Why infrastructure stocks will continue to outperform industrials

Domestic infrastructure and capital goods stocks have been on a strong trajectory. Over the past three years, capital goods stocks have tripled in value on average, while infrastructure stocks have doubled. Given their high prices and valuations, there were concerns during the recent general election period whether this trend would continue. However, these concerns have been eased by the formation of a stable coalition government and expectations of continuation of growth policies. The RBI reinforced this optimistic outlook by raising its GDP growth forecast for FY25 to 7.2% from 7.0% in its June policy update.

Dated June 13, 2024

Note: The BSE Capital Goods index primarily comprises industrial equipment makers and service providers.

The Nifty and BSE Infrastructure indices are wisely diversified, ranging from energy, construction, power, equipment, transport to tourism. The BSE has performed better with higher exposure to PSUs and mid-cap stocks.

Capital goods have outperformed infrastructure stocks due to their thin capital requirements compared to the larger long-term and working capital required by infrastructure companies. Capital goods cash conversion cycles can take 2-4 months in total due to longer inventory, manufacturing and EPC periods and higher dependency on timely disbursement of government funds. As a result, capital goods companies are seeing higher earnings, improved balance sheets and significant upgrades as utilisation rates increase.

Prospects for EPC companies in the infrastructure sector are currently favorable, with daily completion rate of road works increasing by 20% in FY24. This trend is expected to improve in the medium term. Fund mobilisation from NHAI is on the rise, ₹The $2.78 trillion in FY25 is likely to boost corporate orders. India’s gross fixed capital formation (GFCF) to GDP ratio hit an 11-year high of 33.5% in FY24. The new government has acted swiftly to approve 3,000 km of highway projects in 100 days, underscoring its focus on infrastructure development.

Similarly, in the infrastructure sector, sectors like railways, cement, affordable housing etc. will benefit greatly. As of February 2024, the government is 85% committed on capital expenditure for FY24. Further, the government has outlined a purchasing plan. ₹1 trillion worth of coaches are expected to be manufactured in the coming years. Modernisation of 40,000 regular bogies into standard Vande Bharat bogies and ramping up rail coach production are expected to further boost the profile of the sector. The Cabinet’s approval of 3 crore rural and urban houses under PMAY scheme is expected to have a major multiplier effect owing to linkages with over 250 allied industries. Strong infrastructure drive through government’s NIP, GATI Shakti, budgetary outlays, robust order intake and a healthy tender pipeline are expected to drive profitability and improve return margins in the coming years.

Valuation-wise, like the NSE Infrastructure Index, the BSE Infrastructure Index is currently trading at 18x ​​1-year forward P/E, a premium historically but in line with country specific valuations. However, given the robust business and earnings growth prospects, such sectors deserve to trade at a premium and we expect that to continue over the next 1-3 years.

Growth in the capital goods sector is being driven by expansion in capital investment in India. Budget 2024 estimates real capital expenditure at INR 13,700 lakh crore, with capital investment projected to grow at a CAGR of 27.7% from FY22-FY24. India’s GDP is expected to grow at a CAGR of 6-7% from FY24-FY30, with private consumption expenditure projected to grow faster than government spending. The Production Linked Incentive (PLI) scheme is expected to attract investments worth INR 3-4 trillion over the next four years, facilitating the creation of 200,000 jobs.

The average backlog-to-sales ratio of Capital Goods index constituents is a generous multiple of 2x. On average, industry constituents’ sales are expected to grow at an average of 18% annually from FY24-26, while EPS is expected to grow at an average of 24% annually. With most metal prices remaining elevated, margin compression is likely to occur due to rising raw material costs. However, high growth projections should help maintain healthy operating margins. In terms of valuation, infrastructure stocks are in a favorable position compared to capital goods, as discussed earlier. Capital goods are currently trading at all-time highs and trading at a one-year forward P/E of 40x. However, such premium valuations are likely to continue due to the optimistic outlook.

Author Vinod Nair is Head of Research at Geojit Financial Services.

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