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Core sector stocks: High risk, high profit
Devangshu Datta in New Delhi | April 07, 2008 09:47 IST
Creating a short-term portfolio of infrastructure stocks at the right prices is a high-risk, yet high profit exercise.
The best performing industries of the past two years have included power, engineering, construction, capital goods, telecom, etc. Broadly, these are infrastructure-related industries that have seen strong, even geometric growth.
These are also, by and large, not industries that receive very high discounts globally. In India, however, they have been treated as growth sectors that deservedly, receive growth industry discounts.
The market trend has changed in the past three months and sentiment has turned far more pessimistic. Sooner or later that will affect the real economy badly -- it already has, in consumer-driven segments like automobiles, housing finance, and big-ticket consumer durables where the past year has been flat.
The sentiment breakdown may have an impact even on investment-driven industries because investors are becoming increasingly hesitant about big bets.
We've seen this in the form of IPO failures, which would have been unthinkable earlier. There is also anecdotal evidence that private equity investors are finding it difficult to meet their own targets for raising cash.
Projections about India's infrastructure drive predicate two important factors. One is that, given infrastructure has to be ramped up on a war-footing, it's been assumed the central government and most state governments will be more or less rational in policy-making.
Two, the flow of private domestic capital and FDI will continue unabated for the next five years because the required resources cannot be raised otherwise.
Sadly the current global and domestic scenario makes it likely that there will be disappointment on both counts. Given general elections, and a spate of assembly elections, political irrationality can be expected for the next year or even more, especially if the next Central coalition is unstable. We can also expect that FDI flows will be cautious given how the US recession and the subprime crisis have snowballed.
Is it time to re-rate high-discount infrastructure plays on the grounds that growth targets may not be met? Definitely. Is it time to abandon infrastructure completely and switch back to defensive sectors instead? I am not so sure about this.
My sense is that there will be a down-rating of infrastructure as serial disappointment sets in and price corrections could be more severe than across the broad market.
However, while growth may miss near-term projections, it will remain good in the long-term. That means there could be bargains. Timing those bargains could be a critical exercise.
A case in point. Take an engineering blue-chip like Larsen and Toubro. This is currently trading at about Rs 2,850, down from highs in the Rs 4,300 zone in December 2007 and up from a (split-adjusted) price of about Rs 900 in January 2006.
In the same timeframe where the Nifty logged a return of 67 per cent, L&T has returned over 200 per cent. It has also lost about 33 per cent from its peak, where, in comparison, the Nifty has lost about 26 per cent.
Obviously L&T is a high-beta asset. The current PE of L&T is around 52 (annualising the first three quarters of 2007-08) in comparison to the Nifty, which is valued at about 20-21 PE.
How much further can L&T's share price fall? Quite a bit if this high-beta characteristic is maintained. How likely is it to miss growth projections in 2008-09? Quite likely -- so, there's likely to be another sell off. How likely is it to make growth projections circa 2010-11?
What we may get is a scenario where PEs are down-rated coupled to stable growth projections in a 3-year timeframe. That implies the L&T stock in particular is worth buying at below a ceiling of Rs 2,500 with a target of Rs 4000 in Q1, 2010-11. If there's a long term bear market, you may get trades at Rs 2,000 or even less.
We are likely to see similar scenarios playing out across other names in these sectors -- L&T was just a convenient example. What may make sense in these circumstances is to create an infrastructure 'slush fund' that can be tapped at short notice. Enter only when the prices seem right.
This strategy carries its own risks since prices may not correct to the desired levels if the market roars back. But the buy and hold strategy carries even more risk because PEs of 45-50 will not be sustainable in a cyclical downturn.