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Last Updated : Jul 24, 2019 09:14 AM IST | Source:

Infrastructure funds: Weak show, but many lessons for investors

Thematic funds are risky and making gains mostly depends on timing your entry and exit well

Nikhil Walavalkar @nikhilmw

Investing in mutual fund schemes focused on the infrastructure story has some interesting lessons for investors. Over the past 10 years, the infrastructure funds category has delivered 7.28 per cent returns as compared to 9.84 per cent returns recorded by the Nifty. Multi-cap funds returned 12.98 per cent on an average in this period.

The usual advice given by experts is that retail investors should stay out of thematic funds. But they also point out that there are lessons from this experience that would help investors understand equity as an asset class better. Here are a few learnings from such thematic investments.

Understand the nature of business

Infrastructure is a capital-intensive business. Typically, these projects take at least three to five years to start generating steady cashflows. The space is led by the government in most cases. The companies ultimately work on the projects awarded by government agencies. The element of bidding to win a project leads to cut-throat competition.

And that’s why many companies involved in road building, power plants and other such infrastructure projects have struggled to make money. Take the case of highway construction companies.

“In many cases, the assumptions were too aggressive. Toll growth did not happen as per estimates,” points out Binod Modi, senior research analyst, Reliance Securities. Any impact on their profitability would lead to depressed stock prices and negligible or nil growth in net asset values of infrastructure funds that invest in their shares.

Many times, investors mistakenly assume that an order win would immediately translate into increased profitability for the company. In the heady days of the bull-run prior to January 2008, the stock prices of many infrastructure stocks ignored execution risks totally. However, the reality was far different. Many projects were stuck due to land acquisition issues and lack of environmental clearances. It led to infrastructure assets being built much later than the original timelines. In some cases – such as gas-fired power generation plants, the assets never became functional. Investors must understand that there is a wide gap between the projected profit and cash profits accumulated on the books of the company after paying all other claimants.

Sales pitch can be misleading

“It hurts to see that the maximum number of bankruptcies were seen in companies in the infrastructure sector and allied activities at a time when our country did not have adequate infrastructure and the government was in favour of building infrastructure,” says a fund manager who wish not to be quoted. Logically, a company should make profits in a business where there is demand. However, in the infrastructure sector, barring a few, many emerged as wealth destroyers or offered returns below that of the market.

Pictures of flyovers, swanky airports, metros and bullet trains feature prominently in the sales documents of these funds. These marketing collaterals typically talk about where we as a country stand and what is required. Indian standards are compared with American or Chinese standards. Stocks and themes are marketed showing the opportunity size. “These were low return on equity businesses and cyclical in nature. You just cannot buy and forget them,” says Ashish Shanker, head investment advisory, Motilal Oswal Private Wealth Management.

Unless a company makes profits, there is no point looking at the big opportunity or whatever infrastructure the country doesn’t have yet, but desperately needs, no matter which sector the company operates in.

Indebtedness can hurt cashflows

The very nature of the business made many infrastructure companies raise debt. The equity in most cases was capped at 30 per cent of the project funding requirement. But beyond this threshold, if companies needed funds, they had no option but to raise debt. Even if the project was completed on time, a majority of the initial cashflows were used to service the loans. And not much was left for equity investors.

Due to delays arising out of land acquisition, lack of environmental clearances or any other reasons, debt servicing became a serious issue and many companies. This crisis precipitated when Infrastructure and Leasing Financial Services defaulted in its payments and several of its infrastructure projects came undone. The ensuing credit and liquidity crisis made many investors wary.

Then, there are companies whose promoters pledge their own shares to raise funds, like in the case of Essel Group. But such moves are dangerous. Companies with high percentage of promoter pledged equity have been seen as a cause for concern, as such firms could witness a serious correction in stock prices if the lenders sell the shares to recover their dues or for covering their margin requirements. Investors would be better off staying away from companies that have highly leveraged balance sheets

To make the matters worse, while working with the government, some promoters were seen affiliated with a few political parties, and corporate governance issues too cropped up.

Look for less-risky, better-managed options

The infrastructure story does have some winners too. But they come from unexpected quarters. In infrastructure, the most talked about stories of the asset owners and asset builders rarely made money for shareholders.

However a calculated risk taken on suppliers – cement companies – paid rich rewards. “Cement companies have been major beneficiaries of infrastructure projects. These firms could generate cash without facing working capital constraints or receivable problems,” says Modi. Cement has been a key input in the creation of assets such as roads and buildings. He recommends investing in select names in mid-sized cement companies.

Some small and mid-sized companies offering consumable commodities such as specialized steel, pipes, tubes and tools too gained in terms of the rising sales and profit over time. Though these were small value items, the rising volumes ensured that they witnessed good growth over a period of time, resulting in rewards for shareholders.

Services firms and companies giving equipment on hire too benefitted from the boost given to infrastructure assets. Crane rentals, earth moving equipment providers and engineering design services firms too did well.

Most of these companies earned their dues irrespective of the timely completion of projects and the revenues they generated for the asset owners. To that extent, these businesses were low-risk and also rewarded their shareholders.

Timing versus time spent in the markets

Investors are often told that it is not the timing but the time in the market that counts. However, in some cases, this advice may not hold. “Infrastructure is a cyclical business and investors need to enter and exit at the right time,” says Ashish. Mutual funds from the infrastructure category posted superior returns in 2007 (86 per cent) and 2009 (57 per cent). But, after those shows, the theme has been going downhill, barring the two good years in between – 2014 (59 per cent) and 2017 (47.95 per cent). “If you buy and hold an infrastructure fund for long period, the returns are not great. However, the buy-and-hold strategy works for diversified equity portfolios,” says Gajendra Kothari, founder and managing director of Etica Wealth Management. He invested in an infrastructure fund in the year 2011 and is now sitting on single-digit returns. He hopes to exit the investments with 12-13 per cent returns in the future.

Avoid chasing past returns

Investors tend to enter when they see a year or two of good returns. Infrastructure funds returned 54 per cent and 86 per cent, respectively, in 2006 and 2007. Through 2008, 2009 and 2010, infrastructure funds returned -56 per cent, 85 per cent and 8.5 per cent, respectively. Most investors entered infrastructure funds after the initial years of good returns. In the past two years, most investors entered mid and small-cap funds after their stupendous rally from late 2013. But from early 2018, these schemes have had a rough ride.

If you enter a fund after a massive market rally, chances are you are getting in at a point that is close to a new high. So, there is a possibility that you will have to settle for lower returns or even losses in the subsequent few years. In thematic investing, this can be much more brutal. “Theme-based investing suits only sophisticated investors. Others should restrict themselves to multi-cap funds with a good long-term track record,” says Ashish.
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First Published on Jul 24, 2019 09:14 am
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