By Taponeel Mukherjee
Nate Silver, the American statistician and writer, once remarked: "The key to making a good forecast is not in limiting yourself to quantitative information."
In line with Silver's thesis, global and domestic infrastructure market participants in India, who are in search of the elusive edge that allows them to race ahead of others, will need to look beyond quantitative information to understand the country's economic growth dynamics better and identify undervalued assets.
Infrastructure assets, in general, share some broad characteristics such as being capital intensive, highly regulated, utilised for provision of essential services, and being long-duration in nature; but they vary by level of competition and regulation. Some assets are highly regulated and less competitive, while others are less regulated and more competitive.
Within the broad spectrum of infrastructure assets, "patronage" assets are those that are less regulated and more competitive -- such as airports and toll roads. Since "use" or "patronage" influences these assets, they are more elastic to changes in economic conditions than assets that constitute social infrastructure such as a water pipeline that supplies a city. The variation in the user-demand of an asset as a function of prevailing economic conditions presents an opportunity to the discerning investor to invest in "patronage" assets where the market is not pricing in its correct valuation.
"Patronage" assets such as toll roads, airports and seaports deliver financial returns in two parts: One, a base return; and two, excess consumption-driven return. The first is the basic return one would expect from investing in the infrastructure asset, say, an airport. This base return is the return priced by consensus amongst investors.
Excess consumption-driven return is where the difference in valuation occurs across investors because certain investors value the asset much higher sensing a significant consumption-driven upside. The upside, captured through higher-than-expected "patronage", is what allows real outperformance for investors. Surely a challenging proposition, but one that can assist investors to deliver outsized returns.
For instance, in the case of an airport, it is possible for an investor to understand as to why the actual passenger traffic will be much higher than the passenger traffic projection range that the broad investor base considers reasonable. The investor's above consensus passenger traffic projection could be because an investor has an investment insight, which the rest of the market lacks. The investment insight allows the investor to analyse the potential for the airport asset and understand dynamics that could create exponential growth in passenger traffic in the future.
Alternatively, an investor's capacity to assist in building enabling infrastructure so that actual passenger traffic far outstrips passenger traffic projections could be another reason as to why he is willing to invest into a specific project involving "patronage" assets at a higher price than the rest.
For example, for an airport, the investor might see value in creating a tourism hub centred around the airport rather than a point for the simple movement of people. Hence, the investor is ready to take on additional risk to create an infrastructure ecosystem that can potentially capture significant excess consumption-driven upside.
For those convinced of the consumption-driven boom in India in the decades to come, high growth "patronage" infrastructure assets provide an attractive investment proposition. The excess consumption-driven return is possibly the reason why certain Indian infrastructure assets have seen valuations that were significantly above the consensus value.
While certain "patronage" infrastructure assets provide an attractive investment opportunity, one must bear in mind that such a strategy will succeed provided there is a sound financing structure and excellent risk management capabilities.
The obvious risk with "patronage" infrastructure assets lies in over-bidding. Toll road projects such as BrisConnections in Australia and Indiana Toll Road in the US, suffered from traffic projections that were overly optimistic, leading to sub-optimal results for investors. Thus, it is essential that infrastructure investors here explore the high growth that consumption-driven infrastructure assets offer with some degree of caution.