Last year should have been India’s year. With investors losing faith in China because of fears over the property market and scandals at US-listed Chinese firms, it was a golden opportunity for the world’s other emerging giant to take centre stage.
In October 2010, Indian stocks had finally returned to their pre-financial-crisis highs. There was widespread hope that reforms would unlock India’s full potential, allowing an economy that had grown at an average of almost 7.5% a year for the last decade to match, or exceed, China’s double-digit pace. Everything seemed to be falling into place.
It didn’t. A year on, stocks are down 23% from their peak – this is almost as big a slide as the one in Hong Kong-listed Chinese stocks. Policymaking is paralysed, with the government flip-flopping on reforms. Bad governance is constantly in the headlines, following a string of scandals, including an alleged US$40bn corruption case involving telecoms licences that directly implicated the then-telecoms minister.
Far from accelerating to 10%-plus, growth is now slowing to around 6%. Many business leaders warn that the country risks losing momentum. The rupee has fallen to a new all-time low versus the dollar and there are dire mutterings about the balance of payments and the budget deficit.
So what’s gone wrong? Can India get back on track? And after recent falls, do Indian stocks represent an emerging-market bargain?
What went wrong?
The first question is easy to answer. The issues that beset India in 2011 were always there – investors were just happy to overlook them in better times. Many analysts like to put China and India in opposition to each other. This isn’t necessarily the best way to look at it from an investor’s point of view – you can always buy both – but as an exercise, it does help to show why India has been so disappointing of late.
The popular argument is that India has far better long-term prospects than China. It’s a democracy. It’s a broadly free-market economy, rather than a state-directed one, meaning that capital is allocated more efficiently. It has better institutions, governance and legal rights. It has far superior demographics.
In historical terms, India is akin to the US of the early 1800s, while China resembles the apparently successful but doomed Soviet economy of the mid-1900s. That’s an attractive picture, and you can understand why it has drawn so many investors to India in recent years (in 2010, foreigners pumped a record US$29bn into Indian equities). Unfortunately, it misses a number of realities about India’s economy.
Yes, India is a democracy – the world’s largest. But while elections are fair, the political outcomes are deeply flawed. Roughly a quarter of the members of the Lok Sabha (the lower house of parliament) have been convicted of, or are facing, criminal charges – many on very serious offences. Unsurprisingly, problems like this at the top indicate widespread corruption throughout the system. India ranks slightly behind China on Transparency International’s Corruption Perceptions Index (China ranks 75 and India ranks 95 out of 183 countries).
Politics is also fragmented. State governments have significant power, while recent governments have been dependent on cobbling together coalitions. This makes it hard to push through major changes, and investors are growing especially disillusioned with the current parliament’s lack of significant reforms.
For example, in November the government raised hopes by promising to liberalise rules for foreign investment in retail chains, only to backtrack when coalition partners said they would not back the changes. This may sound like a trivial change, but retail reform is a big issue: India’s retail sector is highly inefficient and would hugely benefit from foreign expertise and investment.
However, the move is unpopular with the country’s millions of small shopkeepers. As a result, the opposition, which backed liberalisation while in power, is now shamelessly decrying it. It’s a good example of how party politics is letting India down.
Some would argue that India’s messy democracy is ultimately better than China’s more authoritarian system because it respects individual rights and ensures changes are more carefully thought through. Perhaps so, but you can also argue that the Indian system is holding back the country in many ways.
Take infrastructure. China’s government has driven a huge amount of investment in power generation, roads, rail and other facilities. Yes, a significant amount of that will be wasted. But from a development point of view, perhaps it’s better to have too much infrastructure rather than too little; regular blackouts and terrible roads are a huge bottleneck to growth in India.
Or take demographics. It’s certainly true that India is in much better demographic shape than China: its average age is 25 against China’s 35, with a huge number of younger people potentially able to enter the workforce. The trouble is, there aren’t the same opportunities for them to work as there are in China. India’s far more restrictive business and employment laws make it much less attractive to set up the low-cost, low-skill manufacturing ventures that are the first step on the development ladder.
As a result, India simply doesn’t have the capacity to tap its demographic dividend by getting underemployed rural workers off the land and into an industrial economy, as we’ve seen in China.
Issues such as this are holding India back substantially. Talk of the economy consistently growing at 10% or more wasn’t unreasonable – if major reforms are enacted and infrastructure investment steps up.
But right now, India seems to be hitting severe growth constraints at not much more than half that. When growth hit 10% last year, the economy was left overheated and wholesale price inflation is still running at more than 9% year-on-year, despite the best efforts of one of the emerging world’s most competent central banks.
And now the good news
If all this sounds pretty off-putting, it should. The problem was that many of the investors who pumped that US$29bn into the Indian market in 2010 didn’t understand this. They saw India as a great Asian growth story without the more worrying aspects of China. Had they better understood India’s problems, perhaps they wouldn’t have been so taken aback by recent events.
This gap between reality and expectation matters, because foreign investors have a very substantial influence on the Indian market (surprisingly so, given the restrictions on foreign investment – it seems to be driven by the fact that foreign funds tend to bulk buy and sell almost in sync and India lacks the depth of domestic investment institutions to smooth out these effects).
So when foreign investment switched from huge inflows to a small net outflow of US$358m the following year, all momentum went out of the market. To make things worse, domestic sentiment has suffered on the back of the scandals, political paralysis and interest-rate hikes – hence that 23% fall in the Sensex last year.
The good news is that India’s strengths are not a myth – they just need to be kept in context. The country is producing some genuinely world-class companies, especially in the technology sector. The difficulties of operating in India mean that the firms that do succeed are often very well run.
There’s little question that large, private Indian companies are typically much better managed than the large Chinese state-owned ones (although be aware that corporate governance is still a major issue and there are many state-controlled or influenced companies in the Indian market).
Demographics are immensely helpful, while rising incomes – especially in rural areas – mean that India is seeing strong and stable growth in domestic consumption. Reforms and investment are likely to happen over time – it’s just that they’ll probably be much slower than most people would like, both inside and outside the country.
The recent outcry over corruption is encouraging. It suggests the system can be cleaned up in the long run. A government anti-corruption watchdog is almost certain to be set up in the near future, although how much bite it will have remains to be seen.
Even if India is often frustrating, this isn’t necessarily a disaster from an investment point of view. It’s often more profitable to be a firm operating in an awkward, capital-constrained environment than in a much more open one.
China’s infrastructure boom, for example, is likely to mean much lower returns to investors in that infrastructure than to investors in Indian projects with lower competition. Indeed, it’s conceivable that China could be a more successful development story in the next decade or so in terms of lifting living conditions for a larger number of people, but India will still perform better investment-wise.
Right now, the Indian market seems reasonably cheap relative to recent history; the MSCI India is on a price/book ratio of 2.5 against an average of 3.1 since 1995 (this is as far back as Bloomberg data go for this market).
On the downside, investors may have to be patient. There are few obvious reasons for the market to rally strongly in the short term. Yes, the central bank may be able to begin cutting interest rates in 2012 – possibly relatively soon – and we can hope that the government might get its policies back on track as well; moves to open the Indian stockmarket to foreigners are welcome, even if they are a rushed attempt to attract more capital.
However, sentiment remains poor, both domestically and abroad. India needs foreign capital to support stocks and to fund investments in the underlying economy. While the euro crisis continues, investors remain cautious about most emerging markets. GDP growth is likely to slow and company earnings may disappoint. Meanwhile, the government’s finances are in no shape to fund another major stimulus programme.
So there is absolutely no need to rush into India at the moment. However, that said, it is a good time to be planning your entry. The downside from here is probably limited, unless there’s another global panic. And today’s market valuations balance India’s potential and weaknesses much better than they did a year ago or in 2006-2007.
While 2011 was a disaster, 2012 may be an excellent time to look at adding some Indian investments to your portfolio.
Will India open its doors to foreign investment?
One of the frustrating aspects of India for foreigners is its restriction on overseas investments. Only registered foreign institutional investors, non-resident Indians and people of recent Indian ancestry can invest directly in the Indian market. While some Indian companies also have American Depositary Receipts (ADR) and Global Depositary Receipts (GDR) listed in New York and London, it’s a limited selection and many are not attractive investments.
But this may be about to change. Alarmed by the collapse in foreign investment last year, the government has announced that all qualified foreigners will be allowed to invest directly in the Indian market. Unfortunately, the details of this will be announced on 15 January, after this story goes to print, so it remains unclear exactly what ‘qualified’ will mean; it might include a minimum portfolio size or require a bureaucratic process of registration.
Nonetheless, any step forward in opening up the Indian market and allowing us easier access to some of the more attractive domestic companies is welcome.
Don’t expect India to be available at most stock brokers who offer international trading anytime soon – it will remain a niche market for direct investment and if the government expects a flood of capital from this change, it’s likely to be very disappointed.
But if the rules are reasonable, it’s possible that determined private investors willing to do some work may be able to get access sometime in the next year.
Indian investments to add to your portfolio
The Aberdeen New India Investment Trust (LSE: NII) stands out among dedicated India funds, with a clear bias towards higher-quality, large-cap companies. The fund has a total expense ratio (TER) of 1.5% and trades on a discount to net asset value (NAV) of 11.1%, which is slightly wider than its average of 8.4% over the past decade.
More conservative investors will probably prefer it to the other main India closed-end fund, the JP Morgan Indian Investment Trust (LSE: JII). This trust showed more willingness to buy lower-quality firms during the boom (although the portfolio is now more cautious).
However, if you are looking for a more geared (and risky) way to play an Indian market recovery, it has listed subscription shares that expire in January 2014 with an exercise price of 291p (LSE: JIIS). Do be aware that these are far more volatile and less liquid than the ordinary shares.
The Aberdeen team also runs an open-end fund, the Aberdeen Global Indian Equity Fund, which has a very similar portfolio to their investment trust. As is normally the case with a unit trust or an Oeic, the TER is higher at 2.11%, although this can be cut by using a fund supermarket that rebates trail commission such as Cavendish Online. Among other open-end funds, the First State Indian Subcontinent Fund has a very strong track record, but has been closed to new investments; if it reopens, it’s well worth a look.
As for individual stocks, there are a handful of good-quality major Indian companies listed abroad (plus a number of lesser ones). ICICI Bank (US: IBN), the country’s largest private-sector lender, looks attractive at current levels, having been beaten down by fears of rising bad loans as the economy slows. Peer HDFC Bank (US: HDB) is generally viewed as a high-quality and more conservative institution. The IT services and consulting firms Infosys (US: INFY) and Wipro (US: WIT) are among the best businesses that India has.
Many of the most interesting Indian stocks do not have foreign listings, so if the Indian market is opened up to foreign individual investors, the number of investment opportunities will rise enormously, especially in areas such as consumer goods.
For historical reasons, many foreign multinationals have listed subsidiaries in India, meaning it would be possible to invest directly in Nestlé India (IN: NEST); Colgate Palmolive India (IN: CLGT); ITC (IN: ITC), the local associate of BAT; and several others.
Meanwhile, homegrown firms such as Marico (IN: MRCO) and Godrej Consumer Products (IN: GCPL) are using their experience of marketing to rural consumers in India to move into African markets. Motorcycle group Hero (IN: HMCL), cement producer Grasim Industries (IN: GRASIM) and logistics firm Container Corporation of India (IN: CCRI) should also benefit from long-term trends in India’s development.