Some of the most rewarding investments in history have been in businesses that sit quietly in the background, collecting small fees on enormous volumes of activity. Observers of the NSDL Share Price frequently describe the company as a toll collector on the capital market highway. Those who study the CDSL Share Price often use a similar analogy. Such comparisons capture why patient investors find market infrastructure so appealing.
The Toll-Road Analogy Explained
A toll road makes money every time a car passes through, regardless of where it’s heading. Similarly, a depository makes money on the movement of securities, regardless of whether an individual investor profits. This detachment from the success or failure of individual transactions gives the business its relatively stable nature.
As more and more cars pass through, the toll road revenue keeps rising without a similar increase in costs. Similarly, as more and more investors and securities pass through the capital market system, the same infrastructure accommodates the increased traffic without a similar increase in expenses.
Compounding Through Scale
Scale is often a good friend to technology-driven businesses. The fixed costs (data centres, compliance teams) get distributed across a larger volume of accounts and transactions, which in turn improves margins and creates room for distributing dividends.
Long-term investors would love the combination of compounding the company creates via growth in volumes as well as the reinvestment of dividends. The two forces working in unison tend to create exceptional results, so long as the entry point valuation is reasonable.
Barriers That Protect the Franchise
New entrants have an exceptionally difficult time fighting an established franchise in the market infrastructure space. Regulations are strict, requiring years of due diligence before a new entity can clear the regulatory hurdles. Meanwhile, decades of relationships with exchanges, brokers, banks and issuers create a network effect that is extremely hard to replicate. The same network also creates high switching costs for institutional investors, who would have to convince millions of individual investors as well as thousands of intermediaries to switch platforms, for no real reason.
These barriers to entry do not create entry bans, but make competition extremely difficult for the foreseeable future. In an investment context, this means the business can be extremely defensive for a long period of time.
The Importance of Patience and Realistic Expectations
Quality does not always translate to predictable stock price appreciation. Shares of market infrastructure companies tend to rise and fall with the broader market, and often rise much sharper during bull runs due to expectations of increased trading activity. Similarly, stock prices can fall quickly when the mood of the market changes. An overly enthusiastic investor buying during a frenzy may have to wait much longer for profits than someone who has been patiently accumulating shares over a period of time. Even more important, patience in this context means not selling off during a fall, as the fundamentals of the business have not changed.
Complementing the Core Portfolio
The core wealth creation portfolio of most families will focus on diversified equity funds, insurance, and disciplined savings. Once that core is in place, individual equities can play the role of satellites. Market infrastructure companies can fit nicely in the satellite space, as the risk profile of such a business is fundamentally different from most banking, manufacturing or consumer advertising companies. The market infrastructure name is unlikely to rise and fall in tandem with the rest of the market, creating diversification benefits. It must, however, be remembered that such a stock is still a proxy for a healthy market.
What Could Go Wrong
Patient investors must keep in mind that a prolonged bear market can hurt revenues and profits. Softer markets also mean lower volumes and hence potential decreases in transaction-based income. Policy changes from regulators can hurt the business model of such companies, as can defaults, frauds and other events that hurt the reputation of the market infrastructure space as a whole. Valuations can also come under pressure, despite healthy operations.
This awareness will keep patient investors from taking excessive risk, or investing money they cannot afford to leave tied up for long periods of time.
Closing Thoughts
Market infrastructure businesses are compelling long-term investments due to their recurring revenue streams, operating leverage, high barriers to entry and exposure to India’s financial deepening. For the patient and well-researched investor, they can be fascinating areas of exploration.
