in the infra theme over the next 12 months? Naren: The one common factor in all infrastructure stocks is their rather large interest cost. They are big payers of interest and are therefore vulnerable to interest rate shocks. If interest rates go up sharply from here - either on account of persisting inflation or liquidity issues etc - this sector will be impacted. So, that's the one key issue we should be watchful about.
