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Infrastructure funds: Hot property!
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August 04, 2007 12:33 IST

Well, here is one opportunity that everyone is sure about -- the infrastructure sector. Investors are pouring money into infrastructure stocks and funds. The logic is very simple. India is a growing economy and there is huge demand for infrastructure. So, these companies are likely to see exemplar growth.

Indeed, this is right. What is also true is that you, the investor, are exposing yourself to a high risk by investing in the sector. It's time you took stock of the situation.

Before proceeding, here's a word of caution. In this note we are not taking a call on when rationality will return to the stock markets with respect to the valuations of atleast some of the infrastructure stocks. We are simply focusing on whether you should be invested in infrastructure funds, and if yes, what should be the allocation.

These days it is not uncommon for us to meet clients who have invested over 20% of their portfolios in dedicated infrastructure funds. Add the infrastructure component that is present in the diversified equity funds and what you have is an allocation well in excess of that (maybe as high as 35%). Well, even if you are an investor who has a high risk appetite, this kind of an allocation may be stretching it too far.

The risk factors
Without delving too deep into the analysis of the sector, here are some points of concern you need to keep in mind when evaluating the prospects of the infrastructure sector:

One, there is indeed a tremendous growth opportunity; however, will this growth be profitable? Given that the competition is already very intense, profitability will be a big issue. Ultimately, stock prices track earnings growth, not sales growth.

Two, with more multinational engineering and construction companies coming to India, the competition is likely to intensify further. Profit margins in India are higher than the international average; there is no guarantee that margins in India will not move to the international average. If this were to happen, profitability will be hit.

Three, with demand growing so rapidly, and companies stretching themselves to grow, execution risks arise. Any failure on the execution front (lapse on recruitment, quality related issues, delay in execution) could have significant monetary and non monetary consequences for the company.

We recently met one of our clients, who works in a reputed company that is into engineering and construction. On being asked what the biggest challenge his company faces, his answer was very prompt -- execution risk. For some reason investors, who are outsiders, are ignoring this risk completely!

Finally, from a stock market perspective, as a smart investor, you need to evaluate how much of the future growth and the potential risks are factored into the stock price. Only if the risk-return ratio is favourable should you consider an investment; if you were to go by this criterion, not many stocks would find favour.

And this takes us to a very critical point. Why restrict your fund manager by limiting his mandate to investing only in infrastructure stocks?

If you have selected a good asset management company (AMC) with a smart fund management team, give them the flexibility to invest the monies across sectors. Of course if they find something attractive in the infrastructure sector, as per their criteria, they will own it for you.

So our recommendation to you is avoid infrastructure funds. If, however, you have a huge appetite for risk maybe you should consider having 5%-10% of your monies in such funds (and that too in funds which are from AMCs that you can entrust your monies to!). Anything more than that and you are taking undue risk.

Here are some numbers to ponder over:

The 20 Best Performing 'All-Equity Funds' over 1-Year
Equity FundsNAV
Reliance [Get Quote] Media & Ent.30.122.3 22.2 92.4 47.2
JM Basic 26.858.8 31.0 89.0 34.5
Reliance Power47.946.0 25.6 88.2 60.9
DSP ML Tech.29.420.3 15.5 85.3 18.7
StanChart Premier17.62(0.3)25.0 82.2 36.1
Reliance Banking49.146.0 25.5 75.2 45.8
UTI Thematic Banking24.883.5 13.5 73.5 30.8
ICICI [Get Quote] Pru. Service Industries17.65(0.5)9.4 73.0 39.7
Taurus Starshare 49.787.0 17.0 72.9 12.1
Sundaram Capex Opp.21.566.1 19.8 70.6 51.6
DBS Chola Opp.32.635.0 13.7 70.1 13.0
DSP ML Tiger40.335.0 17.4 69.3 56.4
Magnum Midcap26.644.8 12.3 68.0 53.4
Tauras Discovery Stock 18.580.5 9.9 67.8 5.2
ABN AMRO Equity Opp.25.943.4 19.5 67.7 50.3
ICICI Pru. Infrastructure22.825.4 16.7 67.4 50.0
UTI Infrastructure 34.026.2 15.2 67.3 47.3
Tata Infrastructure29.266.5 19.2 66.7 53.9
Reliance Pharma 26.213.1 27.0 66.1 35.8
Reliance Growth324.134.0 15.6 65.3 34.1
BSE Sensex6.1 10.4 44.7
S&P CNX Nifty5.0 10.9 44.1
(Source: Credence Analytics. NAV data as on July 31, 2007. Growth over 1-Yr is compounded annualised)

What should investors do?

It is apparent that sector funds have dominated the performance charts over the last one year. The infrastructure funds, which have been highlighted in the table, grab the maximum number of places in this listing. Now, as an investor, it is natural to consider investing in sector funds and in particular the infrastructure funds.

But as a smart investor, it is important to realise that if you are looking at building long-term wealth without taking undue risk, sector funds are best avoided. But if you still wish to own them, ensure they account for no more than 5%-10% of your portfolio.

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