Has India’s history of high-growth become a hindrance to investment?

Nicholas Earl, 11/11/2019

When Narenda Modi secured a second term in office as prime minister earlier this year, his success at the ballot box seemingly vindicated five years of free market reforms designed to liberalise India’s economy and clean-up its perception as a sleeping giant awash with black money, erratic regulations and conflicting political interests.

However, despite Mr Modi’s best efforts to portray the country as a nation on the rise, building on a legacy of economic growth with reforms designed to both boost its economy and permanently change its image on the world stage, India continues to pose significant problems for investors looking for growth and income opportunities in the emerging markets sector.

The country’s main index, the SENSEX, has an average price to earnings ratio of around 25-times. Considering that the S&P 500 trades on about 17-times, it’s reasonable to think that valuations are a tad stretched. Other high growth emerging markets, such as China’s Shanghai Composite Index, is just 13.7-times. Therefore, India has some issues in trying to   lure overseas financiers to invest in the world’s second largest population. Meanwhile, macro-economic problems continue to diminish investment appetite.

However, India still attracts significant investment, and the reforms implemented by Mr Modi are typically observed with a long-term perspective. Nevertheless, it is conceivable that previous periods of chaotic but impressive growth, and its more flagging fortunes in recent months have dissuaded investors from what could potentially be one of the world’s most attractive markets.

The China problem 

As mentioned above, India’s investment prospects have been hampered by both its recent economic slowdown, and the contrastingly attractive proposition that is China 

From a macro-economic perspective, India has suffered significant difficulties since Modi’s re-election. Its GDP growth rates continue to decrease, falling from eight percent last year to a six-year low of five percent in Q3 2019. Ratings agencies Moody’s, Fitch, S&P and the IMF have all adjusted their growth forecasts for the country, in the past 12 months, decreasing formerly optimistic predictions to more measured outlooks. Productivity has also taken a knock due to declining car sales, house purchases, and a decrease in completed building projects.

The slowdown of growth in India is also being felt in China, which Andy Rothman, investment strategist at Matthews Asia, described as a ’10-year story’. However, while China’s growth into the second largest economy in the world made continued double-digit growth mathematically improbably, India’s faltering growth is not so easy to explain away.

India had its own Lehman Brothers debacle with the default of IF&LS, a firm funded by India’s central bank that many smaller listed companies relied upon for financing, a shadow bank in essence. Ocean Dial Asset Management’s India Capital Growth Fund was hammered by the default of IF&LS, something its manager David Cornell says was “regrettable and avoidable with hindsight”. Up until its default, IFLS had supercharged some of Mr Cornell’s holdings, he mentions one company which until its financing was cut had delivered a 600 percent return.

Contrast that to China and the differences are stark. The Chinese government had a huge crackdown on the shadow banking sector and despite its falling growth rates Beijing has not lifted its restrictions on the practice. IF&LS is an indication of the fragilities of India’s equity market and something investors from the around the world saw and gave them cause to worry.

Meanwhile, China continues to rake in significant sums, securing the largest slices of overseas investment. Foreign Direct Investment (FDI) increased by $34.3 billion in June 2019, which although a drop-off from the $47.6 billion raised in the previous quarter was over double the amount India raised through FDI initiatives ($16.9 billion).

The V8 engine of emerging market growth that is China has also recently opened up its fixed income market to international markets. A bond market that is the third largest in the world after the US and Japan as well giving investors positive yields makes the country even more attractive to foreign investors although its journey in opening up its capital markets has been a long and arduous one. It started with quota systems such as QFII, the initiatives such as the Hong Kong Shanghai Stock Connect and now a similar device for its bond markets has made it easier for foreigners to invest in both its equity and bond markets.

However, China still has some issues that might tilt investor interest in favour of India. For instance, the Chinese government has a ban on foreign ownership of domestic companies and has a history of great volatility as seen in 2015’s Shanghai Composite Index horror show when the index lost over 30 percent of its value in just a few weeks.

The Indian consumer market

China’s recent success is due in part to its transitioning from an export led manufacturing economy to that of a domestic consumption reliant system, which many have said make the US’s trade tariff policy a non-starter. Exports make up for less than 1 percent of its GDP.

Shashank Savla, one of three managers responsible for the Liontrust Asian Income Fund also noted the price conscious nature of the Indian consumer. Approximately 70 percent of the population in India still lives in the rural areas, meaning hundreds of millions of Indian people still depend on agriculture as their main source of income. Furthermore, 70 percent of the average Indian citizen’s income is still spent on food, making consumer staples a major sector as opposed to consumer discretionary, a key ingredient of China’s success.

“The average Indian consumer is quite price conscious,” he explained. “This is even true with mobile services which are growing strongly. It is one of the most competitive markets in the world, and you have data prices which are the lowest in the world.”

Mr Savla also noted that the dividend yield for the market is low, unsurprising given the sky valuations placed on its stocks

He explained: “There are few reasons for this, firstly they are not always able to raise money easily when they want to. Secondly, because of the significant growth opportunities they need a lot to withhold in order to reach capital expenditure.”

India’s investment barriers such as expense and low dividend yields are possibly the chief reason for its lack of attraction to investors. Reflecting investment appetite in the market, Mr Savla’s portfolio only has three percent of its equities in India, despite the size of the country’s economy.

China is not renowned for its inclusive attitude towards investment, providing India with a possible opportunity. China’s government centrally limits foreign money, and while its more developed market is considerably cheaper, its utilisation of state industries and restrictive attitude toward privatisation are not conventionally appealing prospects for investors.

Comparing the two nations, Mr Savla said: “In India, 80 per cent of the private companies are listed companies. So, in terms of market cap, 80 per cent are private and 20 percent are state owned. This is quite different to China where you have 70-80 per cent actually are state owned.”

He also acknowledged India’s equities situation which could be perceived as imbalanced compared to developed markets.

He said: “50 percent of Indian equities is owned by the promoters like SOEs with governments as the owners. The foreign institutional investors own around 20 percent. The rest is domestics like mutual funds and high net worth individuals, corporates and insurance companies.”

Another area of contention for investors comparing India to China are the differences in employment law. In some areas, India is comparably developed to European markets, with strong unions and regulations preventing significant employee overhauls even if the company needs to restructure to reduce costs and adjust to the changing economic climate.

Mr Savla said: “Unions and local regulations make it difficult to fire a large number of people in case the company is not doing well and needs to save costs and restructure. That is also true in a lot of European countries as well.”

He argued that it was difficult for large manufacturing units to set up operations in India, and provide more revenue streams for investors because employers can’t hire and fire easily.

“If anything could be done on that [employment law] it could improve India’s growth potential,” Mr Savla concluded.

However, this view is disputed by Divya Mathur, co-manager of the global emerging markets strategy at Martin Currie.

Mr Mathur believes India has some natural advantages because of the secure employment it provides workers. Recalling a conversation he had with a Taiwanese company, he noted that its manager argued that India’s low turnover of employees was a consequence of the closeness of manufacturing plants to where people, which ensured production was easier to stabilise. This contrasts favourably to China which has high levels of employee turnover because people travel to industrial zones to perform a specific role for an allotted period of time and then return to their home region.

Modi Magic?

Mr Modi’s first five years as prime minister were characterised by sweeping reforms and economic liberalisation plans. His focus was on removing the stigma of corruption in the country, and re-energising its economy. He was by no means universally successful during his first term, with his policies dividing opinion of both the investment world and the wider Indian population, but he was fundamentally rewarded for his reformation efforts with the support of 38 percent of the electorate in May earlier this year.

This notion is supported by highly favourable reaction from the nation’s major press organs to his electoral success, with newspapers such as the Daily Sun titling its lead article following his win with the phrase “Modi Magic”, while the Economic Times proudly proclaimed “Yes! Prime Minister!” across its front page. 

On a turnout of 67 percent and 900 million voters, the Bhajarita Janata Party (BJP) managed to take control of both the Lok Sabha (lower house) and Rajya Sabha (upper house). Defying expectations of a reduced majority or a tenuous coalition, the governing party won 303 of the 545 seats in the lower house, with a leading position in the upper house courtesy of its National Democratic Alliance. This was an increase from the 282 seats it won in 2014, when Modi secured the first majority in India for over 30 years, taking over from an ailing coalition led by the left-of-centre Indian National Congress.

Theoretically, this should make India more attractive to investors, and dilute any short-term difficulties faced by people comparing its current situation with the growth rates of the past. During his first term in office, Mr Modi created a unified goods and services tax, dissolving state differences and additional regional expenses, and also increased capacity for foreign expenditure on railways and construction projects. Other measures undertaken by the former chief minister of Gujarat include extending the expiration date of industrial licenses, and reforming property laws so that deposits and investments in future housing resulted in new constructions and fewer bankruptcies.

He also implemented a sizeable cut in corporate taxes. The effective tax rate has been reduced from 34 per cent to 25 per cent, with new manufacturing firms being set up between now 2023 enjoying an even lower 17 per cent rate.

Explaining the effect of these policies, Mr Mathur said: “I have been investing in India since 1997 and have seen quite a few new governments. But what the 2014 election result did was give India hope. The wasted years in India can include the early years of post-independence up until literally the 1990s. The country was on sub-par growth relative to the other Asian economies and I think what you have to deal with India are very old and informal ways of doing business that need to change.”

He argued that these measures, which he compared to UK prime minister Margaret Thatcher’s privatisation policies in the 1980s show a government trying to address significant structural issues. In the short term, this will be detrimental to growth, but Mr Mathur thinks that the Indian population has affirmed its approval of the reforms by granting him a second majority.

From an investor perspective, Mr Mathur argues India is ready to be open to further foreign direct investment, along with more growth and income funds.

He said: “If you talk to the taxi drivers, and the people in the hotel such as the guy carrying your luggage, and they see the short-term pain. What they are fed up with is what they had been used to in the past. I think the key to understanding Mr Modi is that the first term was about major reforms and getting some formalisation into place, which has really impacted growth unfortunately. De-monetisation and GST both created uncertainty but these are the foundations of what you need to put in place. I think the second term will be more of working on the success of the first term.”

Mr Savla was more mixed about how successful Mr Modi’s measures had been, but did suggest he maintained popular support.

He said: “There have been quite a few changes, an example would be the demonetisation which was controversial which impacted growth for a couple of quarters. On the ground, it was initially supported by a lot of people as the premise was it would root out corruption and black money out of the system and recapitalise the banks. In the end, a lot of the money came back into the system so it didn’t turn out the way they expected it to be, but that did not dampen the support for Modi. He was shown as a strong leader, not afraid to do things differently and brave to take risky measures and also trying to do something to reverse the corruption had become a problem.”

He also pointed to the introduction of the Monetary Policy Committee which targeted inflation. The inflation rate used to be around nine to ten percent in 2013 before he came to power, but has now decreased to two to three percent. From an investor perspective, the bankruptcy act is also attractive. It prevents promoters from just declaring bankruptcy and buying back assets at a cheaper price from banks.

Mr Cornell shared Mr Savla’s outlook on India’s prime minister, and reiterated the importance of his tax cuts.

He said: “The recent reduction in corporate tax levels is a big boost for domestic manufacturing, and the government of India has sent a clear message that it wants to attract more foreign investment in manufacturing at a time when China is looking less attractive for overseas investors. It is a pretty sharp move by the Prime Minister to bring corporate tax rates down to 15 percent for incremental capacities in India. “

Speaking directly about investors, he added: “If the domestic economy is going to grow consistently at seven to eight percent GDP growth, industrials are going to form a major part of that. So, while the market is on its knees, it’s a good time to pick some of stocks up!”

Embracing the future prospects of India

Mr Cornell also believed that the recent problems caused by a slowdown in economic growth and the troubled state of the banking and financial sectors did not change the long-term picture for India. Although India remains a difficult market in the eyes of many investors, its future remains positive. The contrast between its growth in the past and the problems today ignored the significance of its structural reforms.

He said: “People voted for Mr Modi, and they voted for him because every village in India now has electricity - over 100 million toilets have been installed. These are areas of wellbeing that stock market investors rarely focus on or care about but do matter hugely for the man on the street. I think we need to focus on the direction of travel the country is going in, and the incrementally beneficial progress that can be made in regards to productivity.”

Electrifying the towns in India also brings companies supplying a wide range of goods that need power to the fore. India may be on the brink of seeing consumer discretionary rise as a sector as goods such as TVs, fridges and similar products now have a wider customer base.

Commenting on liquidity problems, he added: “The government is also doing a lot to increase liquidity in the market. When the oil price started to go up in early 2018 the reserve bank of India, in order to mitigate higher oil prices, sucked a lot of liquidity out of the Indian economy in order to slow its growth down. Now that its oil prices have fallen back down again and the economy has slowed dramatically, it is reversing that situation by putting liquidity back into the economy. In theory, that should increase the demand side fairly soon but that hasn’t translated yet. So, it is a question of time.

Ramesh Mantri, an independent advisor to the Ashoka Equity Investment Trust, which is managed by White Oak Capital Management, also believed that Mr Modi’s premiership had so far been untainted by the slime of scandal believing this would improve the perceptions of long-term investors.

He said: “He has clearly been very focused on improving governance, and bringing credibility to the office. One of the most appreciated things about Modi is there has not been a single scam in India. Traditionally every government in India ends up with a corruption scandal. His reforms have been pro-clean up and pro-transparency.”

Mr Savla pointed to the growth in both retail investment and mutual fund investment, which could be indicative of large flows of capital in years to come.

He said: “The mutual fund market has also benefitted quite significantly over the last few years as inflows into the markets have been increasing, with systematic investment plans (SIPs) remaining a very sticky project.”

He also noted that the number of SIPs has increased from $28 billion in 2015 to $40 billion in 2016, with monthly SIP inflows moving up to $62 billion in 2017 and to $80 billion in 2018.

Mr Savla said: “It’s just more than a billion dollars a month being put up by households into the equity market, and that’s sticky money as once you have set up a SIP you have set it up for 3-4 years so you don’t change it on the short-term basis.”

Addressing directly whether its history of growth, contrasted with the contemporary situation in India could affect investor appetites, Mr Savla said: “The slowdown is compared to expectations, a few years back there would be some projects that would presume continued eight percent growth but because the growth rate is now five percent there is no need to accelerate those investments or invest more. So, they will wait for growth to improve before spending any more. It is more on the medium term, near term growth has slowed down but I do expect growth levels to recover and capital expenditure going forward.”

He also suggested that immediate positives can be found from India’s policies, with foreign institutional investor inflows increasing from $8 billion to 11.5 billion in the past year, picking up demonstrably since the newly announced corporate tax cut.

He concluded: “Most of the measures Modi has taken are positive for the medium term, with all the reforms he has been doing including bankruptcy and real estate reforms, and GST which created a pan-Indian market will take time to work. India is such a vast and diverse country but all the measures he has been doing are looked at quite positive.”

The approach of the Ashoka Investment Equity Trust, which remains very successful, could perhaps offer a pathway for prospective investors. Mr Mantri believed that to be successful in India it is important to focus not just on superior returns and capital in the present day but growth potential, while acknowledging that established brands and companies are not guaranteed to be successful in the future.

He said: “What you want to see is businesses which have a great future, that is something we are focused on. So, we are looking at businesses that typically have industry structures which are attractive and where competitive intensity is limited.”

“We look for long-term scale-able growth opportunities. India is a fast-growing economy. You want to invest in sustainable industries growing faster than the economy and within that companies getting market share faster than the sector. You want companies increasing the scope of the market, and want market share. When you say sustainable, this also means businesses with an ESG framework, because you can’t have long-term sustainable growth without committing to environmental and social norms along with governance which is super-critical in our process,” he explained.

The trust does all of its 2,000 meetings a year in India, with its nine-person team meeting publicly trading companies, e customers, vendors, experts, regulators, and even ex-employees of potential holdings including CFOs and CEOs, to get a full perspective on the business.

He said: “We believe you can have a very standard investment philosophy as these doesn’t matter much. What matters is the execution of your investment philosophy. The challenge is about having a strong disciplined execution with a high-quality team, which is what White Oak is all about.”

Alongside a thorough approach to investing, Mr Mathur believed that investors need to embrace the changing investment climate in India.

He said: “Investing in emerging markets twenty years ago was very different from investing in emerging markets now. The worry I would have is whether my portfolio manager is aware of opportunities, and do they have an open mindset to the new opportunities of today compared to twenty years ago? When you look at investing twenty years ago in emerging markets, consumer names would be a great place to invest in. There is still a mindset that this is the only where place people should invest, and that ‘we won’t invest in all these new-fangled technology names’.”

Explaining his position to prospective investors in India, he concluded: “We think you have to look at what’s happening and take the opportunities as you see them. We see threats to some of the traditional consumer names, because there is disruption happening across emerging markets, and we see new players coming in. We have to make sure that we correctly analyse those new companies to make sure we understand what opportunities they present. Also, there are going to be some companies that can deal with this as well. There are some companies with a heritage of thirty to forty years, that may continue for another twenty to thirty years.”

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